Dialogue: Get used to miser's touch

It's a mean Budget, sandwiched between last year's spending initiatives and next year's election campaign, says BRIAN FALLOW.

On the face of it, the Budget's forecasts for the coming years are encouraging for anyone looking for expensive fiscal initiatives - whether new spending or tax cuts.

Burgeoning operating surpluses are projected - $641 million for 2000-2001.

But they are basically a mirage.

If you think this Budget is austere and miserly, get used to it. There are more where that came from.

Last year's "front-loading" and the prospect of prefunding New Zealand Superannuation respectively have pre-empted and will pre-empt about half of the underlying real growth in revenue, leaving barely enough to keep real, per capita spending constant.

There are several reasons for not taking the projected surpluses as reliable indicators of the affordability of future spending or tax relief.

For one thing, the operating balance is not simply the difference between the Government's revenue and its spending.

It also reflects revaluations - that is, changes in the net present value of the cost of public servants' pensions and the cost of meeting long-term ACC claims for accidents which have already happened.

These rise and fall with interest rates and can substantially blow the operating balance around. This year revaluations will wipe $1.1 billion off the operating surplus.

So the Government has introduced a new measure, the Operating Balance Excluding Revaluations and Accounting Changes (Oberac) to reflect the manageable part of the fiscal outcome.

Oberac shows rising surpluses, but the projections do not reflect the cost of Government plans to start building reserves to partially meet the future cost of the state pension.

Apparently this is what the GAAP accounting standards require, but it is nonsense. GAAP requires prefunding to be treated not as an expense, like teachers' salaries, but as a capital item, like student loans.

But the reality is that prefunding would represent a major, continuing claim on future tax revenues, exactly as if the Government was setting up a ministry requiring an annual budget of more than $2 billion.

If Oberac did reflect prefunding, it would lop $600 million off the surplus for the coming year, $1.2 billion off 2002/03, $1.8 billion off 2003/04 and $2.9 billion off 2004/05.

As for what is left, that is subject to forecasting error - and the margin of error when forecasting economic growth even a year or two ahead is substantial.

A study of the Treasury's macro-economic forecasting record by Dr Arthur Grimes of Victoria University's Institute of Policy Studies found that it was on average out by 1.3 percentage points in its year-ahead view of GDP growth, and by an average of 1.6 percentage points two years ahead.

This just reflects the intrinsic difficulties of economic forecasting and New Zealand's vulnerability to shocks, such as the current slowdown in world growth and the drought in parts of the country.

Private-sector forecasters are no better, and the Treasury is as liable to underestimate as to overestimate growth, Dr Grimes found.

But an error of 1.3 per cent on GDP growth would add or subtract about $500 million to or from the operating balance.

It seems, then, that if you want a handle on the Government's ability to pay for major spending initiatives or tax relief, you have to look at the fundamental drivers.

The economy's trend growth rate, at a generous estimate, is 3 per cent a year. The Government represents about a third of the economy.

So its revenue should rise by the equivalent of 1 per cent of GDP, or $1 billion, a year on average in real terms.

Such a figure is also consistent with the Government's self-imposed triennial spending cap.

The problem is that last year's Budget "front-loaded" spending initiatives and, in the process, limited the amount available for new spending this year to $600 million and a similar amount next year.

The Government has not been able to live within that limit this year, and 2002 is an election year.

Then there is the impact of prefunding, which will require about 2 per cent of GDP when fully up and running.

Put another way, it will mop up two years of the natural, underlying real growth in the Government's revenue. As it is to be phased in over four years, the annual impact will be to pre-empt only half of that underlying growth.

The other half is barely enough to offset population growth and keep real per capita spending steady.

This line of argument assumes, of course, that the Government will be able to muster the parliamentary numbers to pass the New Zealand Superannuation Bill, which is still before a select committee.

It also assumes that the Government will not resort to increasing tax or returning to deficit financing.

New Zealand is already more heavily taxed than its three largest trading partners - Australia, the United States and Japan. In light of the difficulties New Zealand already faces in attracting and retaining both capital and skilled labour, going against the OECD trend of falling tax-to-GDP ratios does not look smart.

After seven years of running fiscal surpluses, a return to structural deficits would not be a good look, either.

The credit rating agencies have been clear about this. New Zealand (as distinct from the Crown) is up to its nostrils in debt to the rest of the world.

This is all private-sector debt. Nevertheless, Standard & Poor's has warned that the private sector's reliance on overseas savings leaves the Government little room to deviate from cautious fiscal policy.

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