Strategic priorities for the 2005 budget

The fiscal headroom available to the government is much smaller than media reporting would suggest.

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21 February 2005

Hon Michael Cullen Speech Notes : 6pm Monday 21 February 2005 Strategic Priorities for Budget 2005 & Beyond Level 6, 22 The Terrace, Wellington

Anyone who has lived in New Zealand for twenty or thirty years will appreciate the irony in the way government accounts are presented nowadays. Those of a cynical bent will remember budgets in the 1970s and 1980s as a kind of fiscal makeover. An ailing invalid (or possibly even a corpse) was pumped full of hormones and dressed in fancy clothing so as to give an appearance of vitality to the financial journalists.

On occasions it seemed the definitions of accounting terms were stretched almost to breaking point in an effort to make deficits seem friendly, unfunded liabilities seem benign, and expenditure blowouts seem just a little harmless fun. One thinks immediately of Sir Robert Muldoon's appearances in the Rocky Horror Picture Show, plastered with makeup and taking indiscriminate jumps to the left and the right.

Perhaps that is an overly cynical view. Whatever the case, nowadays we have a different challenge. After five years of solid economic growth and conservative fiscal management we have a set of accounts that is robust and that has underpinned a period of almost unprecedented economic stability, bringing numerous benefits to New Zealand businesses and the community at large.

The perception, however, is that the government's finances have now entered a golden age, with unlimited capacity to sustain additional expenditure commitments. Expectations are running well ahead of fiscal prudence and even fiscal possibility, so my challenge this year is to encourage a more realistic and sober view of the government's financial position.

The fact is that we are indeed in a reasonable state of good health. But we know one of the biggest enemies of good health is over indulgence, which is what nearly all opposition politicians and lobby groups are conjuring up in their public statements.

In the December Economic and Fiscal Update the Treasury increased its budget night growth forecast for the current year from 2.8 per cent to 4.7 per cent and its forecast for the operating surplus from $5.7 billion to $6.5 billion. This will allow a modest set of increases in the indicative allocation for new expenditure and a reduction in the domestic borrowing programme for this year from $2.35 billion to $2.15 billion.

However, the near term outlook is not so positive. Falling terms of trade, declining net migration, slower consumer spending and the effects of higher interest rates and a higher dollar are tipped to pull the growth rate back to around 2.5 per cent in the next two years. Accordingly the operating surplus is forecast to peak this year at $6.5 billion and fall to $6.2 billion in 2005-06; $5.3 billion in 2006-07; and $4.9 billion in 2007-08.

These declining operating surpluses will be almost fully absorbed in contributions to the New Zealand Superannuation Fund and in funding the government's capital programme.

Nominal debt will begin to rise slightly after 2006, moving from $32.9 billion to $34.9 billion in 2008-09. However, gross debt as a proportion of GDP is projected to fall steadily over the forecast period from about 25 per cent currently to about 20 per cent, where it is likely to plateau. Meanwhile, net debt is forecast to fall to 7.6 per cent of GDP by 2007-08 and to zero when offset against the $15.2 billion assets projected for the Superannuation Fund in that year.

That still leaves us needing to address very significant ongoing expenditure pressures in areas such as health care, which force upon us difficult trade-offs even within current baselines.

Our public health spend in 2004 was $8.1 billion (which represents one in five dollars of government spending). That is an increase of $2.3 billion from the $5.8 billion of expenditure in 1999. The pressure for more expenditure on health care is a perennial concern and it is a worldwide phenomenon although it is in the interests of some lobby groups to portray it as a purely local issue.

On the supply side, we have a globalised health care industry in which very large investments have been made in human and intellectual capital, in the shape of training, hi-tech equipment and pharmaceuticals. All of these are seeking an adequate return, if not the maximum return possible. Hence the shortages of health care workers of various kinds, and the phenomenon of health care-related inflation constantly running above the rate of inflation at large.

On the demand side there are rising expectations as to the quality, timeliness and affordability of health care. And alongside that a sometimes unclear relationship between expenditure on health care and improvements in the health status of the population. Hence the familiar tension between interventions which prolong one life, and public health interventions in areas such as community mental health or child health screening, which have a more diffuse but arguably more significant impact on the health of communities. Both are clearly important; but how to get the mix right is an ongoing challenge.

Despite these kinds of expenditure pressures, we have been able to pay dividends from careful fiscal management. We have increased investment in infrastructure, in education and housing, and, through the Working for Families package announced in last year's budget, we are implementing a major programme of expenditure aimed at supporting the incomes of families caring for children. There has been nothing niggardly about this government, just a firm commitment to prudent long term fiscal goals and a drive to ensure that public spending is good quality in terms of value for money.

So there will be few surprises in the content of Budget 2005. Where you may notice some change is in the presentation. After a five year struggle I am about to give up as lost the effort to educate the media on one of the basic questions of third-form accounting: What is cash? There does not seem to be any way to explain the difference between an operating balance (which normally includes a variety of non-cash items, such as depreciation and unrealised increases in the value of assets) and a cash surplus which may be available for new expenditure, or if you like for tax cuts.

