KPMG Budget Briefing

Finance Minister Bill English’s third budget has been delivered at a time when New Zealand and the economy, has been affected by events at home – Pike River and the Christchurch earthquakes and abroad with the recent floods in Queensland and tsunami in Japan. As a result, a seemingly patchy 2011 remains until the Canterbury rebuild gains impetus.

National’s first Budget was a function of the rating agencies demanding a credible path back to surplus in the headwinds of the Global Financial Crisis. This challenge was met with some tough decisions – deferring income tax cuts, cutting KiwiSaver, and tighter control over, and reshuffling of, the public purse.

The Government‘s 2010 Budget made some important and much needed structural changes to the tax system. It stamped its own view of what was sustainable over the Tax Working Group’s recommendations by cutting income and company tax and raising GST with compensation. This was delivered with a medium-term economic focus in mind, looking past the immediate fiscal costs.

This third Budget further builds on the themes of the first two – fiscal restraint, value for money in delivering public services and reshaping key policy frameworks.

2011 has a savings and investment focus. In particular, getting New Zealanders to practice what Government has been doing for some time – reducing debt. And the reason? To encourage households and businesses to save. The Australian economy has demonstrated the benefit of a strong superannuation sector. The message seems to be getting through and KiwiSaver has been one of the sparks.

2011 Budget briefing

19 May 2011

The proposed KiwiSaver tax credit reductions and taxing the employer contributions shifts the onus to greater employee and employer contributions to make up the difference. This is not a bad thing per se – incentives come at a cost, including currently higher Government borrowing. The need for action on retirement savings must be compelling with or without incentives. It is however dependent on income growth and a robust savings sector.

Debt reduction is also key. The Government has clearly signalled its intention to pursue mixed ownership of some State Owned Enterprises as a mechanism to reduce funding pressure. The Government, knowing that its policies need to be sustainable in the long-term, is giving New Zealanders the ultimate say in November.

This Budget is about holding the course rather than dramatic reform. The Treasury is telling us the combination of increased private savings, reduced Government expenditure and Canterbury rebuild will see us through. Many businesses are facing challenging times at present; it is essential that the underlying assumptions are accurate and expected future economic benefits are realised.

Government has laid out the pathway and is relying on the electorate to understand the economic realities for New Zealand. The November 2011 election will be a vote of confidence in economic direction.

Jan Dawson Chief Executive

Budget 2011 – is it good for you?

Official Supplier of Accounting and Tax Advisory Services © 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. kpmg.com/nz-budget Mixed ownership model for SOEs – cash in hand or future yield In an effort to reduce the Government’s borrowing, which is currently in excess of $300 million a week, Finance Minister Bill English today announced that it will pursue a partial sale of four State-owned enterprises – Mighty River Power, Meridian, Genesis and Solid Energy, as well as reducing the Government’s stake in Air New Zealand. This was based on the advice received from Treasury early this year. The Government is looking to achieve a number of policy objectives through mixed Crown and public ownership. The fiscal impetus provided by the floats may be a welcome tonic for Crown debt – between $5bn and $7bn according to Treasury estimates – but this alone is an insufficient motivation to sell assets. It is not solely a question of trading off the expected return from the SOEs on the future. The Government has also pointed to the potential positive impact on private savings, capital market activity and the market disciplines that will be applied to the firms. We expect that the floats will be designed with these goals in mind.

Most importantly, mixed ownership is an important step towards more active balance sheet management by the Crown. The Government realises that there are assets that it will need to acquire from time-to-time to achieve policy objectives. The Government’s bailout of Air New Zealand in 2001 was a good example of this, its recent acquisition of Helicopters NZ from South Canterbury Finance is perhaps better seen as an unusual side effect. New schools, roads and hospitals will continue to be built. The Crown can best manage these costs and risks if it also has freedom to exit some assets on favourable terms to reinvest elsewhere, optimising its portfolio and using its balance sheet to its advantage.

