The Macroeconomic Implications of the Public Finance Act

Presentation to the Symposium: ‘Wellbeing’, Budget Responsibility Rules, and the Public Finance Act (15 April, 2019, Victoria University of Wellington) [1]

Macroeconomic analysis, research, policy and forecasting is based upon two major data bases. One, provided by Statistics New Zealand, is centred on the National Accounts, but there are many additional elements. The other, which this paper focuses on, is the Crown Accounts, the financial statements of the New Zealand Government.

The Crown Accounts are a part of the system which enables parliament to the government’s financial activities to account, a constitutional imperative that goes back to the seventeenth century, or earlier. The accounts are regulated by the Public Finance Act 1989. They are not designed for macroeconomic purposes.

One of the most robust and significant laws in public policy analysis is Gilling’s Law which states the way you score the game shapes the way the game is played. The relevance here is that the Crown Accounts are scored for one purpose but they also shape the macroeconomic debate and management of the government. (Space precludes saying much about their role in wellbeing which may be the central role of government; it was outside my remit.)

This paper argues that the shaping is not always helpful. It accepts that while the Crown Accounts fulfil some purposes they are not entirely fit for their constitutional purpose of holding the government to account. However the main focus here is that the scoring also distorts macroeconomic policy.

It is apposite to begin with Gilling’s Law since Don Gilling was on the 1982 Public Sector Accounting Committee (chaired by Jeff Chapman) which formulated the accounting system which is enacted in the Public Finance Act. Previously, the principles underpinning the public finances were neither systematic nor comprehensive, so that in the past the government could manipulate its financial activities at the expense of parliamentary scrutiny. After 1989 there was a rigorous framework specified in legislation with principles set independently by the accumulated wisdom of the accounting profession.

Generally Accepted Accounting Practices (GAAP) come largely from the profession’s experiences with the business sector. The result is that business practices, conventions and needs largely underpin the accounting principles set out in the Public Finance Act. That explains, for instance, why the Crown Accounts do not include among the reported assets the single largest and most influential asset any government has – the sovereign power to tax. Businesses do not have this power; it was omitted.

I do not have any practical problem with the omission of the sovereign right to tax from the asset list – in any case it would be difficult to measure. However, as Gilling’s Law reminds us, that the Crown Accounts are scored by business principles warns us that we can easily lapse into thinking about the government as a business. [2]

The neoliberal mood of the 1980s was comfortable with the business approach but a government is no ordinary business. It is huge, which may be one of the reasons the neoliberals wanted to reduce it in size and scope.

More fundamentally, a government does not have a bottom line – of profit – in the way a business has. Its objectives are numerous and inchoate, rather like those of a household actually. Indeed one might see the current policy shift towards a ‘wellbeing’ budget as reflecting a change from a government-as-a-business approach to a government-as-a-household one.

However, a kind of business-oriented ‘bottom line’ was sneaked into the public accounts. Among all the myriads of measures explicitly and implicitly in the Crown Accounts the current Public Finance Act makes particular reference to debt levels. In particular, Section 26 G which is derived from the 1994 Fiscal Responsibility Act states that:

The Government must pursue its policy objectives in accordance with the following principles (the principles of responsible fiscal management):

(a) reducing total debt to prudent levels so as to provide a buffer against factors that may impact adversely on the level of total debt in the future by ensuring that, until those levels have been achieved, total operating expenses in each financial year are less than total operating revenues in the same financial year; and

(b) once prudent levels of total debt have been achieved, maintaining those levels by ensuring that, on average, over a reasonable period of time, total operating expenses do not exceed total operating revenues;

I am not going to give a detailed analysis of the clause – merely observing here that there are some logical oddities but that the undefined term, prudent, enables a government to ignore them.

Rather, the point to be made is that the Act’s principles of responsible fiscal management give first prominence to debt levels. Other measures are mentioned; for instance, ‘total net worth’ is instanced in subsection (c). None is given as much significance as the debt level.

New Zealand’s economic history well illustrates that public wellbeing has more than once been compromised by high offshore debt levels, while Treasury officials are charged with the onerous tasks of funding the debt and fending off credit rating agencies. Yet, it would be a strange (or dysfunctional) household whose primary focus was the debt level.

Unfortunately, as Gilling’s Law warns us, too often we score the fiscal situation giving excessive prominence to the debt ratio. Just to remind us, New Zealand has one of the lowest public debt-to-GDP ratios in the world (based on accounting conventions; New Zealand’s are a lot cleaner than elsewhere). It is better that it should stay down there, but currently we need not to be obsessed with debt levels.

(Were debt double the current level I would be much more concerned. Currently I am more concerned about private offshore debt appreciating that a reason for keeping government debt levels low is to offset private failure; we need to address the private debt problem more directly.)

