Super - no pain, no gain

By BRIAN FALLOW

Finance Minister Michael Cullen's superannuation policy is to lay an extra place at the Budget table, for the needs of future superannuitants.

It is an exercise in tax-smoothing - bad news for taxpayers in the short and medium term, good news for taxpayers in the long term.

The idea is for the Government to take more tax than it needs to over the next 25 years in order not to increase the tax burden later on.

The politics depend on the fact that the generation of taxpayers with most to lose, the baby-boomers now in their peak earning years, also have a major vested interest in the fiscal sustainability of the present New Zealand Superannuation scheme.

If nothing is done, once the baby-boomers (born between 1946 and 1965) start moving from the workforce into retirement, the Government will find itself at a beggar's crossroads, which leads to disaster in every direction.

The cost of New Zealand Superannuation will rise inexorably from its present 4 per cent of gross domestic product, eventually reaching 9 per cent by the middle of the century.

All other things being equal, that would push up Government spending from 35 per cent of GDP to 40 per cent, with a correspondingly large increase in taxation.

Given the international mobility of much of the tax base, both individuals and firms, that may not be an option.

The other routes from the beggar's crossroads involve cutting back the entitlement side of the equation.

One option would be to erode the universality of the pension through income testing, as the OECD has recommended. A small step taken in that direction in the 1990s, the surcharge, was deeply unpopular and eventually abandoned.

Another option would be to reduce the value of the pension relative to other incomes. But when the previous Government messed with that, allowing the married couple rate to fall below 65 per cent of the average wage, it paid an electoral price for doing so.

Raising the eligibility age from 65 would be another option.

Dr Cullen's plan to avoid arriving at that crossroads is to "partially pre-fund" superannuation, building up a national nest egg while the demographic going is good.

Much of the discussion of the viability and credibility of the policy has centred on the outlook for Budget surpluses.

Will the surpluses be there to pay for it? But this is a red herring. Dr Cullen is not proposing to take the Budget surplus - the difference between Government revenue and spending, whatever that happens to be - and hand it over to the fund managers to invest.

Rather, the policy is to crank up the flow of tax dollars into New Zealand Superannuation from the current 4 per cent of GDP to around 6 per cent.

The excess over what is required to pay superannuitants will be invested, building up over the next 25 years, then drawn down to help carry the fiscal load (see graph, D3).

That excess will vary. On present projections it peaks at $2.4 billion in today's dollars in 2010. "By then, though, GDP will have grown, so the contribution is about 1.7 per cent of GDP," Dr Cullen said.

"There is a tight period from 2005 to 2010 during which something like 1.7 to 1.8 per cent of GDP has to be put into the fund. That tightness reduces gradually over the following 15 years. It is a discipline, but not the fiscal straitjacket it is being portrayed as," he told a conference of fund managers last week.

Dr Cullen is, of course, not the first Finance Minister to recognise the problem. The policy of running fiscal surpluses and repaying public debt over the past decade was all about reducing debt- servicing costs and strengthening the Crown's balance sheet in anticipation of the looming blowout in superannuation and health costs.

eipBut the main inroads into public debt were made in the mid-1990s.

When Budget surpluses are projected, debt reduction has to compete for them with increased Government spending and tax cuts.

By the late 1990s, debt reduction was the runt of the fiscal litter.

Rather than hope it will fare better in future, Dr Cullen proposes to introduce a vigorous and greedy new piglet, pre-funding.

The question is whether it will tend to crowd out the existing piglets - health, education, police, defence and so on.

Dr Cullen, unsurprisingly, says no. The Government's medium-term fiscal projections (from 2003-04 on) include a "fiscal allowance"of $1.2 billion a year, a sort of contingency fund to allow for weaker-than-expected economic growth or new spending initiatives.

Dr Cullen says that with that $1.2 billion allowance, and the pre-funding, the Government will still operate within its target of keeping spending around 35 per cent of GDP with a degree of comfort over the coming decade. "That, remember, is the decade in which contributions impose the greatest discipline on the Government."

But it does not leave much of a margin of error. On past performance, the Treasury's economic growth forecasts two years ahead are liable to be out by 1.6 per cent. A forecasting error of that order could alone wipe out half the $1.2 billion allowance.

Under Dr Cullen's scheme the Treasury will have to calculate each year the contribution the fund would require if the contribution rate were to be held constant as a percentage of GDP over a rolling 40-year timeframe.

In exceptional circumstances, Dr Cullen says, the Government may choose to contribute less than is required, but it will have to be upfront if it is falling behind and what it will do to make up the shortfall.

How that trade-off between flexibility and credibility plays out over time is clearly crucial to the scheme's success.

Ask economists about the plan's economic effects on national savings or economic growth and it is difficult to get a straightforward answer. "It's desirable, I guess, to have a degree of tax smoothing," said AMP Henderson's head of investment strategy, Paul Dyer.

"Instead of putting up taxes gradually over the next 30 years we are going to run tighter fiscal policy in the short term and then not have to put [taxes] up so much in the future.

"But you don't need the super fund to achieve that result.

"If the Government wanted to run bigger surpluses now and just use those to retire debt, you would get the same result."