The mixed ownership programme is not without risks. Depending on the timing and nature of the floats they can place pressure on the limited amount of local capital, making it harder for other firms to raise the debt and equity that they need to grow. The floats will also confront difficult policy questions, for example relating to water allocation and Treaty settlements. The Government will need to ensure that it strikes the right balance between realising value and ensuring that the floats are perceived as successful. These issues will crease the brows of Treasury officials for the remainder of the year. We expect that the first float will be scheduled for the first half of 2012. The Budget announcement does not include binding constraints on foreign investment. The flexibility this affords is a positive signal. The mixed ownership model is more likely to bring national economic benefit if it attracts new foreign capital into New Zealand than investors taking an overweight position on the local energy sector.

Managed appropriately with necessary restrictions or limitations, the mixed ownership model should be good for New Zealand and our capital markets. The devil is in the detail, but until that detail is available, next year by all accounts, businesses must adopt a wait and see approach before making a judgement on the merits.

© 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Mixed ownership is an important step towards more active balance sheet management by the Crown KPMG 2011 Budget briefing I Page 2 © 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Getting back to work A better, safer Christchurch should be an attractive place to base a business which serves not only the rest of the country but the world KPMG 2011 Budget briefing I Page 3 Christchurch: the facts Government’s cost $5.5bn Private sector $15bn EQC + ACC $3.6bn The rebuild and recovery of Christchurch is at the heart of the assumptions underpinning New Zealand’s return to surplus. • Funding for Canterbury Earthquake Recovery Authority (CERA) of $25.5m over two years • Further $10m of support for Cantabrians • Total Government spending of $8.8bn over the next few years to help Christchurch rebuild, including ACC and EQC spending • Government creating a $5.5bn Canterbury Earthquake Recovery Fund (CERF) for CBD demolition, temporary housing, welfare and business support and new infrastructure • Government will launch a new Earthquake Kiwi Bond to help fund the recovery in Christchurch while providing savers with a new savings option. It will contribute to the Government’s CERF Treasury’s assumptions on the timing and impact of the Christchurch rebuild are central to the Government’s planned return to surplus by 2014/15. It is the majority of New Zealand’s forecast GDP growth in 2013 and 2014. This fact will bolster the Government’s determination to get the build done on time, as New Zealand’s return to surplus relies heavily on the timing of the spend. This matches the need for some urgency in setting the vision for the rebuild. Canterbury business and residents need to have some certainty to proceed.

The Budget does not yet provide this. The assumptions imply a weaker recovery in the rest of the economy. This has implications for businesses relying on stronger growth which may not eventuate. By contrast, it provides some upside for the Government if growth elsewhere is stronger than forecast. Key 2011 budget changes: • Reprioritised spending on health and education – ‘additional’ $3bn in spending over four years • Rebuilding Christchurch – $5.5bn in infrastructure, business support and land remediation • Government department efficiencies, saving $980m over four years • Working for Families abatement thresholds reduced, abatement rates increased, and CPI inflation increases delayed – saving $450m over four years. • KiwiSaver tax credits reduced with contributions increasing to 3 per cent, saving $2.6bn over four years. • Partial sale of energy SOEs and Air New Zealand, raising $5bn to $7bn • Bank’s thin capitalisation requirements tightened, raising $100m over four years • Review of tax rules for mixed-use assets and livestock valuations © 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.

Today’s Budget signifies a further step in the Government’s ‘sinking-lid’ approach to stemming a decade long trend of government expenditure increasing relative to GDP. The Government’s stated agenda is to shift New Zealand’s economic focus to savings, productive investment and exports. An area of focus of this budget is to tighten the squeeze on low productivity, core government expenditure and return this expenditure to investment on high priority frontline services, infrastructure or to reducing deficits. In doing this the government intends to release resources to the productive sectors and so increase New Zealand’s capacity for sustained economic growth.

In this Government’s two previous Budgets, public sector expenditure was, in the main, tackled through pressure on departmental expenditure, in essence the cost of running the Wellington bureaucracy. In particular the Government focused on reducing costs in the ‘back office’ – roughly 10 per cent of departmental spend – and redirecting savings to frontline services such as the police, nurses and teachers. This focus continues. Government departments are expected to find a further $980m over three years once they absorb the impact of staff retirement scheme costs, previously funded centrally. The Government has also signalled that further negotiation of savings targets will follow after the Budget. It is clear that the expectation of further value for money savings won’t disappear under this Government. This means more services and better advice with fewer resources.

