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May 14, 2012

New Zealand to Legislate an Expenditure Rule

Posted by Ian Lienert

Euro-zone countries are being admonished by the EU to strengthen their fiscal frameworks, including by introducing a legislated budget balance rule in national legislation. On the other side of the globe, the New Zealand Government has announced that its fiscal framework will be strengthened, by introducing a spending fiscal rule in amended legislation. The similarity of the EU and New Zealand actions is striking, given the large differences in fiscal consolidation needs. For example, Euro area gross general government debt was nearly 90 percent of GDP in 2011, in contrast to New Zealand’s relatively low ratio of 44 percent. [1]

The New Zealand Government’s announcement was preceded by considerable analysis and strong criticism by some commentators. The Government’s advisor, the Treasury (New Zealand’s “ministry of finance”), while supporting self-imposed limits on new spending as a means of controlling growth in expenses, does not support a legislatively embedded formula-based spending limit.[2] However, because of the Government’s agreement with a minor political party there is a proposal to amend the Public Finance Act, which, if enacted, would make the new fiscal rule permanent, unless a future government initiates its repeal.

Background

New Zealand’s principles-based fiscal framework has served the country well. The landmark Fiscal Responsibility Act 1994 required, inter alia, public debt to be reduced to, then maintained at, a prudent level by ensuring that, on average, over a reasonable period of time, operating expenses do not exceed operating revenues, i.e., the (accrual) budget balance had to be zero or positive.  It is up to the Government of the day to define what was meant by a “prudent” level of debt. In 1994, the maximum net debt target was initially set at 30% of GDP. During the 1990s, the net debt target was successively reduced, to 15% of GDP during 1998-2000.

Medium-Term Expenditure Frameworks (MTEFs)—fixed nominal spending baselines for three-year periods—were introduced in 1992/93. The baseline was composed of non-indexed departmental spending and indexed non-departmental spending, e.g., transfers were indexed to inflation. Prior to 1997, a specific policy decision was required to change non-indexed spending.

The 1997 Budget introduced a $5 billion cumulative cap on new spending initiatives over the fiscal years 1998 to 2000. The spending ceiling was on top of the fixed nominal baseline and formula-driven indexed items. Rules were established to determine what counted against the spending cap. Separate caps for operating expenses and capital were introduced and included as line items in the three-year fiscal forecasts. The three-year expenditure ceilings were not prescribed in legislation.

In the 2002 Budget, further changes were made.[3] These aimed to: (1) get closer links between the fiscal management approach, overall fiscal policy and progress towards long-term fiscal objectives; and (2) simplify the rules for allocating the amounts available for new spending, which were re-labeled as the Operating Allowance (for revenue and expense initiatives) and the Capital Allowance (for capital initiatives). The allowances were expected to be set for a medium-term period, with a view to achieving the Government’s medium-term operating balance and debt objectives. It was not expected that the allowances would be revised frequently. However, when there were positive revenue surprises during 2005-2007, the Operating Allowance was revised upwards, usually twice a year, when the economic and fiscal forecasts were updated. During the economic upswing, the Government used part of the unexpected additional revenues to increase spending.[4] As a consequence, core government spending (“Crown expenses”), which had fallen progressively in the decade to 2005 (from 32½% of GDP to 29%), rose sharply during 2005-09.[5]

Proposals for an Expenditure Rule

Given the need to constrain governments from using cyclical revenues (in upturns) to increase structural spending, in its 2008 Briefing to the Incoming Minister, the Treasury suggested adopting an additional fiscal anchor in the form of a medium term expenditure or revenue constraint. This would allow the Government to signal its intent to restrain the growth in spending over the next three years (in New Zealand, parliamentary elections are every three years). The OECD also recommended consideration of a spending cap.

