Presentation to a Treasury Workshop on the Long-Term Fiscal Projections; 26 September, 2012.

I am writing a history of New Zealand from an economic perspective. The manuscript – 250,000 words and I am only up to the 1970s – includes a number of appendices looking at the data. One is on government spending. The Treasury has made a contribution to the writing of this appendix; it contains material which is helpful, I think, to long term fiscal projections.

The consistency of the long-term data bases over time is deeply problematic, despite some Herculean efforts by Matthew Gibbons – we should all be very grateful to him.

There is far too much detail to describe the entire appendix here. This brief summary comes to a profound, dismaying conclusion. While population presents a problem, a greater challenge is the upward pressures of expenditure.

I begin with the following graph which shows Central Government Expenditure as percentage of GDP back to 1876. The aggregate excludes social security spending (to which I shall return), war expenditure, and debt servicing and other financing costs.

It is possible to discern a couple of micro-patterns in the graph, which will not surprise us. First, in war time, other spending is relatively lower and, second, government spending tends to be relatively higher when the economy is depressed compared to when it is booming.

But I can see no political pattern in the spending. The changes for the red – leftish – years look much the same as for the blue – rightish – years. The claim that Labour are the big spenders and National are frugal is not supported by the evidence. However, the Muldoon era aside, it is true that the left tends to outlay more on social transfers than National.

That each party favours its own voters is not surprising. What is surprising is that there is not an obvious pattern for other expenditure items; a comfort to long term projecting since it is not necessary to assume a future government of one colour or the other.

The big issue from the graph is there is unquestionable upward long run trend, amounting to 1.3 percentage points of GDP a decade. If the long-term trend continues we might expect trend government expenditure to be 6.5 percentage points of GDP higher in 2061 than it is today plus whatever happens to debt servicing and social transfers. (If there is war, all bets are off.)

For my projections I am going to use the shorter data base since 1947; it is more detailed (and consistent). First I illustrate the general approach by heath spending.

The long-term series shown that growth of health spending begins in the 1940s. Here the political narrative is correct – it was initiated by a Labour Government but after that both Labour and National increased spending as time went on. (Part of the early increase in expenditure is the ending of the contribution from local authority rates and charity.)

Why the additional spending? Briefly there were four effects:

• new treatments such as drugs and surgical treatments;
• affluence means we want higher quality of treatment;
• the price of services rises relative to goods, because productivity rises are slower (the Baumol effect);
• population aging.

We can only measure the last effect, which arises because older people require more health care than younger people. The graph shows that aging has added about 1.0 percentage point to spending since 1950. However the other three effects were stronger, adding 2.5 percentage points in the last fifty years.

Here is a table in which I have itemised the various expenditure categories, and shown what the logic of past rising spending patterns means for

Projections of Expenditure Class: 2010-260

	2010	2060 This Paper’s Projections			2060
Expenditure Class	Base Year	Aging Effect	Spending Pressure	Total	Current Projection
Health	6.9	3.2	2.5	12.6	11.1
Education	6.2	-1.8	2.0	6.4	5.2
Law & Order	1.7	-0.3	1.5	2.9	7.3
Heritage, Recreation Culture, Primary	1.2		1.5	2.7
Other government	5.5			5.5
NZ Superannuation	4.4	3.6		8.0	8.0
Social Security	6.8			6.8	3.3
TOTAL	32.7	4.7	7.5	44.9	34.9

In summary the table shows a much stronger government expenditure growth than the current projections, suggesting that the 2060 government spending will be about 12.1 percentage points of GDP higher than it is today. Of this 4.7 percentage points come from the changing age composition, while 7.5 percentage points come from additional spending pressures.

Since this projection and the current one use the same population projections, the main source of the divergence is the spending pressures. These are but (broadly) a projection of the trends of the last 50 years.

There is one other source of a divergence between the two projections. The current projection assumes that there will be no real increase in benefit levels for a further 50 years (70 years in all, given there has been none since 1991). Currently the gross unemployment benefit rate for a single adult is 26 percent of the average wage; it is projected to be 12 percent in 2060. [1]

Such a decline in the relative value of benefits would result in a huge increase in inequality and relative poverty, which is unlikely to politically sustainable (or possibly it will lead to mischief ranging from substantially increased government spending in health, education and law and order at one end to civil riots and worse at the other).

(This projection of New Zealand Superannuation is the same as for the current one which is a real increase in line with other incomes. I have some hesitations with that assumption. NZS is based on a single income household of two people. That situation is becoming sufficiently rare to raise the possibility that there will need to be some recalibration of NZS.)

The point of the long term fiscal projections is to identify pressure points. Thus far the projections have recognised that there is an issue of a sustainable path for the debt (and hence the fiscal deficit) and that the aging population is putting severe pressures on fiscal management. All this paper has done is point out that another source of pressure – apparently almost twice as severe than the age composition one – is the public’s demand for publicly provided services. It is of course possible that the public’s demand will abate but in terms of our current understandings, that seems unlikely in the immediate future.

I am acutely aware that this conclusion will be of no comfort to the Treasury. I have worked with it – off and on – for almost 50 years and know much of its history back to 1840. Expenditure pressures and controls have preoccupied them over all that time.  The fiscal situation a Treasury  faces is either: stress, great stress or intolerable stress.

My gloomy message is that the stress is not going away; it would be unwise to project that it will.

[1] The gross benefit rate in second quarter 2012, was $229.01 p.w, and the gross average wage was $884.75 p.w. including overtime.