To achieve this, Government departments will need to focus on new ways to use their resources more efficiently and effectively – from the back office right up to the front line. Many departments have yet to grasp this particular nettle with both hands. Savings to date have generally represented the ‘low hanging fruit’ rather than smarter changes such as fundamentally rethinking business processes and service delivery models. Budget 2011 has signalled that the Government expects officials to achieve harder-to-get savings on top of the easier ones already delivered. The challenge they face is that longterm improvement, whether delivered through a merger or a new IT system, requires investment to realise the gains.

This creates an immediate conundrum for the Government. Smarter delivery of public services has an up-front price that will need to be found within the reduced government spending track announced today. Keeping the squeeze on Government expenditure Government departments are expected to find a further $980m over three years KPMG 2011 Budget briefing I Page 4 Government expenditure: Who is lighter after Budget 2011 30 33 36 39 42 45 1996 % of GDP 1997 1998 1998 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 NZ government expenditure (% of GDP) Source: OECD

Infrastructure spend is under pressure. A budget deficit of 8.4 per cent of GDP means funds are scarce and must be used efficiently.

Meeting challenging growth targets with limited capital means smarter and more focussed procurement. The Government’s priority is removing bottlenecks in New Zealand’s broadband, transport and electricity infrastructure, as well as providing schools and other social infrastructure.

The population base growth and relocation is driving need for investment in transport infrastructure – both road and rail. Industries critical to the economy such as dairy, forestry and tourism also rely on efficient transport networks to fuel economic expansion. Accordingly, Government has provided a further $250m to fund KiwiRail’s 10-year turnaround plan and spending continues on ‘Roads of National Significance’. Likewise, ensuring New Zealand is technologically equipped and globally connected to compete on the world stage is a priority, and the strong commitment previously indicated through the investment in Ultra-Fast Broadband and Rural Broadband initiatives continues with $942m included in the Budget.

Where the private or voluntary sectors have capital, knowledge and expertise in infrastructure delivery and management then a focus will continue on procurement methods to utilise this expertise and challenge the status quo.

The water sector is a good example. The Government has indicated a desire to partner with rural communities to get water infrastructure up and running. $35m has been set aside for an Irrigation Acceleration Fund to support the development of irrigation infrastructure proposals.

This is expected to unlock economic growth potential in a future of rising global food prices, with consideration of up to $400m being made available to invest alongside the private and community sectors in future years. The availability of quality housing continues to be an economic constraint as businesses seek to have their people located near their client locations. Reform of the housing sector is expected to continue apace. The state housing portfolio represents the second largest Crown asset.
Understandably, getting greater value for money from the $15bn invested is a priority. The focus is on nurturing the community housing sector to complement and support Housing New Zealand Corporation. $45m has been tagged for this.

The National-led Government’s targeted infrastructure spending will prioritise removing the bottlenecks to future economic growth and facilitate partnerships with communities and the private sector to increase the total investment in New Zealand. © 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Efficient infrastructure: an economic boost

Efficient and well directed infrastructure spending will boost economic growth and make New Zealand an attractive place to do business © 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Savings and investment

Savings was expected to be the centrepiece of this year’s budget. Unfortunately (and perhaps predictably) reality has not lived up to the hype. Increasing New Zealand’s savings and investment remains a key plank of Government economic policy. Even with the trimming of incentives, Government expects KiwiSaver to provide the boost to New Zealand’s private savings.

In 2010, Government imitated the successful approach of the Tax Working Group by setting up a Savings Working Group (SWG). The SWG’s February 2011 recommendations should have played a similar role to the TWG’s 2010 proposals, a number of which were implemented in last year’s Budget. Unfortunately, the events in Canterbury have cast a shadow on Government’s ability to implement much reform in the short-term. It has also influenced the KiwiSaver measures, which are contrary to the SWG’s approach.

So what were the SWG’s key recommendations, the Government’s reaction in Budget 2011 and what do we think should happen?

For the full story on investment and savings, visit kpmg.com/nz-budget SWG recommendation Government response KPMG verdict Tax Inflation index interest income and expense Not adopted Not supported due to complexity – A discount on tax on interest (similar to Australia) would be a simpler option but fiscally expensive Reduce PIE/savings tax rates and continue with GST and income tax switch Not adopted Should be a longer term aim as taxing capital is more distortionary than taxing labour or consumption (raising GST) Extend PIE tax rates to interest and dividends (RWT a final tax) Not adopted Arguments either way. Levelling the playing field between PIE and non-PIE investments makes sense from an efficiency perspective. However, from a wider savings policy perspective, should specific types of savings (e.g. KiwiSaver) be incentivised?