More specifically, the Treasury proposed a three-year rolling ceiling on total government expenses (with some exclusions[6]).  A margin of 1% to account for unexpected contingencies was proposed to be included in the cap. The biggest change under the proposal would have been the inclusion under the cap of changes in forecast costs that go through the Baseline Update process, e.g., higher than expected costs of indexed benefits. As a sanction under the proposal, if spending exceeded the cap, the Government would be required to state, either in its Budget Policy Statement or in its Fiscal Strategy Report, the reasons for the breach and what steps would be taken to reduce spending to ensure it did not breach subsequent caps.

The Treasury’s proposal did not require a change in existing legislation; the Government of the day would be given discretion to change the expenditures ceilings. In contrast, two other proposals for spending caps suggested amending the Public Finance Act (PFA). These were:

  1. Proposal of a government-initiated taskforce.[7] The Minister of Finance would be required in the PFA to specify a five-to-ten year target for future operating spending—either the real per capita level of spending, or spending as a share of GDP. The Minister would be required to report publicly on progress relative to the longer-term spending goal.
  2. Proposal of the ACT Party:[8] A Taxpayer Rights Bill, drawing on the experience of Colorado, would limit spending growth to the rate of inflation plus the rate of population growth. Any proposal for higher spending would be subject to a referendum. Furthermore, any revenue above the revenue limit would be refunded to taxpayers, unless retention of this excess revenue is approved by referendum.

The Treasury’s and the other proposals were considered at political level. However, in the 2010 Budget the Government decided not to introduce a formal cap on total spending. At that time, the Government took the view that the current system’s cap on new spending initiatives (via the Operating Allowance) achieved some of the objectives of a total spending cap.

In the November 2011 election, the National Party, which had led the previous Government (following three successive terms of a Labour-led Government during 1999-2008), won 59 seats in the 121-seat parliament. In order to govern with a majority in parliament, it entered into political agreements with three minority parties, including ACT. In its December 2011 “Confidence and Supply Agreement with ACT New Zealand”,[9] the National-led Government agreed to legislate within the two years a total expenditure limit.

On April 26, 2012, the Minister of Finance announced that the Government would introduce to Parliament a proposal to amend the Public Finance Act (see www.national.org.nz/Article). Under the amendments, total spending (with some exceptions) will be limited to grow at the rate of growth in inflation and population, as set out in the National-ACT coalition agreement. Also, under the proposal, future Governments will be required to:

  • Consider the impact of their fiscal strategy on the broader economy, in particular interest rates and exchange rates.
  • Set out their priorities for revenue, spending and the balance sheet, rather than focus narrowly on debt as is currently the case.
  • Take into account the impact of fiscal policy decisions on future generations.
  • Report on the successes and failures of past fiscal policy.

Assessments and Comments on the Expenditure Rule

When the Treasury assessed the ACT Party’s original proposed Spending Cap Bill in April 2011,[10] it concluded that the spending cap proposal has potential benefits to make it less likely that cyclical revenues would be locked into ongoing structural spending. It noted that the spending cap would likely lead to smaller government, given that core Crown expenses tend to grow faster than inflation and population growth. On the negative side, the Treasury did not support imposing hard parameters in legislation. It noted that “a legislated spending rule could lead to efforts to circumvent the rule – potentially favouring certain types of decisions (e.g., tax expenditures or regulatory changes) and raising the risk of unintended or perverse outcomes. To be effective, the fiscal framework needs to be reasonably stable over time. This criterion would not be met if a legislated spending rule was likely to be overturned, shortly after its introduction, because it lacked widespread and enduring political support.”

The Treasury’s preferred approach is to focus on enhancing the principles-based approach, via a systematic review of the PFA. This would identify opportunities for:

  • enhancing the reporting requirements of the Act, for example, by requiring a government to state its expense objective in numerical terms.
  • examining how the principles of responsible fiscal management could better support macroeconomic stability (e.g., by requiring governments to have regard to the risks of pro-cyclical fiscal policy, particularly during expansionary periods).
  • supporting greater public discussion of intended government fiscal strategy and ex post scrutiny of performance.

