With Steven Joyce set to present his first Budget this week, Brian Fallow looks at some of the Finance Minister's options given the cyclical tailwind at his back and the looming election

By Brian Fallow*

The economic growth forecasts underpinning Thursday’s Budget are likely to be pretty cheerful. 

The Reserve Bank’s latest forecasts have the economy growing 3.4 per cent on an annual average basis over the year ahead, and the consensus among forecasters when NZIER surveyed them in March was 3.3 per cent. The latest official read, for calendar 2016, was 3.1 per cent. 

More relevant for fiscal purposes is growth in nominal GDP which reflects not only real growth but also inflation and export prices. It is a rough proxy for the tax base. 

By the end of 2016 it was growing at an annual average rate of 5.6 per cent, compared with an average of 4.4 per cent over the previous 10 years. 

This cyclical tailwind at Steven Joyce’s back is showing up in the tax take. Three-quarters of the way through the current fiscal year tax receipts were running 7.3 per cent ahead of the equivalent year-to-date level a year ago. 

Core Crown expenditure, on the other hand, was up 3.5 per cent and the operating balance before valuation gains and losses (Obegal) was running $1.3 billion ahead of forecast. 

So at this hump in the cycle, there should be more money on the budgetary table than we have seen for years. 

What factors will the Government have to weigh as it allocates it? 

An ageing population

The first is demographic: a rapidly growing, and relentlessly ageing, population.

The population is expanding at a bit over 2 per cent a year, boosted by net migration gains which forecasters in recent years have consistently underestimated. 

Then there is the underlying structural issue of an ageing population putting upward pressure on two big-ticket items: health and superannuation. Between them they account for 38 per cent of Government spending and 90 per cent of the increase in spending over the past six years. 

As a rough guide overall government operating spending would have to rise by about 4.3 per cent (around $3.5 billion) to remain flat in real per capita terms. 

Housing pressures on household incomes

The second major issue the Budget will have to confront is the pressure on household incomes coming from the dire state of the housing market. 

Every indicator there is bad: rampant house price inflation, the household debt-to-income multiple at a record high and a negative household saving rate. 

The new housing affordability measure from MBIE can be read not only as an indicator of declining affordability of housing but conversely as an indicator of the pressure on incomes after housing costs. 

The pressure is greater in the lower reaches of the income distribution. Statistics NZ’s household living costs price indices, which unlike the CPI include mortgage interest costs, recorded a rise of 2.1 per cent in the cost of living for the lowest 40 per cent of households ranked by income over the year ended March, compared with 1.9 per cent for all households. 

“We remain committed to reducing the tax burden, and in particular the impact of marginal tax rates on lower and middle income earners, when we have the room to do so,’’ Joyce said in a pre-Budget speech to the Wellington Chamber of Commerce. 

He did not elaborate but he has made it clear that any adjustments foreshadowed in the Budget to the income tax scales will be to thresholds, not rates. 

Changes to Working for Families?

The reference to marginal tax rates suggests, however, that one thing that might change is the income-testing surrounding Working for Families tax credits which cost the revenue upwards of $3 billion a year. 

The abatement rate which determines how the credits are whittled down once incomes rise above a certain level creates a zone of relatively high effective marginal tax rates, which might be a candidate for adjustment if battler families are the target group. 

As for adjusting the income tax thresholds themselves, it is high time fiscal drag was addressed. That is the stealth tax increase by which the combined effect of inflation and a progressive tax scale pushes more and more of people’s incomes into higher tax brackets over time. 

Since the income tax scales were last changed in 2010 the CPI has risen 10.4 per cent and the average wage 17.3 per cent. 

The effect of fiscal drag is most apparent for those in the top bracket, earning more than $70,000. They comprised 11 per cent of taxpayers in 2010 and they collectively paid 48 per cent of the revenue from income tax. Now they represent 17 per cent of taxpayers and contribute 60 per cent of the income tax take – or at least they did at the time of last year’s Budget. 

If the coming Budget were to adjust the tax thresholds to compensate for CPI inflation since the September 2010 quarter, the top of the lowest band would be raised from $14,000 to $15,500. The boundary between the lower middle and upper middle brackets would rise from $48,000 to $53,000 and the top rate would kick in at $77,300 rather than $70,000. 

The revenue cost of those adjustments would be around $900 million, according to a helpful tool the Treasury publishes.  

It factors in the revenue clawed back from any income tax reduction, through GST and some increase in company tax as people spend that extra disposable income. 

Clearly, restoring the tax thresholds to their real level in 2010 is only one of many possible adjustments. 

But it would gobble up most of the $1.5 billion operating allowance the Government penciled in last year for this year’s Budget. The operating allowance is money for new spending initiatives and/or tax cuts. 

Opportunity cost of $3 billion a year

Another key aspect of fiscal policy, but one which gets zero attention on Budget day, is the debt target. 

New Zealand’s net government debt is $62 billion or 23.4 per cent of nominal GDP. 

That is very low by international standards. The International Monetary Fund puts average net government debt among 35 advanced economies at 71.4 per cent of GDP. 

If the Government were prepared to leave it at the 24 per cent level (and assuming nominal GDP rose at a cyclically adjusted rate of around 4.5 per cent) as a matter of arithmetic it would be able to run an annual cash deficit of around $3 billion. 

Right now it could borrow that money quite cheaply by historical standards, and invest it perhaps in infrastructure, social housing, education – useful things like that. 

The Government's policy is not to do that but instead to drive the debt ratio down to 20 per cent of GDP over the next three years, and then to between 10 and 15 per cent of GDP by the mid-2020s. 

A case can be made for doing that, particularly as a matter of intergenerational equity. The young get a raw deal from current policy in enough ways already -- over climate change, housing and superannuation -- without sticking them with a higher interest bill on Government debt. 

And the very low net debt the present Government inherited – around 5 per cent of GDP – was helpful in dealing with the double whammy of the global financial crisis and the Christchurch earthquakes. 

Even so, the opportunity cost of $3 billion a year and mounting, is steep.

*Brian Fallow is a former long serving economics editor at The NZ Herald. This is the sixth article in an election year issues-based analytical series on economic policies he's writing for interest.co.nz.

His first article is here. 
His second article is here. 
His third article is here.
His fourth article is here.
His fifth article is here.