Once we move away from thinking of government as a business whose activities are characterised by its accounts we face the challenge of evaluating the government’s finances systematically. In simple terms, how do we judge the quality of the government’s balance sheet or income and expenditure account (to use the old fashioned terms) in terms of the nation’s wellbeing?

The message from Gilling’s Law is that the evaluation framework affects how the government manages itself. Even were Treasury officials immune to the law, politicians and the public are not. They will latch onto a simplified score card which will frame the discussion and ultimately public policy.

Moreover, the reality is that because the presentation by the annual budget is one of the major political and economics events of the year (with the Economic and Fiscal Updates as echoes), the score card is going to have be associated with it, probably derived from the Crown Accounts even though, as I have argued, they are not really designed for that purpose.

The danger is that we lapse into placing the level of debt at the top of the score card even if the primary interest is meant to be wellbeing. This is well-illustrated by the current ‘Budget Responsibility Rules’ which emphasis the debt track, even though I am not convinced that public debt is a significant problem at the moment.

There is a considerable degree of uncertainty as to what is a prudent debt level. Suppose a big financial institution fell over in the course of the necessary rescue of it and the government took on extra debt. (I have in mind the instance of the US having to deal with AIG.) I agree the country would be worse off, but what are we to conclude about the Crown balance sheet?

Or consider the consequences of the Canterbury earthquakes. Again the country was worse off, and the Crown balance sheet suffered. But again it is not obvious that its quality deteriorated relative to the country as a whole, or in what way it did. It can be argued that part of the mismanagement of the earthquake recovery was because of the way the focus on the debt-to-GDP ratio rather than the overall quality of the Crown balance sheet.

A third instance is the previous government’s partial privatisation of some of the public electricity generators. There may, or may, not have been good reasons for doing this, but surely those reasons are not reflected in the reduction in the debt in the Crown balance sheet, which was offset by the reduction in the value of the assets the government held. I would make exactly the same point when the government nationalises assets, as an earlier one did in regard to Air New Zealand and Kiwirail. In each case there is a management problem related to funding, but for a pragmatist it is not obvious that the change in the Crown balance sheet is the main measure of the quality of the decision.

At one stage I thought we might switch to focussing n ‘Crown Net Worth’ rather than Crown Debt. Its use could contribute to resolving a number of problems already alluded to or about to be mentioned. Unfortunately, the measure defined in the public accounts is not suitable, because it is heavily influenced by revaluations. So while Crown Net Worth was zero twenty odd years ago, currently it is around 45 percent of annual GDP more than two-thirds of the additional net worth is accounted for by the revaluations of assets.

I guess I should have anticipated difficulties, alerted by the shoddy corporate accounts before the 1987 sharemarket crash, the Enron debacle, what happened in the financial sector during the GFC and, most recently, auditors reporting businesses were going concerns shortly before they keeled over. Whether the notion is recoverable – a sort of net worth before valuation gains and losses (analogous to OBEGAL) – needs to be explored.

Thus far I have focused on stocks, on the Crown balance sheet. Usually the interest of the macroeconomic discussion is about flows, especially the size of the government deficit.

The two are interdependent. Aside from assets sales and purchases, the debt track determines the size of the fiscal deficit. Choosing a debt track, say as a set out by the current Budget Responsibility Rules, therefore determines the size of the government deficit. This is not a great issue for a neoliberal economist who thinks that the deficit should be zero, the implication in the second subclause of Section 26G of the Public Finance Act.

It is a rather strange restriction. What prudent household would aim to balance its budget exactly when the household was growing or fail to make provision for future retirement? Surely, too, we expect a growing business to retain some of its profits for reinvestment. Similarly we might expect a prudent government to do the same, saving out of its revenue for increasing the government’s capital stock – increasing its net worth. Of course a prudent government, like a prudent household or corporation, will borrow for some of its capital investment. It seems very strange that the Public Finance Act should be so restrictive.

It is true the Section 26G has various let outs. Indeed they are sufficiently numerous and vaguely specified to make it easy to avoid the tight application of the explicit restrictions in the section. I am not a great fan for that sort of legislation.

These are structural considerations. Many economists without neoliberal persuasions want to manage the deficit for short-term macroeconomic purposes as well, as Section 26G allows. Deficit management is more difficult than elementary textbooks portray while forecasting the deficit is subject to large errors because it the difference between two very large aggregates, the forecast of each being subject to large errors. Even so, deficit management cannot be ruled out; the Key-English Government was right in 2009 to open up the deficit given the drastic international downturn following the Global Financial Crisis.

I have not the space to say much about the issue here; others in the symposium will address it. Rather, I conclude with a set of recommendation that come out of this paper.

