Speech To Wellington Regional Chamber of Commerce

Hon Dr Michael Cullen, Minister of Finance

Westpac Trust Stadium

The annual Budget is to be presented on 24 May. Today I want to explain the context in which it is being pulled together, and share with you my thoughts about how we can improve the presentation of Budget information so that the public has a stronger base on which to evaluate the government’s management of its finances.

The economic context for the Budget is relatively positive. There are risks associated with prospects for the world economy and the outlook on the current drought.

The deterioration in the world economic outlook has meant that New Zealand’s economic prospects, particularly in the immediate future, are slightly weaker than envisaged in the December Economic and Fiscal Outlook.

Despite that softening, the medium term economic prospects are good. I anticipate steady growth, unemployment staying down at levels we have not seen for more than a decade, inflation moving rapidly back to low and steady levels, slowly rising living standards and a much more comfortable balance of payments deficit.

The pattern of growth is more balanced than we have experienced in the last decade, and the business cycle is far less volatile.

The fiscal outlook remains positive, and largely in line with previous forecasts. The key question is how the financial data are analysed, and whether supplementary indicators can be developed to give better insight into the state of the public finances.

The problem I face is a problem that many of you face every year. You have your annual accounts prepared by accountants and independently audited. This is to protect the interests of shareholders. But as managers, you need extra information. It is where management accountant meets beancounter.

The extra information you need is to give you a richer understanding of your stewardship of your businesses, to identify underlying strengths, and to isolate potential risks that you must prepare for.

In recent years, governments in New Zealand have done a lot to improve the accounting treatment of the public finances. They have also improved the basis for an analysis of the financial statements. My belief is that we need to do better in this analytical dimension of the presentation of the accounts.

A vital dimension of the improvement in accounting treatment has been the adoption of generally accepted accounting practice or GAAP rules.

This has been backed up in at least the last two terms of government by the adoption of an overall spending limit for new policy initiatives.

Together they provide;

- confidence (especially in finance markets) that the government hasn’t fiddled the books;

- discipline (on Cabinet collectively) by imposing a top-down limit within which competing demands need to be prioritised;

- predictability, about the scale and sequencing of any increase in the government’s command of economic resources.

They therefore have value.

Having said that, it must always be remembered that accounting standards are designed for a particular purpose. They should not be used for purposes for which they were not intended.

I have absolutely no intention of interfering with the application of GAAP rules. The problem is that we need additional financial indicators.

GAAP rules were developed primarily in a private commercial environment. That environment requires that the profitability or otherwise of an enterprise be clearly and consistently measured. It also requires that the market value of the enterprise be properly and objectively measured and reported.

This protects creditors, especially under a regime of limited liability, and shareholders, especially under a regime of tradeable shares.

The idea of profit and loss does not migrate quite so easily into the arena of public finances. For a start, larger profits - operating surpluses in this case - are not always a sign of good management. They can indicate that taxes have been held up at higher levels than they should have, or that necessary social services have been underfunded.

Secondly, with the government, the size of the operating balance is not necessarily the key indicator of financial success. Levels of spending in relation to the rest of the economy,

and the level of public debt are key macroeconomic variables, and should get every bit as much attention as the size of the surplus.

There is also much more variability in the balance than would be the case in a normal business operation, and this is not always appreciated.

The reason is that the operating balance is - typically - a very small difference between two very large numbers. Last year, the operating surplus was around $1.5 billion, compared with total expenses of over $36 billion. A one percent variation in expenses would have magnified into a 25 percent variation in the surplus - either way.

But even that doesn’t really tell the full story about what really matters, which is the government’s stewardship of those parts of the public finances that are more directly under its control.

The operating balance is moved - fundamentally - by accounting policy changes and variations in valuations. The published operating balance can hide major differences in stewardship performance as between the years.

In 1999, for example, the government posted a small $184 million surplus in what I would call the manageable part of its operations: revenue minus expenses.

But it sold Contact Energy, airport companies and the like, and the sale price for them was $2 billion above book value. The government didn’t do anything to manage the windfall - the book values were too low compared with market values. After other valuation changes, the net effect was a reported surplus of $1,777 million, which did not give a true reflection of the knife-edge state of ongoing operations.