Refund excess imputation credits Ruled out – fiscal cost/ avoidance Should be a longer term aim – refunding imputation credits is the correct policy result as the shareholder is the correct ‘tax base’ Non- tax KiwiSaver: • Increase the default employee contribution rate to 4 per cent • Improve incentives (e.g. increase the member tax credit to $2 for every $1 contributed) • Increase in employee and employer contribution to 3 per cent from 1 April 2013; • Employer contributions subject to Employer Superannuation Contribution Tax from 1 April 2012; • Member tax credit halved to $10 per week (max $521pa) from 1 July 2011 Arguments either way. KiwiSaver tax credit cut reflects fiscal pressures, as presently the Government is borrowing to fund the payment of member tax credits. Employers (and employees) will however face additional costs to make up the shortfall Changes (e.g. tax reform) to support a well functioning annuities market No change The Budget does little to address the issues (e.g. over-taxation of annuities) – increasingly important as ‘baby-boomers’ approach retirement and KiwiSaver enters the draw-down phase

© 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. KPMG 2011

KiwiSaver: then and now Employee contribution (1%) Employer contribution (1%) Labour National 2008-09 2009-10 2010-11 2012-13 2013-14 2011-12 Your contribution Key: Government contribution 010203040500200400600800$10002008-092009-102010-112011-12Tax credit $ per week2012-132013-14Kick start paymentKick start paymentMember tax creditEmployer tax credit New Zealand’s SMEs may well ask themselves three questions when assessing the 2011 Budget. • Will it increase economic activity? Outside the rebuild of Christchurch, there was little in the Budget to directly stimulate economic activity. The goal of the Budget’s fiscal restraint is to keep New Zealand’s sovereign credit rating stable and SMEs will welcome interest rates and exchange rates remaining steady as a result. While the Government is forecasting growth, its spending cuts may slow growth in parts of the economy. Businesses should assess their ability to benefit from the Government’s expenditure on the earthquake recovery. • Will it make it easier to do business? This Budget does not directly reduce the red tape that hinders SME growth. The much discussed tax reforms for SMEs remains a work-in–progress. Other areas, such as immigration, will cause increased frustration as SMEs seek to hire skilled immigrants to assist business growth should the economy improve. • Will it assist me in finding skilled employees? This no-frills Budget will do little to stem the loss of skills offshore, especially to Australia. SMEs may also find skilled staff drawn from their local economies as the rebuild of Christchurch gets underway. Owners of small-to-medium sized businesses may not be truly satisfied as a result.

There will also be wider concern that changes to KiwiSaver and Working for Families will see additional costs move from the Government onto SMEs. Tangible support for SMEs? Labour’s KiwiSaver concept had members, employers and Government contributing. Employers were to increase their contributions over time to 4 per cent by 2011. The previous Government provided tax credits and some tax concessions through capped tax rates. National, on coming to power in 2008, reduced employer and member contributions and also cut employer KiwiSaver subsidies, due to fiscal pressures. In this Budget, it proposes a reduced Government member tax credit contribution of $10 per week (down from $20) from 1 July 2011, but increased employee and employer contributions to 3 per cent each from 1 April 2013. The actual employer contribution will be less than this because it will become taxable with the removal of the current exemption from Employer Superannuation Contribution Tax from 1 April 2012. The original scheme relied on inertia (automatic enrolment, with positive action required to opt out), the Government contribution and tax concessions to create the incentive to invest and save.

The Government expects the remaining tax concessions and increased employer contributions to maintain and increase the savings level. There are two keys to this outcome. Increasing contributions are not a problem if incomes are increasing at an equal or higher rate so that New Zealanders can continue to meet their costs of living. The Budget predicts good income growth for those outside the public sector. The latter will also need to self fund the higher employer contribution from existing baselines. Fund providers and Government need to build on the start already made to convince New Zealanders that contributions are in their best interests. This means that funds need to be transparent about their approach and returns. The regulatory and other regimes that will be needed to make PIEs attractive for non-residents, for example, should help provide confidence to members.

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