First, section 26G of the Public Finance Act, ‘Principles of responsible fiscal management’ should be revised to set out principles only, and not include directives – especially any which encapsulate a particular ideology, such as are currently in Section 26G(b)

In the case of the current PFA the formulation could push the government toward an inappropriate response in a crisis. If it was a financial crisis a government would obviously have to pay considerable attention to its debt and borrowings. But that does not mean the response should be Austerian in which the burden of adjustment was placed most heavily on the poor. Of course, the incumbent government might choose that option. But it should do so consciously not because of a few lines written years earlier in a statute by a parliament which did not understand their import.

Here is how I might amend Section 26G (a) and (b) – combining them (no (b) is necessary):

The Government must pursue its policy objectives in accordance with the following principles (the principles of responsible fiscal management):

(a) attaining and maintaining total debt to prudent levels so as to provide a buffer against factors that may impact adversely on the level of total debt in the future.

Second, public sector accountants and economists should come together to make the public accounts more framed to the government as a government (more analogous but not exactly the same as a household) than as a business. This is not to abandon the principles embodied in the GAAP but to adapt then.

There are a number of changes here which are relevant. For instance, the current accounting conventions do not handle intergenerational issues well (recall that audited business accounts which dont give an indication that the firm may still fall over). The Crown not a business, but there is a danger of being unprepared for future commitments.

A fundamental but deeply symbolic change would be to recognise that the government holds different sorts of assets and to stop lumping them all into the same category in the Crown Accounts. There needs to be much better disclosure and characterisation on the face of the balance sheet of the different nature and purpose of assets and, in particular, of heritage assets that cannot be sold or disposed of. Some assets are commercial, which may or not be sold, while some assets are heritage and are never to be sold. I have suggested the latter be called Ake (forever) and be separately disclosed.

I understand GAAP wanting to have all assets held by an entity included and that doing so by its valuation rules is a convenient means of doing this. But it is ludicrous – and misleading – to treat a share in Air New Zealand and the document on which Te Tiriti o Waitangi is written as the same in the Crown Accounts.

The group of accountants and economists also need to develop a subsidiary set of Crown Accounts which are more useful for macroeconomic management. Here is my sketch of such a set. It involves four additional sub-statements.

The investment activities statement which would show government investment spending including (net) interest payments on debt. Offsetting revenue would include motoring levies and (net) borrowings.

The social transfer activities statement, which would show social security and other benefits as outgoings offset by ACC levies and revenue from income tax accruing above the base rate (currently 10.5 percent).

The third statement would cover the government’s activities involving providing collective services (such as core administration, defence, the environment and justice), and the fourth statement the government’s activities involving providing personal services (such as education, health and legal aid). The fourth account would include excise duties from alcohol and tobacco.

This fourfold division is schematic and there is much devil in the details, but by focusing on the broad purposes of government fiscal activity – investment, redistribution, providing services which the private market does badly, providing services which the market cannot do at all – it would frame the current fiscal debate in a more constructive way than today’s approach of lumping everything together. It is a step towards a wellbeing dimension in the Crown Accounts.

(There would be, of course, a fifth ‘reconciliation’ statement, which would show the net spending of each of the divisions and the funding from taxation whose main purpose was revenue raising and any other source not elsewhere included.)

It would also be helpful for macroeconomic analysis to have a reconciliation between the Crown Accounts and the national accounts. It was once done routinely but no longer. Treasury macroeconomists must have great difficulties using the Crown Accounts. Those of us outside do.

A further task for the group would be to write a (short) account of how to judge the performance quality of the Crown Accounts and in particular to identify some key summary measures. A particular aim should be to identify a better headline indicator than the debt-to-GDP ratio. I shall not be surprised if it, let us call it ‘Gilling Score’, is a net worth measure in which revaluations are dealt with differently from the current practice. It would remain a fiscal measure, and not capture general wellbeing. How to get a Gilling score for wellbeing needs to be pursued. Without one, wellbeing will be neglected by the public.

Finally, the group needs to think about presentation. The Crown Accounts fail their primary purpose of enabling parliament to scrutinise and control the government’s financial actions. It would be very unusual for a Member of Parliament to come to grips with today’s Crown Accounts and the estimates of expenditure – most hardly look at them.

I do not think their increasing opaqueness is deliberate, although aggrieved but interested MPs might well think they were being given the mushroom treatment. What has happened is that the material presented to parliament is increasingly developed for internal public sector management. The primary constitutional role of the Public Finance Act has been forgotten, or honoured only in the breach.


[1]  I am grateful to Geoff Bertram and Don Gilling for discussions which contributed to this paper.

[2]  Economics also suffers from Gilling’s Law. When the national accounting system was first articulated by Simon Kuznets he pointed out that it was not measuring wellbeing. Nevertheless GDP (or one of its associates) began to be used as an indicator of wellbeing even where, on occasions, its pursuit reduced the public welfare.