In my first budget, the operations operating surplus (for want of a better term), was $852 million, but after valuation changes and write-offs, it ended up at $1.5 billion - nearly twice what a measure of stewardship would have revealed.

Some of the valuation changes that are used flow from highly technical and inherently subjective assumptions.

By way of example, a part of the employer contribution to the Government Superannuation Fund was not paid in alongside the employee contribution, leaving the government with an unfunded liability for meeting some of the costs of GSF benefits.

The amount of this liability is calculated annually. The assumption is that the government should have a stock of assets sufficient to meet the unfunded liabilities as they emerge over the next forty, fifty or sixty years.

If interest rates rise, the notional amount needed now to cover this future cost falls, and vice versa. The change in the valuation is added to or subtracted from the operating surplus.

The valuation change does not involve hard cash, it is based on essentially theoretical assumptions, and it usually reverses out over time. In the meantime, though, it can have huge impacts on the level of operating balance that is reported.

For example, in 1998, the operating balance was given a ten percent lift by a reduction in the unfunded liability. In 1999, it was cut by 20 percent. In 2000 it was boosted by 16 percent.

Over the three fiscal years the change in the unfunded liability was only $5 million, but year by year it played havoc with the reported balance.

This year, because interest rates have fallen, the unfunded GSF liability will show an increase, and in later years, when interest rates rise, that will reverse out.

In this Budget, the operating balance will be reduced by a $230 million negative movement in the unfunded GSF liability compared with forecasts used in the December Economic and Fiscal update.

A more recent effect concerns the valuation of future ACC liabilities. With the move to full funding, GAAP rules require changes in future ACC liabilities to be booked against the operating balance. In the 2000 financial year, ACC valuation changes increased the operating balance by $519 million. This year they will reduce it by around $880 million compared with DEFU.

We will still report an operating balance according to GAAP. But we will produce an additional fiscal indicator that strips out the effects of these valuation and accounting changes. It allows the public to get a more accurate fix on the effectiveness of our financial stewardship without abandoning GAAP.

The differences are not pedantic. They can change fundamental perceptions about trends in public finances. In the three years - 1999 to 2001 - the headline operating balance according to GAAP shows a steadily declining surplus. Take ut valuation and accounting policy changes and we get the exact opposite - steadily rising surpluses.

Enter a new indicator - the Operating Balance Excluding Revaluations and Accounting Changes - affectionately known as OBERAC in my office: Oberac will be born on 24 May 2001.

But there is a much bigger challenge around the corner. Full adherence to GAAP would require what is known as line-by-line consolidation of the government accounts.

This would involve all government owned activity - including the operation of SOEs - counting towards levels of expenditure and levels of debt.

It is a measure of the government’s commitment to GAAP that line-line-consolidation will be introduced in the 2002 Budget.

It is important to remember that GAAP has a specific and limited purpose. It does not count or assess the broader roles of the government in the economy.

We therefore need to make sure that supplementary indicators are developed so that the GAAP results do not lead to ideological bias in decision making, or sub-optimal financing.

Let me give you two examples. The requirement for employers to take out accident cover for their employees is directly a consequence of government regulation.

It makes no economic difference if the cover is provided by private insurers or by the ACC. The government is still determining the form and level of activity. But if ACC is privatised, the apparent role of the government in the economy falls.

Nobody forces anyone to use stamps. The fact that the government owns New Zealand Post is largely irrelevant from an economic point of view. The government is not determining the use of resources. Ownership is a philosophical preference.

But if governments want to meet expenditure/GDP or gross debt/GDP targets, they may be pressured to privatise when there is no economic, or indeed financial, reason to do so.

The problem is not so much GAAP, but the use of GAAP in checking how well the government is performing in relation to its long-term fiscal objectives and its short-term fiscal intentions.

There will be no final resolution of this problem in the 2001 Budget, but we are well on the way to resolving it and will make final decisions in next year’s Budget. The Fiscal Strategy Report will include an update of work in progress.

