The big projected deficits in 2008

As part of the current political debate about the relative capability of the two main parties to manage the government finances responsibly, I sometimes see references to the large deficit forecasts that greeted the incoming National government in 2008.

I wrote about this issue a few months ago, in response to some specific claims made by one analyst at the time.  I’m reproducing the bulk of that post below (not indented).  My bottom line, supported with documentation is

But on best Treasury advice, the then Labour government thought they were leaving an essentially balanced budget [ie the 2008 Budget, their final fiscal policy choices], on top of an already very low debt level, not deficits.

 

It is certainly true that when the current government took office in November 2008, official fiscal forecasts showed large deficits for many years into the future.  But the last fiscal initiatives of the outgoing Labour government had been the 2008 Budget, the parameters for which were set out in the Budget Policy Statement released at the end of 2007.

Throughout much of the previous Labour government’s term of office, a key theme of fiscal policy developments had been the surprising strength in revenue.  It was, in many respects, why the fiscal surpluses were so large during those years –   Treasury and the government kept being taken by surprise, and Treasury was (prudently) cautious about treating the surprises as permanent.  If it was just a series of one-offs, or something cyclical, it wouldn’t have made sense to increase spending or cut taxes in response.

The Treasury gradually revised upwards their assessment of the underlying fiscal position.  Unfortunately, they took a particularly optimistic stance by the end of 2007.  I can recall the then Prime Minister making much of the fact that Treasury was now assuming that most of the revenue gains would prove permanent (and thus could support some mix of increased spending and lower tax rates) without the risk of dropping back into deficits.  I joined Treasury on secondment in mid-2008 and I have seen documents written to the Minister of Finance during early 2008 stating that reassessment.  I was under the impression that some had been released, perhaps as part of the pro-active release of 2008 Budget papers, but on checking that link on the Treasury website, I couldn’t see the paper in question.

But the facts of the reassessment aren’t in dispute.  Several Treasury staff produced a paper last year on the process of getting back to surplus, including the background to the deficits.  Here is what they had to say

Over the period 2005-2008, the Treasury increased its estimates of structural revenues by around 1 percentage point of GDP each year, and by 2008 the Treasury considered most of the operating surplus was “structural”

and

When the tax reductions [along with further spending increases] were announced in Budget 2008, the Treasury was still predicting the operating balance to remain in surplus through the forecast period, albeit at a lower level.

With the benefit of hindsight, the degree to which the surpluses were structural was overestimated. Although the tax reductions announced in 2008 turned out to be well-timed from the perspective of stabilising the economy following the GFC, their permanent nature added to the subsequent structural deficits.

Here is the chart from the 2008 Budget Economic and Fiscal Update.

Figure 2.6 – Total Crown OBEGAL

Figure 2.6	- Total Crown OBEGAL.

Source: The Treasury

That document was signed off  by the Secretary to the Treasury as representing his best professional assessment of the economic and fiscal outlook, incorporating the effects of announced government policy.  In New Zealand –  unlike many countries – the forecasts are those of the professional advisers, not those of the Minister of Finance.

On the basis of the economic and fiscal information available to it, the Treasury has used its best professional judgement in supplying the Minister of Finance with this Economic and Fiscal Update. The Update incorporates the fiscal and economic implications both of Government decisions and circumstances as at 9 May 2008 that were communicated to me, and of other economic and fiscal information available to the Treasury in accordance with the provisions of the Public Finance Act 1989.

John Whitehead
Secretary to the Treasury

14 May 2008

The projected surpluses by the end of the forecast period were tiny –  essentially the budget was projected to be in balance by then.  The economic and revenue outlook had worsened over the first few months of 2008, after the broad parameters of the Budget had already been sketched out in the BPS.   As we now know, New Zealand was already in recession by May 2008.   But on best Treasury advice, the then Labour government thought they were leaving an essentially balanced budget, on top of an already very low debt level, not deficits.

Of course, the government was wrong in that assumption.  But, specifically, Treasury was wrong in its best professional advice.    Perhaps the government would have run quite expansionary discretionary fiscal policy anyway, even if Treasury had been less optimistic about how permanent the revenue was.  They were, after all, behind in the polls, and the PM’s office –  didn’t Grant Robertson work there? –  would no doubt have been putting a lot of pressure on the Minister of Finance.  But that hypothetical didn’t arise.    They didn’t have to make such awkward political choices –  their own professional advisers told them they could have tax cuts and spending increases, and still keep the budget in (modest) surplus.  The Opposition National Party shaped its, more generous, tax cutting promises on much the same sort of Treasury forecasts and estimates.  (And a few years earlier, the 2005 election had partly been a bidding war as to how best to spend the surplus –  not whether there really was a structural surplus).

