Part 2: The value of the 2016 Statement

2.1
In this Part, we consider the Treasury's intentions and audience and what the 2016 Statement says about the nature of the financial challenges and opportunities ahead. We also consider how the Treasury's projections support the wider discussion of the 2016 Statement.

2.2
The main variables presented in the 2016 Statement are based on the "core" Crown, which includes all the main activities of the Crown but excludes, for example, Crown entities and state-owned enterprises. To be consistent with the Treasury's approach, our comments also focus on the core, rather than the consolidated, activities of the Government.

The Treasury's intentions and audience

2.3
The fiscal responsibility provisions in the Act were amended in 2004 to include the requirement for a statement on the Government's long-term fiscal position. However, there was little Parliamentary debate about the purpose of these statements.

2.4
In a background paper to the 2013 Statement, the Treasury discussed the reasons for the fiscal responsibility provisions, which were:

… a response to shocks (such as Britain going into the Common Market and the 1970s' oil price shocks), unaffordable policies (such as Think Big, or supplementary minimum prices for sheep meat) and the inevitable consequence: huge external indebtedness and lower living standards. These fiscal provisions reflected a resolve never to be so exposed and vulnerable again.¹⁴

2.5
Because the Act does not specify what contents are required for the long-term fiscal statement or how it should be prepared, the Treasury has considerable freedom in its design, preparation, and communication.

2.6
In publicly introducing the Treasury's first statement in 2006, the then Secretary to the Treasury outlined two intentions:

• to increase the quality and depth of public information and understanding about the long-term consequences of government spending and revenue decisions;
• to support finance ministers in pursuing a prudent fiscal course through time and to assist with improving public sector performance.¹⁵

2.7
The Treasury's website reaffirms these intentions:

The Treasury sees the purpose of these statements as being to increase the quality and depth of public information and understanding about the long-term consequences of policy decisions and to assist governments in making fiscally-sound decisions.¹⁶

2.8
These intentions emphasise the value of better long-term information for long-term decision-making.

2.9
Consistent with the Treasury's intentions, the two main audiences for the long-term fiscal statements are the general public and the Government. The statements and their projections are also used externally by international organisations (such as the OECD) and internally to influence the Treasury's policy analysis and by other government agencies (including the Ministry for Business, Innovation and Employment, the Productivity Commission, and the Retirement Commissioner).

2.10
In introducing the 2016 Statement in November 2016, the Secretary to the Treasury was clear that, for the Treasury, the 2016 Statement should continue to reinforce "the importance of policy advisers and decision-makers continuing to keep a focus on the medium to long-term" and include "projections of government revenue, spending and debt, and analysis of the factors that will drive these in the decades ahead".¹⁷ Particular emphasis was placed on incorporating the Treasury's Living Standards Framework,¹⁸ the effects of potential shocks, and the need to build "fiscal buffers".

The financial challenges and opportunities ahead

2.11
The 2016 Statement is clearly written and with less technical content than earlier long-term statements. It is organised around three simple messages:

• it is crucial that the relationship between the Government's long-term financial sustainability and New Zealand's well-being is managed;
• there are many challenges and opportunities that New Zealand could face in the future; and
• the financial consequences of population ageing are significant.

2.12
We consider each of these messages below.

Managing the relationship between the Government's long-term financial sustainability and New Zealand's well-being is crucial

2.13
Central to the 2013 and 2016 Statements is the understanding that the Government's long-term financial sustainability will affect, and will be affected by, New Zealand's well-being. If nothing is done to understand, plan for, and manage this relationship, a deterioration in well-being and/or public finances could follow.

2.14
To manage this relationship, the Government needs to understand and plan for the challenges and opportunities that could affect its spending and how that spending is funded.

2.15
Building on the 2013 Statement, the 2016 Statement continues to focus on the Treasury's Living Standards Framework as one way to better understand New Zealand's well-being. The framework is used by the Treasury to "incorporate a broad range of factors, distributional perspectives and dynamic considerations"¹⁹ into its policy analysis and advice.

2.16
Well-being is expressed through the four capitals of the Treasury's Living Standards Framework. These are financial and physical (combined) capital, human capital, social capital, and natural capital. It is the Treasury's view that public policy enhances the capacity of these four capitals to generate well-being if that policy is sustainable, equitable, socially cohesive, resilient, and generates economic growth. We agree.

2.17
Through the Living Standards Framework, the Treasury has considered whether improving social outcomes provides financial benefits as well as improved living standards. Various possibilities were discussed, including broader investment in human capital and achieving more equitable outcomes for Māori.

2.18
We consider this a positive step in illustrating and understanding the relationship between the Government's long-term financial sustainability and New Zealand's well-being.