I am not for a moment suggesting any move away from sound accounting principles. The operating balance (specifically the OBERAC, or operating balance excluding revaluations and accounting policy changes) is an important indicator. It describes the starting point for assessing the health of the public purse, and for considering strategic options in terms of investments in capital (in the form of infrastructure, hospitals, prisons and so on) and management of long term liabilities such as the impact of population ageing and the maintenance of prudent levels of public debt.

The problem is that the operating balance has not served us well as a headline indicator. In political economy terms it can create the illusion of spending options that do not really exist, and it leaves me as finance minister defending complex truths against an attack of appealing half-truths. That is never a fruitful debate.

The truth is that if one looks at the cash surpluses we have run, they are relatively modest, and the outlook is for them is shaky. In 2003/2004, for example, we achieved a cash surplus of $520 million. The current forecast for 2004/2005 is for a cash surplus of $1.4 billion. However, this cash build up will be needed to fund capital spending during the next three years, when we are anticipating cash deficits of $705 million in 2006 and around $1.5 billion in 2007 and 2008.

As was noted in December's Budget Policy Statement, current forecasts provide scope for some additional spending in the short term beyond that signalled while still meeting the debt objective. However, prudence dictates that any such spending should not be economically stimulatory and should be fiscally neutral over the longer term. In layman's terms, that means that the relatively small and uncertain cash surpluses that are forecast are not sufficient to support the kind of tax cuts that those on the right are proposing, or the kind of expenditure increases which (ironically and schizophrenically) those on the right are also proposing.

Once we take account of capital investments, which are essential for future economic growth, and investments in the New Zealand Superannuation Fund, which are essential for future fiscal stability, what we have left is a thin layer of fat. What National and others are proposing would involve cutting into the muscle and weakening our fiscal well-being. Sadly this fact is lost upon many New Zealanders.

The major purpose of a set of accounts is to provide a transparent picture of the government's financial position for accountability purposes and a sound basis for considering and debating investment decisions. If the structure of our government accounts is failing to do that because important players in the public discourse have difficulty grasping the true nature of the government's bottom line, I have no qualms about changing it to make it clearer.

So you can expect to see in Budget 2005 the familiar level of financial transparency under the Public Finance Act, but greater clarity on the cash position, which is the amount that is actually available as a spendable surplus. Then we can have an informed debate on the evidence about how sustainable that is over time, and whether we can realistically entertain structural changes to revenue or expenditure.

So much for the accounting side of things. In terms of economic strategy, the emphasis this year is likely to be on two major areas of ongoing weakness in an otherwise very strong game. These are:

· savings; and

· productivity.

There has been an ongoing debate over the relationship between domestic savings rates and economic growth. The neo-classical position argues that so long as you can readily access someone else's savings it does not matter how much you save yourself. Not surprisingly, this argument has held sway in the United States, which has never had any problems dipping into the savings of others, whether the Japanese or the Chinese or the Arabs or the European pension funds.

The opposing argument is that the US experience cannot be automatically replicated elsewhere. It points out that growing economies other than the US, such as much of Western Europe, China and Japan, tend to have higher rates of domestic savings. Indeed the US is starting to realise that there is a limit to how long foreign investors will continue to fund their deficits. Hence the Bush administration's suite of initiatives to support an 'ownership society'. Even they seem to be learning that tax cuts are not self-financing.

Partly this is a matter of increasing the size and depth of the domestic capital market. But it is also about the positive side-effects of having a larger proportion of the population with stake in the market, and a stake that extends beyond the housing market. As David Skilling of the New Zealand Institute has put it:

Asset ownership is increasingly important for meaningful participation in society and the economy. Ownership enhances the ability of people to access opportunities and to invest in the future - by buying a house, financing education and so on - and allows people to cope with shocks. Assets provide greater security, control and independence. A broad distribution of ownership also generates enhanced social cohesion at a national level, and ensures that more New Zealanders obtain the benefits of economic growth.

If we just look narrowly at the Australian experience of compulsory workplace superannuation, there is now a greater level of financial literacy amongst the Australian population, and arguably a greater appreciation of the skills needed to create and manage wealth.

The jury is still out on exactly how all the causal links work: what type of economy is most likely to benefit from domestic savings; how saving for a first home or for an education links into retirement savings, and so on.

So what might we see in the budget regarding savings? In general we will see a savings package that is designed to facilitate rather than to coerce and to "be there" through the individual's full life cycle: through the years in education and training; through the establishment of a family and the acquisition of a first home and, finally, through retirement. But the resources available to support these aims will be limited.

A number of things have already been signalled, and the budget will provide more detail:

· We believe the workplace is the ideal context in which most New Zealanders can arrange long-term savings, and so you can expect a set of measures aimed at rebuilding strong work-based superannuation schemes. Following on from the recommendations of Peter Harris's report last year, there will be a number of mechanisms through which the government will encourage participation amongst employees and minimise the transaction costs for employers.