It wasn’t Treasury at its finest.  It is, perhaps, a reason to be cautious about just how much a fiscal council might add.   Would such a body, faced with similar circumstances –  a long succession of revisions upwards in revenue –  have really reached materially different judgements about the outlook then?  Perhaps.  We can’t know, but back in 2008 Treasury was using its best professional judgement, and the mistakes were still made.

There is a bit of a tendency afoot to suggest that the current National-led government has done a better job of fiscal management than the previous Labour government did.  I’m not really convinced by that story.   I’d accept that the previous government might have had an easier job than the current government has –  since one inherited modest but growing surpluses, while the other inherited deficits.  The current government had some nasty shocks (earthquakes) but also some of the best terms of trade in decades and the weakest wage pressures.      But if we expect our politicians to be guided by professional advice in areas like this, the previous government did what most orthodox opinion advised them to, keeping on delivering surpluses and reducing outstanding debt.  Probably they should have emphasised tax cuts more than spending increases, but this particular debate is about overall fiscal balances.

By the end of Labour’s term, government spending as a share of GDP was rising a lot –  but then Treasury was telling the government the money was there to spend.  And for all the talk of how the new Labour/Greens rules commit a new left-wing government to keep spending at around current National government levels, that level is around the average level that prevailed under the previous Labour government.

core crown expenses

There are things I’d criticise about the previous government’s policy. Allowing big structural surpluses to build up, as happened in the first half of the term, set the scene for a big spend-up later (which would have been big tax cuts if National had won in 2005). It is probably better to recognise the limitations of knowledge and typically keep both surpluses and deficits small. But it is easier to say in hindsight than it might have been at the time.  And in 1999 [when Labour had come to office], the severe fiscal stresses of 1990/91 were pretty fresh in everyone’s memory.

 

Tougher than Ruth Richardson?: implausible spending numbers

An overnight commenter on yesterday’s fiscal post made this suggestion

I wonder if some improvement in the PREFU could help. As you say, the Health budget has been increasing by $6-700m for the last couple of years, but is forecast to change by only minor amounts in future years. No one seriously believes that do they? Why not have assumptions for GDP, population, inflation, interest rates, demographics etc included in the PREFU numbers (maybe they are), and adjust the future years costs/incomes accordingly. So rather than having flat-lining health numbers, adjust for population, (health) inflation, demographics etc. I would hope that this would allow us to get a better sense of how promises stack up relative to a ‘normal’ expectation of what might happen. If someone wants to ‘deliver a modern health system’, but they aren’t going to increase the health budget, at least it would hopefully be apparent.

It may be far from perfect, but should at least be a bit more realistic?

I have a lot of sympathy with what the commenter suggests.  It is, more or less, what Treasury already do for the medium-term fiscal projections (beyond the four year budget window), and it wouldn’t be hard for them –  or an independent Fiscal Council –  to do something similar for the four years of the PREFU numbers (in addition to what is done now, rather than in substitution).   The numbers would be illustrative, and one might need to provide some ready reckoners to allow for different assumptions, but illustrative scenarios can still help to illuminate debate.

In that spirit, how would one look at the Health budget?   As I noted yesterday, in Labour’s fiscal plan they expect to spend $2361 million more on health in 2020/21 than the (basically flat) PREFU numbers.  To be clear, those PREFU numbers do not reflect what a re-elected National government would expect to spend; they just reflect what has already been allocated.

The Labour Party has claimed that their numbers allow for cost increases that would result from continuing inflation and population growth, as well as making provision for the various policy measures they have promised.    In the plan document they summarise this as

Reverse National’s health cuts and begin the process of making up for the years of underfunding that have occurred. This extra funding will allow us to invest in mental health services, reduce the cost of going to the doctor, carry out more operations, provide the latest medicines, invest in Māori health initiatives including supporting Whānau Ora, and start the rebuild of Dunedin Hospital.

The language suggests quite a lot more of an increase in spending than would be implied simply by inflation and population increases from here.

As it happens, we do have some insight as to how they think those inflation and population pressures should be allowed for.  After yesterday’s post a commenter sent me a link to a June 2017 press release from then-leader Andrew Little, which in turn linked to some work Infometrics had been commissioned to do for Labour on whether health spending had kept up with inflation and population pressures over the term of the current government.    In the tables in that short piece of work, Infometrics use CPI inflation and they allow for demographics pressures (ie the combination of an ageing population and a growing population) using (a) actual population growth and (b) some Treasury numbers that weight the population by its demand for health services.  With an ageing population that seems to lead to a demographic increase in demand for health services about half a percentage point higher than the population growth rate  (a bit more in years of low immigration – migrants on average are younger and have less short-term demand for health services).

If we take the Treasury projections for CPI inflation and population increase (from the PREFU), and apply the same sort of ageing population factor that Treasury and Infometrics have previously used, this is what we get.