There are many future challenges and opportunities New Zealand could face

2.19
As noted earlier, the fiscal responsibility provisions of the Act (which contain the requirement for a long-term fiscal statement) were, at least in part, a response to the challenges that New Zealand faced at the time when the Act was passed.

2.20
There is no reason to think that New Zealand will not face other challenges and opportunities.

2.21
As such, the 2013 and 2016 Statements both take a wider perspective of what could affect the Government's long-term financial position than the Treasury did in the 2006 and 2009 Statements.

2.22
The 2016 Statement describes many of the future challenges and opportunities that could affect New Zealand's well-being in detail. These challenges and opportunities include:

• immigration;
• education, skills, and employment;
• housing;
• natural resource risks, including climate change, water quality, and natural disasters; and
• social inclusion and inequality.

2.23
The main message from the 2016 Statement is that, although current government finances remain relatively strong, population ageing together with social, environmental, and economic shocks are all risks to the Government's long-term financial sustainability.

The financial consequences of population ageing are significant

2.24
Despite including a wider discussion about future challenges and opportunities, the 2016 Statement considers the financial consequences of only one challenge – an ageing population – and its potential effect on government spending and net debt.

2.25
The 2016 Statement provides two financial projections based on an ageing population. The first assesses the scale of the financial challenge. It assumes that nothing is done to manage the financial consequences of population ageing and all resulting operating deficits are funded by debt. The second projection shows how the financial challenge can be mitigated. It is based on reducing most government expenses as a share of GDP so that the potential operating deficits are reduced.

2.26
There is also some analysis of other options for how to lessen the financial challenge associated with population ageing.

2.27
Figure 3 is taken from the 2016 Statement and summarises the first financial projection, showing what could happen to net government debt through to 2060.²⁰

Figure 3
Summary financial projection in the 2016 Statement

Core Crown % of nominal GDP	2015	2030	2045	2060
Tax revenue	27.6	28.6	28.6	28.6
Other revenue	2.3	2.4	2.4	2.5
Total government revenue	29.9	31.0	31.0	31.1
Healthcare	6.2	6.8	8.3	9.7
New Zealand Superannuation	4.8	6.3	7.2	7.9
Education	5.3	5.4	5.5	5.7
Law and order	1.5	1.4	1.4	1.4
Welfare (excluding New Zealand Superannuation)	4.2	4.5	4.7	4.7
Other	6.3	6.7	6.7	6.7
Debt-financing costs	1.6	2.2	5.3	11.0
Total government expenses	30.0	33.3	39.1	47.1
Revenue less expenses (operating balance)	(0.1)	(2.3)	(8.1)	(16.0)
Net government debt (without New Zealand Superannuation Fund assets being deducted)	25.1	32.5	94.0	205.8
Net government debt (with New Zealand Superannuation Fund assets being deducted)	12.9	11.5	68.9	174.1

Source: The Treasury (2016), He Tirohanga Mokopuna: 2016 Statement on the Long-Term Fiscal Position, Wellington.

2.28
The projection in Figure 3 summarises the financial outlook for all the main classes of government revenue and expenditure from 2015 to 2060 as a percentage of GDP. Only two aspects of government spending show any material change – healthcare and superannuation. Interest costs also increase significantly because all operating balance deficits are assumed to be funded by debt.

2.29
There are two net debt projections. Net debt without New Zealand Superannuation Fund assets being deducted is the Treasury's main financial indicator, and is the indicator that is referred to the most in the 2016 Statement.

2.30
Each of the past long-term fiscal statements have also shown that population ageing could create higher healthcare and superannuation costs and that this will become financially unsustainable if entirely funded by debt. However, the many other potential challenges and opportunities that are discussed in the wider narrative of the 2016 Statement indicate a more uncertain future than the Treasury's financial projection, focused only on population ageing, suggests.

2.31
In comments to the Finance and Expenditure Select Committee in February 2017, the Treasury used the analogy of the Government as a ship "sailing towards a reasonably far off reef"²¹ – the reef, in this context, being the problems presented by population ageing. In the 2016 Statement, the Treasury clearly sets out the size of this "reef", and further information about it – such as its location, and what would happen if we hit it. However, to use the Treasury's analogy, although there may be favourable tailwinds and a series of storms on the horizon, the 2016 Statement gives little information about their direction, size, location, speed of travel, or consequences. There is also limited consideration of the costs of changing direction or whether missing the "reef" will instead take us closer to some of these developing storms.

2.32
The Treasury gave us various reasons for why other opportunities and challenges were not incorporated into the 2016 projection. These reasons included competing priorities, data availability, and modelling complexity.

