Listener: 3 March 2012.

Keywords: Macroeconomics & Money; Regulation & Taxation;

Forecasts for the New Zealand economy have been wound back since last year. Given the deteriorating state of the world economy, they will probably be wound back even further. And that’s going to make it even harder for the Government to meet its election promise of having its accounts in surplus by 2014/15 – tax revenue will be down and unemployment and hardship up. The forecasts depend on reductions in public spending. However, too-rapid cuts to core government spending reduce the capacity to deal with unexpected issues.

The Government is already embarrassed by revelations of past failures in civil defence (the Canterbury earthquakes), immigration (Kim Dotcom), marine management (Rena) and mine safety (Pike River). Cutting the incomes of beneficiaries, families with children, savers and students, just as hardship increases, would not be a good political look.

Meanwhile, the bill for the Canterbury earthquakes continues to grow. Here, as elsewhere, the Government contrives to make its accounts look stronger than they actually are by deferring decisions. Too often it fails to face up to the challenges, partly reflecting the desperate shortage of ministerial leadership, but also because of a tendency to substitute optimism for intestinal fortitude. The resulting problems accumulate and compound.

What are the options for the May 2012 Budget? The easy course is to hope that things don’t deteriorate further; if they do, panic measures may be necessary by the end of the year. This could mean cuts in spending to achieve the desired short-term Budget outcome, which could be politically and economically disastrous in the long term. Another strategy is to abandon the 2014/15 Budget surplus target. This would be best done by steadily lowering public expectations. The Prime Minister’s January state of the nation speech could have been the beginning of this campaign.

Scrapping the top plank in an election manifesto is always painful, but there are technical reasons for doing so. Failing to act would once again be putting off hard decisions that may create severe damage for the Government by the next election. The Reserve Bank would have to tighten monetary policy earlier than expected to offset the loose fiscal stance. On top of that, this would reinforce international doubts about whether New Zealand is on a sustainable debt path, increasing the likelihood of further – and increasingly painful – credit downgrades, with their higher interest rates.

Prudence suggests the Government should be developing a backup strategy. One possibility is a Canterbury earthquake levy, a surcharge of, say, 3% on each person’s income tax bill. The levy would be used to pay off the government’s earthquake expenses that couldn’t be recovered from insurance and the like. There would be a special account to which these expenses were charged (including those already incurred); proceeds from the levy would be credited to it as long as the account was in deficit – probably for at least 12 years.

The public narrative would be that, earthquake to one side, the government accounts are on track. Rather than overreacting to the shock of the quake and deviating from its path, the government, by introducing the levy, would be making separate provision and spreading the cost over time and according to people’s ability to pay. It would do the same for other large catastrophes – if, say, a volcano erupted in Auckland – so everybody has an interest in this kind of solution.

To the credit rating agencies and those lending us money (including rolling over debt), the message would be very similar (avoiding the forked tongue, for a change): Government spending and taxation is on track for the desired surplus, with steady efficiency-improving cuts to spending; you wouldn’t want to penalise New Zealand with higher interest rates for something entirely out of its control, and which is being addressed in a prudent and fair way, would you?

The alternative? Hopeful thinking, followed by panic and damaging measures.