· We are moving to resolve the anomalies in the taxation of savings and investment, in light of the recommendations Craig Stobo made in his report released last November.

· We introduced a mortgage insurance pilot in September 2004 as a first step toward assisting people into homes. We are looking at further cost-effective ways of assisting home-ownership amongst New Zealanders who would otherwise struggle to get these important first runs on the savings board.

Outside of the budget, as many of you will be aware, the Taskforce on the Regulation of Financial Intermediaries is due to report mid year. This will address many of the concerns raised about the retail savings industry such as problems of conflicts of interest through commission-driven agents, transparency around fees and around the roll up of savings products with insurance products.

Clarifying the situation and taking action if necessary is an important priority, since a corollary of encouraging New Zealanders to save more is ensuring that we have a high quality retail savings industry. That means an industry that provides a range of products suited to local conditions, that operates transparently and applies a high level of expertise while charging competitive fees.

The second major area of focus for this year is productivity. We now have the lowest rate of unemployment in the world; and that means an economy that is running hard up against constraints and looks set to continue to do so. Capacity pressures are becoming a bottleneck to growth and largely for that reason monetary conditions have tightened in an effort to ward off inflationary pressure.

Growth in per capita GDP from the early 1990s to 2004 came in roughly equal measure from labour utilization - increases in the total amount that we work - and labour productivity; how much is produced in each of those hours. However, looking forward, labour productivity is expected to make a larger contribution to growth than is labour utilisation. Treasury's latest forecasts suggest labour productivity growth is expected to improve further and to average around 1.6 per cent per annum in the period to 2009. We have to do better than that.

There is, of course, a natural limit to labour utilisation, meaning that increasing labour productivity is a key long-term determinant of economic growth. As the leading US economist Paul Krugman has put it:

Productivity isn't everything, but in the long run it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

The simple fact is that all OECD countries with higher per capita GDP than New Zealand have higher productivity, while all OECD countries with lower per capita GDP have lower productivity. And the great majority in the first category have higher tax rates and nearly all in the second have lower tax rates.

We need to think more systematically and with a long-term focus on the size and skill level of the workforce that we need. That means getting better value from our tertiary education and workplace training systems. It means better focussed immigration policies and practices. And it means reducing the barriers to workforce participation amongst those have young children, but want to maintain a career.

There are no magic wands, of course; as is apparent in the recommendations of the Workplace Productivity Working Group which submitted its final report to in August last year.

The Group's key proposals were:

· raising awareness of the importance of workplace productivity;

· sharing information and promoting best practice, via industry and employee networks, and through funding "demonstration cases" of productivity improvements in individual firms;

· developing and promulgating diagnostic tools to help firms identify potential workplace productivity improvements;

· carrying out research into various aspects of workplace productivity;

· improving the relevance and delivery of government support programmes for business; and

· reviewing government support for skills training, including expanding support for foundation skills.

Underlying the Group's work was the important idea that productivity is something that happens mainly within firms, and firms themselves are best placed to make decisions about how to improve their productivity.

Productivity is more that just what happens on the shop-floor. Indeed, one of the most important shifts we can make in our thinking is to look more broadly and consider the other drivers of productivity, notably the level and structure of capital investment and the level of managerial skill.

New Zealand has relatively low rates of capital investment compared to Australia and other OECD countries. At the level of individual firms, that means that New Zealand businesses need to increase their investment in plant and machinery.

That leads us in turn to consider how such purchases are financed, and more broadly whether we have capital markets that are as effective as they could be in identifying opportunities to increase value and in sourcing the necessary funds and investment partnerships.

On each of these scores, I think we rate a 'could-do-better'. There is room for improvement in the scope and sophistication of our capital markets. These are not things to be achieved overnight; however steady progress is being made in the revitalisation of the New Zealand stock exchange and in joint public-private initiatives such as the VIF funds for developing our venture capital market.

What emerges most strongly from considering the range of actions needed to boost our productivity is the need for better information flows and better coordination amongst a large number of players across the private and public sectors. Businesses, educators, local authorities, investors, central government regulators, all have parts to play.

There is an inevitable amount of hard slog ahead of us, making the changes that give us incremental gains that add up over the course of years and turn into sustained advantage and improved bottom lines. There are those around who hanker for the old days when the economy seemed to respond to dramatic shocks in the form of deregulation, privatisation, and tax cuts. Because passing 50,000 volts through the chest seemed to get results in the late 1980s, the argument goes, we should wheel out the defibrillator whenever we want to manufacture a step-up in economic performance.

That is not the nature of the game any more. New Zealanders have now had the opportunity to observe first hand the cumulative impact of steady, but not spectacular, growth, and government policies calibrated towards long-term goals of fiscal stability, strengthening economic fundamentals and quality social services. I believe what they are seeking is more of the same.

Thank you.

ENDS

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