2.33
In the 2016 Statement, the Treasury notes that for "technical reasons not all elements are reflected in the long-term fiscal projections" and that "due to information gaps and significant uncertainties in future trends and impacts, natural resources are currently difficult to incorporate in long-term fiscal projections".²²

2.34
The Treasury accept that its long-term financial projections are not wide-ranging or entirely realistic. In an internal seminar, it was noted that, unlike financial forecasts, the Treasury's financial projections are not "a best attempt to predict the future, via comprehensive modelling & expert opinion".²³

How well do the financial projections support the 2016 Statement?

2.35
In our previous report, we noted that the projection in the 2013 Statement did not fully complement the Treasury's new and developing initiatives, including the broader-based Living Standards Framework or the wider public engagement process. Furthermore, the primary focus on demographics and debt had not changed since 2006.

2.36
In preparing the 2016 Statement, the Treasury has made some positive first steps in conceptually modelling social outcomes, and is considering how best to develop the model further. However, we consider that our comments about the 2013 projections still apply.

2.37
In our view, there are two main issues:

• the financial projections provide a narrow analysis of the wider opportunities and challenges facing New Zealand; and
• the significance of the financial challenge of an ageing population is unclear.

The financial projections provide a narrow analysis of wider opportunities and challenges

2.38
The International Monetary Fund's best practice on analysing and managing financial risks states that "Governments must first have a sound understanding of the risks to public finances before they can be properly managed". Otherwise, decisions cannot then be made about whether to:

• mitigate certain risks through regulation or risk-sharing mechanisms;
• provide for certain risks through budget contingencies or buffer funds; or
• accommodate for certain risks through mechanisms such as debt ceilings.²⁴

2.39
The financial projections are presented in Chapter 6 of the 2016 Statement. There is little information about the size, scale, timing, interrelationships, and financial consequences of the other challenges and opportunities that are discussed in Chapters 1-5 of the 2016 Statement. In our view, the financial projections could have been better connected to the wider narrative discussion that is included in the 2016 Statement's earlier chapters.

2.40
To show the extent of the potential challenges that New Zealand could face, the Department of the Prime Minister and Cabinet in 2011 summarised New Zealand's indicative national risks (Figure 4).

2.41
Figure 4 shows that New Zealand could face a considerable number of potential shocks, all of which have different chances of occurring and a range of potential consequences.

2.42
Unexpected opportunities may also arise. Better understanding the range of challenges and opportunities, and how they could interact as a set of plausible scenarios, would provide valuable insights into the relative importance of population ageing, the timing and duration of its effects, any important interrelationships, and the wider consequences on the future financial capacity and sustainability of the Government. All of these are important for governments to consider when deciding on how best to plan for and manage the long-term sustainability of public finances.

Figure 4
The Department of the Prime Minister and Cabinet's Indicative National Risks

Source: Adapted from the Department of the Prime Minister and Cabinet (2011), New Zealand's National Security System.

2.43
A recently submitted doctoral thesis looked at tax policy responses to natural disasters in New Zealand and Australia and compared pre- and post-disaster funding approaches. The thesis noted that:

Historically, most governments, including Australia, have financed the costs associated with natural disasters only after an event has taken place by reallocating existing funds, increasing taxes, borrowing or applying for international aid.²⁵

2.44
However:

… pre-disaster financing can lower the volatility of the budget and improve planning certainty for the public sector by building up financial reserves, providing contingent financing and, in the case of insurance or reinsurance solutions, reducing the financial burden on the government after a disaster.²⁶

2.45
The 2016 Statement's financial projections assume that the Government manages the financial challenge of population ageing largely by borrowing money. Financial sustainability therefore mainly "requires the maintenance of prudent and low average levels of debt over time".²⁷

2.46
Some options from the 2016 Statement's earlier chapters are also mentioned as ways to lessen this challenge, such as by increasing migration, increasing productivity, and implementing social investment policies. However, it is not always clear how valid these options are or what their relationship is to the challenges and opportunities that the Government might face. For example, Chapter 6 of the 2016 Statement notes that a higher net migration assumption of 25,000 people each year would reduce 2060 net debt to 180% of GDP (compared with 206% in the "base case"). This appears significant, but is a net migration of 25,000 people reasonable given the 2016 Statistics New Zealand median projection of 15,000 people or the 2016 Statement's projection assumption of 12,000 people? Furthermore, what would such an increase do to government revenue or to the productivity growth assumption?

2.47
The Treasury considers a prudent level of net debt to GDP to be about 20%. However, the adequacy of this 20% net debt target in response to population ageing or other potential future challenges is not explored as part of the 2016 Statement's financial projections.²⁸

The potential financial challenge of an ageing population is unclear

2.48
The 2016 Statement's financial projections show a dramatic increase in superannuation and healthcare costs. However, as we show in Part 3 of this report, the projected scale of the financial challenge relies on the assumption that nothing is done to offset these increased costs and that the resulting long-term operating deficits are entirely funded by increasing debt. Using debt in this way leads to higher and higher finance costs because of the compounding effect of interest.