One area that is under discussion is consolidating all government owned activity, but isolating measures of core Crown activity. It is the core Crown activities that need to be assessed instead of, or at least in addition to, spending to GDP and debt to GDP targets

Let me turn now to the fiscal “cap” or “limit” of $5.9 billion for new spending initiatives over the three years to 2003.

The $5.9 billion “limit” was developed in the context of preparing the March 2000 BPS. It was included as a “fiscal provision”. The provision was seen as being consistent with both short-term fiscal intentions and long-term objectives.

It had no formal rationale. $5.9 billion could have been too much or too little, and allowed an under or over achievement against objectives.

In practice it was a mix of three things: a broad assessment of the cost of intended government programmes, an allowance for cost pressures arising from existing government programmes and the experiences of previous governments in managing overall spending.

As I have said, it is a useful top-down discipline, and it is useful for both external and internal audiences.

The external audience can judge whether the government is exhibiting the degree of financial discipline it announced at the start of its term. The internal audience - Ministers and departments - are aware of the total amount of discretion that is available, and of the need for prioritisation and trade-offs. There is no bottomless pit!

A number of pressures have emerged since the $5.9 billion was calculated in addition to, or in excess of, the cost pressures that had been assumed and advised in the course of setting the initial spending cap. The real question is; if we knew then what we know now, what level of cap would have been considered appropriate?

The biggest problem I have had with the cap is the unanticipated and largely unavoidable spending pressures that were not allowed for in setting the new policy limit.

The first set of pressures were associated with the emergence of the “bones” - unsustainable base line cuts, which had to be offset against the counting limit.

In effect, money simply “ran out” mid term. It would not have been possible to maintain the existing policing presence if the police baselines had not been supplemented. This was not new policy.

It was new money for existing programmes. It cost $265 million during the term of this government.

Our tax system would have started to bleed revenue if IRD’s capacity had not been boosted by a $107 million funding injection. The Department of Child Youth and Family had been run down, and needed a $77 million resuscitation.

The previous government had intended to introduce a new regime for charging for border protection services, and even though it had not introduced legislation to implement the charging regime it assumed that it would have revenue to finance the protection regime.

The Department of Work and Income needed $36 million more money to run a new computer.

I have gone through this in some detail for two reasons. One is to indicate that the amounts involved are substantial, not marginal. The holes in the baselines that I inherited had to be filled at the cost of nearly $570 million - nearly a tenth of the total new spending that the incoming government had agreed to limit itself to.

Secondly, this money was new spending in a highly technical sense of the word: maintaining a police force, a secure border, a functioning welfare payments system and so on hardly qualifies as new initiatives.

Here I give credit to my Cabinet colleagues in general and our coalition partner in particular. Our collective decision is that there are things that emerge in the course of government that have to displace other things that we would like to have done.

There is no point in recriminations, and there are benefits in maintaining a credible fiscal reputation that outweigh the costs of policies postponed.

We have taken the brave decision to absorb these unanticipated baseline spending holes within the overall spending limit we set at the start of the term.

But there are items that we have not absorbed, and that will require a very small increase the total spending limit.

I would group these under the heading of preservation of national and regional security.

We have made a decision to extend the tenure of our peace-keeping force in East Timor, we had unanticipated costs in Bougainville, we have moved to restore defence capability through a long overdue adjustment to some pay rates. And we had to meet the costs associated with the impact of the exchange rate depreciation and the closure of the Hobsonville Airbase.

Logically, these cannot be seen as new policy initiatives. If it was we would face the ludicrous situation of making military decisions on the basis of how much money was left over from a somewhat arbitrary financial allocation. We would have said that we couldn’t afford World War Two!

These defence capability costs total $202 million over the term of this government.

I have also made a decision to extend the fiscal cap to the extent necessary to meet the cost of continuing the Bovine TB programme and upgrading measures to protect us from foot and mouth.

The fact that the budget for the TB programme - vital to our export earnings and employment base - simply ran out was, in my view, taking the “shonky baseline” practice a step too far. If it is a possum amnesty versus a $75 million cap extension, I will take the cap extension and be judged by that any day.

