Two Cheers for NZ’s Fiscal Responsibility Act

Researchers associated with Stanford University have produced a Sovereign Fiscal Responsibility Index that is an assessment of the strength of a country’s current and projected fiscal outcomes and the quality of its fiscal governance arrangements.

The 2011 rankings here put Australia top of the 34 countries in the index for 2011 and New Zealand second to top.  Australia and New Zealand have relatively strong existing fiscal positions, fiscal projections (to 2050) that look relatively sustainable and relative good fiscal institutions.

The achievability of fiscal projections out to 2050 is clearly a matter of opinion, and New Zealand’s fiscal outlook looks problematic to many given our history of government spending blowouts.

Less problematic is New Zealand’s top score for the fiscal governance component of the index.  Much of the credit for this must be given to the provisions put in place by the Fiscal Responsibility Act 1993 that are now in the Public Finance Act.  Its focus on achieving and sustaining debt at a prudent level through fiscal surpluses on average during each economic cycle could have been (but was not) tailor made for the purpose of giving New Zealand its top ranking.  It surely also deserves some credit for New Zealand’s relatively strong fiscal position, including, the battle by each of the main political parties in the last general election to establish themselves as the party best able to restore fiscal surpluses.

So why the current drive to improve the fiscal position and New Zealand’s underlying fiscal governance arrangements?  Here are two reasons:

  1. A responsible fiscal position is one thing, fiscal settings conducive to greater prosperity and a better quality of life for New Zealanders is another.(The Fiscal Responsibility Act was silent on the question of whether a large amount of low quality spending and unnecessarily high effective marginal tax rates were making New Zealanders at large worse off.  Yet these things matter.)
  2. The enormous increase in government spending in New Zealand between 2005 and 2009, in conjunction with the Christchurch earthquakes, and the drop off in tax revenues have spilled New Zealand into large, fiscal deficits that threaten to persist.(This is a problem independently of New Zealand’s ranking and it is an open question as to whether the Stanford ranking (based on 2010 statistics) fully captured the current extent of the problem.)

See here for an article on the proposed cap for government spending.

Friday Graph: Our Fragile Deficit/Debt Situation

The OECD’s first detailed economic forecasts out to 2013 were released in December.  They include projections for four measures of the fiscal deficit for general government in New Zealand.  (General government is central and local government combined, but central government is the dominant component.)

This Friday’s Graph puts these forecasts into a post 1994 context.

click to enlarge

The graph shows that general government mainly ran fiscal surpluses from 1994 until 2008.  But it has since run significant fiscal deficits, which are persisting.  (The OECD has a detailed explanation of these measures here – scroll down to the notes to tables 27-30 inclusive.)

These persistent deficits are the first real test for the Fiscal Responsibility Act 1994.  It was passed in 1994 in order to make it harder for future governments to repeat the deficit/debt spiral governments put the country into between 1975 and 1984.  The debt spiral occurred because they largely opted for ‘borrow and hope’ rather than fundamental adjustment in responding to two global oil price shocks.

A core feature of the Act is that it requires governments to achieve and maintain prudent debt levels by “by ensuring that, on average, over a reasonable period of time, total operating expenses do not exceed total operating revenues”.

Older New Zealanders do not need today’s Euro and US debt crises to remind them what serious economic problems governments create when they fail to keep deficits and debt under control.  Between 1976 and 1984, according to Treasury’s adjusted financial balance measure here, central government’s annual fiscal deficit to GDP ratios summed to 25 percent of GDP.  The fiscal deficit peaked at 6.9 percent of GDP in 1983-84.  Large deficits tend to persist.  Successive governments wrestled to eliminate those deficits for the next decade. By 1993, the cumulative deficits since 1976 amounted to 50 percent of GDP.  Net public debt was 48 percent of GDP, up from 9 percent in 1976.  The cost of servicing the debt peaked at 19 percent of tax revenues and at 8 percent of GDP in 1988.

So how does the current deficit situation compare?  Treasury’s projections in the 2011 pre-election economic and fiscal update (PREFU-2011) indicate that core Crown net debt, inclusive of the NZS Fund assets, will increase by around 18 percent of GDP between 2008 (when net debt was minus 1.5 percent of GDP) and 2012 when net debt is forecast to be 16.8 percent of GDP.  The sum of the actual and projected annual ratios of the total Crown operating balance to GDP between 2009 and 2012 is minus 21 percent of GDP.  In short, in just these four years, these cumulative movements are uncomfortably close to the increases that it took the earlier governments eight years to achieve between 1976 and 1984.  Another uncomfortable point of comparison with 1984 is that the Crown operating deficit for 2012 is forecast to be 6.0 percent of GDP.  Much more cheering is the fact that New Zealand’s score for economic freedom today is vastly higher than it was in 1984.  A freer economy can be a more resilient economy.

PREFU-2011 projects the elimination of operating deficits in just three years from here – by 2014-15.  But these projections assume sustained expenditure growth constraint and favourable overseas outcomes, including further increases in export prices relative to imports.

However, history shows that New Zealand governments are not good at sustained expenditure restraint, and the composition of today’s parliament gives little comfort on that score.  Meanwhile, the fragility of fiscal positions in the Euro-zone and the US is nothing short of alarming.

In short, eliminating the operating deficit by 2014-15 is far from in the bag.  The fiscal responsibility measures that are now in the Public Finance Act arguably need more mates.

The government’s welcome determination to legislate for a spending cap should help make more credible its commitment to keep control of spending growth.  But even with this measure, there is no avoiding the fragility of New Zealand’s fiscal position at this point, given the external risks.

Despite the assumed spending control to 2016, the ratio of Core Crown operating spending to GDP would still be higher at the end of that period than in any year from 2002 to 2005.

There is widespread agreement that much spending – not just on interest free student loans – is wasteful and unnecessary.  More decisive action aimed at withdrawing government entirely from unnecessary spending programmes and activities, while sustaining well-justified spending, would arouse more intense opposition in the short-term from narrow spending interests, but should reduce the fragility of the fiscal position and make the goal of eliminating fiscal deficits in a few short years more credible.  However, ill-justified spending should be eliminated regardless.  It is not in the national interest for governments to tax and spend poorly.