2.49
The significance of the assumption that all long-term operating deficits are funded by debt complicates an understanding of the nature of the financial challenge. It is unclear whether population ageing is financially challenging because superannuation and healthcare spending becomes difficult, or whether the financial challenge arises only because of the added assumption that all long-term operating deficits are funded entirely by debt.

2.50
The answer to this has important implications for how current and future governments explain and manage the financial consequences of population ageing.

2.51
One way to test the relative size of superannuation and healthcare spending associated with the challenges of an ageing population is to compare the 2060 projections to the latest data from other countries in the OECD.

2.52
Figures 5 and 6 show the 2016 Statement's 2060 projections for healthcare and superannuation²⁹ spending with the latest spending data in other OECD countries.

2.53
Because there will always be differences in how countries design and implement their superannuation and healthcare policies, an exact comparison is not possible.³⁰ However, in our view, Figures 5 and 6 indicate that:

• the projected levels of superannuation spending in 2060 are not out of line with recent spending levels in many OECD countries; and
• the projected levels of healthcare spending are just above what some other OECD countries have spent in recent years.

2.54
Evidence also suggests that as countries become wealthier, their willingness to pay proportionately more for social-related items (such as education, health, and superannuation) increases. If this is correct, then financial projections that hold tax revenues constant as a percent of GDP might be understating feasible funding options. Alternatively, cutting these spending items may not be feasible or acceptable to New Zealanders as part of a 20% net debt target scenario.³¹

2.55
The financial consequences of using only debt to fund the resulting projected deficits is another challenge for the Government in the long term.

Figure 5
The Treasury's 2060 projection for superannuation spending compared to other OECD countries for 2011

Figure 6
The Treasury's 2060 projection for healthcare spending compared to other OECD countries for 2015

2.56
There is more discussion about the nature of the financial challenge in the background papers provided alongside the 2016 Statement. However, in our view, the 2016 Statement could have done more to explain why the projected spending on healthcare and superannuation in 2060 is considered difficult compared to other countries and other challenges.

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14: The Treasury (2013), Long-term Fiscal Projections: Reassessing Assumptions, Testing New Perspectives, Wellington, page 32.

15: Whitehead, J (2006), Facing Fiscal Futures. A paper presented to the New Zealand Association of Economists' annual conference by the then Secretary to the Treasury on 28 June 2006.

16: See treasury.govt.nz.

17: "The Treasury Publishes Statement on the Long-Term Fiscal Position", treasury.govt.nz.

18: See the material on Higher Living Standards in the About Treasury section of the Treasury's website, at treasury.govt.nz.

19: The Treasury (2016), He Tirohanga Mokopuna: 2016 Statement on the Long-Term Fiscal Position, Wellington, page 8.

20: There is no summary table in the 2016 Statement showing how government expenses could be reduced to mitigate these potential operating deficits – this is shown as a line graph instead.

21: "NZ govt finances like ship sailing towards distant reef, Treasury deputy secretary says; Govt currently in very strong position; Risks include ageing population", interest.co.nz.

22: The Treasury (2016), He Tirohanga Mokopuna: 2016 Statement on the Long-Term Fiscal Position, Wellington, page 13.

23: Bell, M (2016), The 2016 Long-Term Fiscal Model (LTFM), Treasury Forum Presentation, slide 1.

24: International Monetary Fund (2016), Analyzing and Managing Fiscal Risks – Best Practices, Washington DC, page 21.

25: Palmer, C (2017), Good tax policy on shaky ground? An assessment of tax policy responses to natural disasters, Wellington, page 147.

26: Palmer, C (2017), Good tax policy on shaky ground? An assessment of tax policy responses to natural disasters, Wellington, page 148.

27: The Treasury (2016), He Tirohanga Mokopuna: 2016 Statement on the Long-Term Fiscal Position, Wellington, page 63.

28: The 20% debt target was discussed in two background papers to the 2013 Statement: Rodway, P (2012), Long-Term Projections: Reassessing Assumptions, Testing New Perspectives and Buckle, R A and Cruickshank, A A (2012), The Requirements for Long-Run Fiscal Sustainability.

29: The OECD data uses the term "pension" instead of "superannuation".

30: The OECD's latest data on superannuation spending is for 2011, and its data on healthcare spending is for 2015. The data is sometimes estimated or provisional. For example, the OECD's latest healthcare spending data shows New Zealand at 7.5% whereas the 2016 Statement shows New Zealand at 6.3%.

31: Freeman, D G (2003), Is health care a necessity or a luxury? Pooled estimates of income elasticity from US state-level data, Applied Economics, Vol. 35, No. 5, page 497.