CPI Inflation – Tsy forecast Population % increase –  Tsy forecast Total demographic % increase Implied % increase in health budget to keep pace $m increase
2018/19 1.7 1.5 2 3.7 608
2019/20 2.1 1.3 1.8 3.9 665
2020/21 2.1 1.1 1.6 3.7 655

If this approach is roughly right, the health budget (total Crown basis) would have to increase from the PREFU estimate for 2017/18 of $16432 million to $18360 million by 2020/21 just to keep pace with inflation and demographic pressures that are expected/forecast but haven’t yet happened.  In Labour’s fiscal plan, they expect to spent $18757 million on health in 2020/21.

On this basis – a methodology we know they used quite recently –  there is some margin between the expected (fiscal plan) numbers and those required simply to keep pace with future cost pressures.  That margin is $397 million in 2020/21.    But they argue –  the numbers are in the tables – that the health budget has been underfunded just for cost and demographic pressures during the term of this government to the tune now of almost $300 million per annum, and if one goes to their Health policy the first additional specific policy promise –  around GP fees – is itself estimated to cost $259 million a year, starting next year.  (Of course, National has made a similar promise in this area.)   It looks likely to be very difficult to deliver all those promises, and cover the basic inflation and demographic cost pressures, within that $18757 million.      That isn’t really surprising because, as I illustrated yesterday, the numbers suggest that health spending as a share of GDP won’t be changing –  and will be lower than it has been for most of the last decade.

Labour health

My actual interest in health policy and the health budget is quite limited (although my wife tells me I’m getting old and so should be more interested), but it is worth noting that Infometrics (and Labour apparently) used CPI inflation as a measure of the cost pressures. Ideally, one would want to use a specific index relating to health system costs.  I’m not aware that we have one in New Zealand –  certainly not one widely available –  but I did have a quick look at the CPI components data.

% increase since 08/09
CPI 13.2
Dental services 27.9
Paramedical services 29.1
Hospital services 32.3

Perhaps there might be some reason to worry that the CPI understates health inflation pressures (although it is true that the item “therapeutic appliances and equipment” –  one of those low inflation tradables – increased by only 2.6 per cent).    Even 1 percentage point more health inflation in total over three years would make considerable inroads into the margin Labour seems to have to deliver more medical services (or the same ones at cheaper prices to users).

In a sense, my larger point in yesterday’s post was about how plausible it is to expect to see government operating expenditure falling further as a share of GDP.  That is what both parties are promising.     Here is a chart of core Crown spending as a share of GDP, stripping out finance costs, and simply looking at the things governments are purchasing and the transfers they are making.

core crown spending 17 election

The data only go back, in this form, to around 1994.  But government spending as a share of GDP –  again excluding finance costs – hadn’t been any lower than shown in this chart (and was mostly higher) in the previous 20 years.

So the National Party’s proposed spending numbers would be smaller as a share of GDP than at any time in the last 40 years, and Labour’s would be smaller than at any time except for two years in the last Labour government that were (a) only very slightly lower, and (b) proved unsustainable, with big increases in spending over the following few years.  Grant Robertson and Steven Joyce: both tougher than Ruth Richardson.

A small government person might well look at these numbers with pleasure, and assume that the government was getting out of whole areas and handing responsibility back to citizens. I recall discussions with the late Roger Kerr who talked of how an advanced economy could have a basic safety net welfare state and still keep spending perhaps 10 percentage points lower than shown in this chart.     But he didn’t have in mind, for example, relentless increases in the share of GDP devoted to NZS (as both parties promise for the next two decades).    Or moves towards fee-free tertiary education.  Or real increases in welfare benefit rates.  Or……

If we compare what the state was spending on things 10 or 12 years ago and what either main party wants to spend on things over the next few years (Labour more than National of course, but in historical perspective the differences are small), how credible is it that the spending share of GDP will be able to be held so low?  Yes, the burden of some spending programmes has been wound back, but it isn’t easy to think of things the state has simply decided to stop doing, and it easy to see areas (in the current electoral auction) where there is pressure to do more.     And it is not as if, in recent years, productivity gains (non-existent for five years now) have been giving us “free lunches”.

I’m not taking a view here on what the appropriate level of spending (or taxes) should be.  My own biases would be to lower both selectively (but also run smaller surpluses).  It is simply a point about the realism of the numbers both parties are campaigning on, given what they say they want to be able to deliver.

But I am still a bit perplexed, as I said yesterday, about why an opposition party campaigning against serious sustained underfunding in various key areas of government spending, and wanting to do some big new things, would also be campaigning on cutting government spending as a share of GDP –  just smaller cuts than the current governing party is promising.   Perhaps it would make some sense (economically) if we were in some sort of fiscal or debt crisis –  all those debates in the UK about the appropriate pace of “austerity” –  but we aren’t.    Net core Crown debt (properly measured) in the last financial year was 9.2 per cent of GDP.    Quite what the political imperative, or the economic narrative, is for further reductions from there is a bit beyond me.