Further analysis was prepared in early 2011 by Anne-Marie Brook of the New Zealand Treasury.[11] She proposed five options “worth considering” (revise the PFA; multiyear expenditure cap; medium-term spending/GDP target; stabilization fund; and independent fiscal council) and two options “not recommended” (a structural balance rule,[12] and active fiscal policy instruments).The Government has chosen the first two of the seven options in this menu.

The latest expenditure rule proposal of the Government—apart from the removal of clauses referring to referenda—is still close to the legislation adopted in Colorado. In Colorado, the rule was successful in reducing revenue and expenditure ratios with respect to GDP. However, there is limit to which the “small government” objective can be taken without adversely affecting the quality of public services and ultimately, economic growth. Empirical evidence in Colorado suggests that the reductions in tax and spending had a negative impact on the State’s economy.  An academic at University of Auckland cites evidence for the deleterious effects on health and education outcomes during 1992 to 2005, when the Act in Colorado was suspended.[13] Trade Unions in New Zealand go further in criticizing the proposal, labeling the expenditure rule as the “height of foolishness”.[14]

I have some sympathy with the views of the Treasury and other critics. In countries where quantitative fiscal rules have been embedded in legislation, there have been many failures and few successes.[15]  Such an approach is likely to succeed only when there is strong and enduring political commitment. There is a strong risk that a future government in New Zealand will initiate the repeal of the imminent amendments in the Public Finance Act, although it may be several years before this would happen.



[1] Central government gross debt is about 35% of GDP.

[2] For a discussion, see the Treasury’s “Regulatory Impact Statement”, April 27, 2011 www.treasury.govt.nz/ris-tsy-scpvb-aug11.pdf and www.stuff.co.nz/national/politics/6099032/Greens-Treasury-against-spending-cap.

[3] For details, see “The New Zealand Fiscal Management Approach: An Explanation of Recent Changes”, January 2003, www.treasury.govt.nz.

[4] Part of the revenue surprises were used for faster-than-projected reductions in debt and, in 2007-09, for tax reductions.

[5] See Figure 7 of “Fiscal Institutions in New Zealand and the Question of a Spending Cap”, NZ Treasury Working Paper 10/07, www.treasury.govt.nz.

[6] The exclusions—mainly unemployment benefit spending and debt finance expenses—are discussed in section 6 of Treasury Working Paper 10/07, op. cit.

[7] 2025 Taskforce (2009), “Answering the $64,000 question: Closing the income gap with Australia by 2025”, First report of the 2025 Taskforce, New Zealand Government, November 2009.

[8] ACT is a minority political party that, inter alia, seeks to limit the involvement of central and local government to those areas where collective action is a practical necessity (see www.act.org.nz/principles). In the 2011 parliamentary election, the ACT party obtained 1 percent of the party votes and 1 electoral seat in the 121-seat Parliament (www.elections.org.nz/elections/2011).

[10] See “Regulatory Impact Statement”, op.cit.

[11] See “Making fiscal policy more stabilising in the next upturn: Challenges and policy options”, June 2011, www.treasury.govt.nz/brook-paper.pdf.

[12] EU countries are being encouraged to adopted structural balance rules in national legislation.

[13] Colorado fell from 24th to the 50th ranked state in the United States in the share of children receiving their full vaccinations. In the early 2000s, Colorado could not afford to vaccinate against diphtheria, tetanus and whooping cough, so temporarily suspended its requirement that schoolchildren be fully vaccinated. The State fell from 23rd to the 48th ranked state for the percentage of pregnant women receiving adequate access to prenatal care. Large education budget cuts had school districts increasing class sizes, moving to four-day weeks and turning off heating during the winter. See http://www.nzherald.co.nz/opinion/failed idea.

[15] See page 25 of my IMF Working Paper 10/254 “Should Advanced Countries Adopt a Fiscal Responsibility Law?”, http://www.imf.org/external/pubs/ft/wp/2010/wp10254.pdf.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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Comments

The success/failure of this will depend on the private sector spending complimenting the public spending in the NZ economy in volatile situations!

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