No easy options to balance Government's books

This year will be extremely tough year for the public service.  Public sector and welfare reforms were going to be demanding enough. Now, filling a bigger than anticipated fiscal hole will provide a far tougher challenge.

It now seems very unlikely that the government is going to get its books back to surplus by 2015, despite keeping tight reins on spending.

The global economic outlook weakened considerably in the latter part of 2011. In the Euro area, politicians have not been able to find credible and lasting solutions to avoid the public debt crises in Greece and Italy of spreading to other countries. The lack of political agreement on fixing the US public sector deficit is weighing on the US economy. The risk is that things could get much worse.

The New Zealand economy is lacklustre too, as households are paying back mortgages, rather than adding to them, and businesses are holding back on investment. New Zealand’s export outlook has also lost its gloss because of the European crisis and slowing Asian growth.  The situation will not change any time soon. Deleveraging is a slow process, and economies take many years to recover from financial crises.

The net result is that tax revenues in the years ahead will be lower than was expected in the pre-election fiscal update.

Consensus forecasts indicate a 1 billion dollar budget deficit in June 2015, rather than a surplus. At NZIER we see reasons to be far more pessimistic about economic growth. If we are right, tax revenues could be 5 billion dollars less than forecast in 2015, while spending on income support and interest payments would be higher.

Regardless, the prospect is a fiscal deficit, not a surplus, and the hole will be substantial. This is large enough to eat up most, if not all, of the 0.8 to 1.2 billion dollar earmarked for new public spending each year.

There are three broad options that can be tried alone or in combination to get back to surplus by 2015.

One option would be to cut spending. Reducing the number of bureaucrats in Wellington won’t be enough. The magnitude of the shortfall implies shelving the 5.2 billion dollars of earmarked new money, a zero budget for the next three years.  This would be a very tough ask: a large share of the new money goes to the health sector just to stand still, covering rising costs from population growth, ageing, and inflation.

Under NZIER’s growth forecast, shelving only the earmarked money would not be enough: twice or three times as much would be needed. At those levels cutting public spending may be counterproductive, undermining already weak economic activity and tax revenues, at least in the short run. Europe is a reminder that strikes and social unrest are just around the corner from drastic cuts.

The areas where savings of such magnitudes could be made are either off-limits (for example, the poorly conceived interest free student loans or the breadth of Working for Families), or need timeframes that extend beyond the government’s target to return to surplus by 2015.

The single biggest cost centres are superannuation and health. But the public needs time to prepare to cope with meaningful and needed changes to New Zealand superannuation.  And structural changes to achieve more cost-effective health care delivery would also take years.

The second option is to raise taxes. The election showed there is not much political appetite for this. And raising taxes can supress activity and so be counterproductive for tax revenue in the short term, and for economic growth in the long term. If set too high, taxes would discourage work and entrepreneurship, and encourage avoidance.  

The third, and painless, option would be to grow the economy. But there is no instant fix. The government can create an environment that supports medium term economic growth: regulations and taxes that encourage work, enterprise and innovation; and investment in public infrastructure and skills to support economic activity. They are all important, but any initiative is unlikely to have meaningful results in the next three years.

There is an alternative strategy. That is to push out the target to return to surplus, as 2015 is no longer credible without drastic action. If this were contemplated, it should not come at the cost of abandoning tight fiscal management. A new, credible target to return to surplus would need to be set to appease financial markets.

As public servants come back from holiday, they will again be asked to identify the lowest value programmes they think could be stopped or scaled back, and to achieve more with less. But this time around the low hanging fruits have gone. None of the available options will be easy or palatable.

Jean-Pierre de Raad is the Chief Executive of the New Zealand Institute of Economic Research.

NZIER is an independent economic research and consultancy group.  Part of its responsibility as a non-profit Institute is to promote debate on New Zealand’s economic challenges.