The Requirements for Long-run Fiscal Sustainability

Bob Buckle Victoria University of Wellington

Affording our Future Conference

10 December 2012

• Can Governments in the future:

– Continue to provide the range and type of public services currently offered,

– without incurring excessive and unsustainable levels of taxes and/or public debt?

• Can governments afford in the future what governments are offering today?

What is fiscal sustainability?

Why does it matter?

• Levels of Government debt can influence: – Inflation and the real exchange rate,

– Risk premium on borrowing,

– Risk of sudden reversals (of foreign lending),

– Scope for governments to “income smooth out” in response to adverse shocks (recessions, financial crises, natural hazards).

• Taxes have efficiency, growth, distribution effects.

• Inter-generational effects (high debt today ⇒ higher taxes tomorrow).

The GFC has highlighted these risks

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Government Debt, Ireland 2006-2012

High Government Debt can be costly

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2007 2008 2009 2010 2011 2012

UK Germany Ireland

5-year sovereign credit default swaps

Finite-horizon inter-temporal budget constraint

- = Target future public debt to GDP ratio

Inherited level of public debt plus sum

of interest paid on that debt over the

future.

Sum of future primary balances (t-g) and interest paid (or

earned) on those balances.

• Returning to “What is fiscal sustainability?”.

• Budget conditions required to achieve an acceptable level of govt. debt in the future (See Fig. 4 in the paper):

What is a suitable debt target?

• Several possible fiscal targets or anchors.

• Many governments, including NZ, target debt: – Doesn’t presume an optimal size or role of Govt.

– May be a weak discipline on spending when tax revenue growth is high.

• In NZ, Public Finance Act requires government to manage total debt at “prudent levels”.

• “Prudent” will depend on: Who holds the debt, level of private debt, reputation, risk appetite.

Recent NZ Govt debt and targets

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General government gross debt as % GDP(2011)

How does NZ’s level of Govt debt compare?

% GDP

Projected Govt revenue and expenses (as % of GDP)

Source: Treasury

Projected Govt debt and net worth (% GDP)

Source: Treasury

Which parts of the budget are expected to change?

Source: Treasury

% of nominal (GDP) 2010 2020 2030 2040 2050 2060 Δ

(% points)

Health 6.9 6.9 7.9 9.1 10.1 11.1 4.2%

Superannuation (NZS) 4.4 5.3 6.5 7.2 7.3 8.0 3.6%

Education 6.2 5.2 5.1 5.1 5.1 5.2 -1.0%

Other Op. Allow. Covered (eg. Justice) 8.3 7.4 7.4 7.5 7.5 7.6 -0.7%

Non-NZS Welfare 6.8 5.0 4.3 3.8 3.3 3.0 -3.8%

Debt-financial Costs (DFC) 1.2 1.9 2.4 3.8 6.0 9.5 8.3%

Total Expenses 33.9 31.5 33.5 36.4 39.3 44.4 10.5%

Revenue (majority tax) 30.2 32.3 32.6 32.5 32.5 32.6 2.4%

Operating Balance (R-E) -3.7 0.8 -1.0 -3.9 -6.8 -11.8

Balance excluding DFC

-2.5 2.7 1.4 -0.1 -0.8 -2.3

Operating balance with and without a debt target

Source: Treasury

-14%

-12%

-10%

-8%

-6%

-4%

-2%

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6%

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Operating balance, Cost pressure scenario

Operating balance, Sustainable debt scenario

What’s influencing these projections?

• Assumptions about tax revenue as % GDP.

• Interest rates on Govt. debt.

• Assumptions about indexation of welfare payments.

• Impact of ageing, income growth, expectations on welfare, health services, etc.

• Demographic and labour force projections.

Demographic Projections for NZ

1960 2010 2060

Fiscal reform has happened before • Welfare reforms after two world wars and the

1930s depression.

• Growth of education after post-war “baby boom”.

• Institutional reforms post-1985.

• And in the future, role of the state could be impacted by: – Changing preferences as real incomes rise and technology

changes, and

– Demographic change due to lower fertility rates and people living longer.

Fiscal sustainability is a concern to many developed economies

• NZ concern over sustainability reflected in – Public Finance Act in 2004.

– Two previous Treasury Long-Term Fiscal Statements (2006 and 2009).

• Fiscal sustainability assessments by OECD, IMF and by other countries.

• Population ageing is a common concern, but not the only influence on fiscal sustainability.

Percent of the Population Older than 65 as a Share of Population Aged 15-64

Source: OECD

Population ageing across the OECD

Population ageing, rising incomes and the fiscal position

• Population ageing is a “good news” story: – People living longer; labour participation amongst

older age groups rising.

• Will have economic and fiscal effects.

• Treasury captures some of these and other effects using their Long-term Fiscal Model.

• A range of government expenditures are age- and income-related, e.g. public health care and superannuation.

Timing of policy reform

• Timing and pace of adjustment important.

• The future and fiscal projections are uncertain.

• May be benefits to waiting for more information before committing to fiscal reform.

• But, there may also be costs to waiting: – Size of fiscal adjustment may rise as total debt and debt

servicing costs rise.

– Reform may get harder as more voters move into the older age brackets.

Illustration: Delaying fiscal adjustments

• If fiscal adjustment starts in 2015:

– Need annual operating balance surpluses of 1.9% of GDP for a decade to pay down debt to 20% within a decade.

• If fiscal adjustment starts in 2020:

– Need annual OB surpluses of 2.2% of GDP for a decade to pay down debt to 20% within a decade.

Conclusions and conference issues

• Fiscal sustainability matters.

• Population ageing, rising incomes and expectations will influence fiscal futures.

• Governments have to decide on: ‒ Suitable fiscal anchor (or debt target), ‒ When to act, ‒ Whether to act - public services and/or tax rates, ‒ How to reform public services (health,

superannuation or other services). ‒ Decision framework to assess benefits and costs of

the options.