Treasury Secretary Caralee McLiesh at the launch of the OECD survey yesterday with Nicola Willis

The OECD’s chief economist yesterday laid it on the line for the new Government: bring the deficit under control or face higher Reserve Bank interest rates for longer.

And to bring the deficit under control, she meant not borrowing for tax cuts.

But there was more.

Without policy changes—introducing a capital gains tax—New Zealand’s government debt would rise markedly from the mid-2030s to the mid-2040s when it would be 100 per cent of GDP.

Clare Lombardelli, who has just headed a 144-page OECD study of the New Zealand economy, told journalists in Wellington that the Government should set spending and tax policies to gradually reduce the fiscal deficit and reach a budget balance.

“This would, of course, be supportive of monetary policy, allowing interest rates to fall sooner than they otherwise would be able to,” she said.

“On the revenue side, any tax cuts should be fully funded by offsetting revenue or spending measures.”

And looking out to the future, the OECD survey said that a capital gains tax would be needed to help finance an ageing population’s superannuation and health needs.

But Finance Minister Nicola Willis, who joined Lombardelli at her press conference, immediately rejected both recommendations.

Adherence to the tax cuts, regardless of their fiscal consequences and opposition to a capital gains tax, are political bottom lines for the Luxon government.

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“We promised New Zealanders cost of living tax relief, and we will deliver it,” she said.

“We will also deliver on what this survey suggests is necessary, which is gradually reducing that fiscal deficit in a way that is sustainable.”

Given that the Government is going to refrain from doing anything on the revenue side, that can only mean a continuing tight control of spending.

But the OECD has endorsed Treasury’s view that sooner or later the fiscal demands of an ageing population will catch up with the Government and it will either have to dramatically slash spending, including superannuation and health, or raise more revenue which means either raising existing taxes or finding new revenue sources such as a capital gains tax.

Willis caught between her campaign promises and economic reality.

However, she is right about one thing: spending ballooned under Labour, which forced the Reserve Bank to keep interest rates high.

“The discretionary increase in expenditure in the previous government’s 2023 Budget (partly due to the North Island Weather Events) has worked against monetary policy efforts to reduce inflation by contributing to an increase in demand in the 2023/24 financial year,” the survey said.

“More of the macroeconomic policy tightening ought to come from fiscal policy in 2024.

“The Government should gradually tighten fiscal policy in the 2024 Budget. This would contribute to the rebalancing of the economy and reduce the burden on monetary policy, allowing interest rates to fall sooner than otherwise.”

The survey said the Government’s 2024  Budget Policy Statement 2024., said this year’s  Budget operating allowance would be less than $3.5 billion.

And the OECD said it would have to stick to it.

“It is key for fiscal policy credibility that, absent a further large negative shock, the government does not deviate from the new operating allowances as set out in Budget 2024,” it said.

Although it had declined from its Covid-19 peak,  total government spending was still around six percentage points of GDP higher in 2023 than in 2018.

“Increasing government expenditure is a political decision, but the increase is also partly due to government spending exceeding the new expenditure allowances set after Covid-19 had already struck,” the survey said.

“The spending slippage against allowances in 2020 can be explained by Covid-19 but shocks in the following years do not explain important increases in expenditure as they occurred after the slippage.

“Expenditure slippage occurred in part due to additional expenditure to cover extensive governance reform programmes in health, education, water, and other sectors, as well as initial work on investment programmes.”

The survey said there was slippage because the Government increased the annual spending allowances set down at the beginning of the three-year parliamentary term.

“New allowances were partly increased because nominal GDP growth was expected to be higher than it turned out to be,” the survey said.

“This led to an over estimation in revenue and therefore spending that would be in line with the operating balance target, highlighting the vulnerability of a balance target to economic forecasting errors.”

Willis was adamant there would be no fiscal slippage on her watch.

“Not only will we post a smaller operating allowance, we will stick to it,” she said.

“That has not been the habit of the Government in recent years;  we’re not just focused on this year’s budget, but on successive budgets, and we will track a path for fiscal consolidation in the medium term.

“The challenge New Zealand has faced in recent years has been something the OECD politely referred to as slippage, that is, finance ministers saying they’ll do one thing and then going on to outspend it.

“And our government is going to be one of steady, consistent discipline.”

Ultimately, however, tight control over spending will not be enough.

The OECD team in Wellington has drawn on Treasury’s 2021 statement on the long-term fiscal position, which it is obliged by the Public Finance Act to present every five years.

The intention is that it will provide a long-term deficit and, therefore, debt forecast.

Treasury  projected the fiscal position over the next 40 years, assuming that expenditure and revenue followed historical trends and legislative settings remain unchanged.

The most significant fiscal impacts come from health and New Zealand Superannuation (NZS) expenditure:

  • Due to demographic change, NZS expenses increased from 5.0% of GDP in 2021 to 7.7% by 2061.
  • Health expenditures increased from 6.9% of GDP in 2021 to 10.6% in 2061. Demographic change accounted for around one-third of the projected increase, with increasing demand for healthcare, rising prices for health services, and wage growth making up most of the remainder.

“As a result, the gap between expenditure and revenue grows significantly,” Treasury said.

“If this continues, net debt will start increasing exponentially.”

The OECD argued that the solution would be to broaden the tax base.

The survey said, “Raising revenues should be first achieved through broadening the tax base and reducing distortions before raising rates of existing taxes.”

“There is a need to reduce distortions to household choice of asset allocation.

“Shares, land and owner-occupied residential property are tax-favoured.

“Most capital gains from shares, owner-occupied residential property and land are not taxed.

“To ensure the tax system is not overly distorting saving and supporting broader growth, capital gains taxation reform should be done as part of a wider review of tax settings for saving.”

This is exactly the same advice the International Monetary Fund offered in March.

Willis’s response then was to say that there were some things that were certain in life, death, taxes and the IMF recommending a capital gains tax.

Yesterday, perhaps because she was sitting next to the person who had made the latest recommendation,  she was more circumspect.

“We’re embarking on the program of tax reform we were voted to deliver,” she said.

“ And we are prioritizing personal income tax reduction.

“That is what we took as a platform to New Zealand voters. And that is the platform we are delivering on.”

The Government is caught.

If it backtracks on the income tax cuts or continues with them but foreshadows a capital gains tax, it will lose credibility.

But if the Reserve Bank believes that the unfunded income tax cuts are inflationary and therefore decides to keep interest rates higher for longer, then the economy will grow more slowly, unemployment will stay higher for longer and very probably Naitonal’s poll ratings will fall.

Nicola Willis’s choices are beginning to look like being between a rock and a hard place.