It would not have been sound policy to make a decision on foot and mouth - a question central to our economic security - on the basis of a spending cap set at the beginning of 1999.

What all of this means is that contrary to all the doomsaying that this government would never hold its fiscal line, we are on course to do so.

Defence capability and animal health protection measures will add something like $270 million to the spending programme. I have pointed out, though, that this still represents a more than $500 million cut in intended spending on new initiatives, because the money was diverted to meeting cost pressures beyond those I anticipated or was advised about.

The $270 million is also a miniscule quarter of a percent of the total spending planned for the term of office of the government. By any budgetting standards, that is super-tight.

Most of the focus on our fiscal performance has been on this operating expense cap. There was also a limit set on capital spending during the current electoral term.

We did not set a capital spending limit in our first Budget Policy Statement or first Budget. It was only finalised quite late in the piece, via the 2000 December Economic and Fiscal Update. The capital limit was set there at $3.2 billion as the companion to the $5.9 billion operations spending limit.

As we near completion of the second Budget, it is clear that in the short term the main pressures are coming on the operating side. Most have been absorbed, although as I explained earlier, the spending cap has been expanded to accommodate some. But at the same time I have lowered the capital cap by $200 million to $3 billion.

The important point is that we are making solid progress towards meeting our long term financial goals. Indeed, I anticipate that when the fiscal forecasts are finalised, they will be broadly in line the results that were anticipated in the December Budget Policy Statement.

This is the second government to use the concept of a total spending cap. I am going to stick with it, but we have learned that it does need fine-tuning.

The next government may want to amend its operations in light of the things we have learned. I reiterate: it is a useful discipline, but if, even at the edges, it is seen to be arbitrary, irrational or tyrannical, it will not last. We need to adjust it to protect it as a discipline.

What then, are some of the questions that need to be asked?

The $5.9 billion was a provision that was assessed to be consistent with operating within the financial parameters set down in the March 2000 BPS.

Since then, growth outlooks have changed, operating balance outlooks have changed and inflation has impacted on both revenue and expenses. A somewhat rule of thumb figure developed in early 2000 could well require up-dating and fine-tuning each year to stay true to its original intention.

If that is going to happen, rules for a regular updating need to be set in advance. Adjustments to a cap should not be an easy post facto rationalisation for a loose fiscal stance.

The $5.9 billion cap applies to operating expenses, not capital. The capital provision is both less testing, in relation to bids for capital spending, and able to be varied during the term of the government.

Work is underway to improve capital budgetting.

Under GAAP and counting rules, an initiative taken in year one of a triennium is three times as expensive as one taken in year three, even though over the longer term the costs are identical.

This could create perverse incentives. If a $20 a week increase in the pension costs three times as much if implemented in year one, there is an incentive to make it $60 in year three. The effect on outyear expenditure is dramatic, but totally disguised inside a counting frame.

This is an obvious perverse effect, and would have been apparent. Timing differences in health, education, conservation, the arts and the like would have more subtle, but equally substantial long-term baseline impacts.

One way to respond to this is to set the cap against both cost and intended (or assumed) timing dimensions. Hence the extra costs of an early start to the house rents policy would be discounted against the counting limit, because over time, it is the ongoing, not the “early start” cost of the programme that really matters. In this approach, the overall cap would be lower than under present counting rules.

Another option is to publish three year rolling cost estimates each year, in addition to, or instead of, a cap set at the start of a term of office. It would be lower than a cap that envisaged a front-end loading of new programmes, such as the one we adopted last year did.

Another issue is when and how the provisions for years beyond the term of office are adjusted. We have tended to use technical provisions, but next year, for example, it would not be very informative if I was to use technical provisions only for subsequent year forecasts.

In order to deal with this, in this Budget I will have to increase the operating provisions that had been made. It makes for a more realistic projection of future spending profiles, but it should not be seen as pre-empting the spending limit that the next government will be bound by.

Anomalies will arise from time to time. These largely relate to whether cost increases arise from a policy change, or from changes in the operating environment. Sometimes it is a finely balanced judgement that has to be made.

If a rigid framework is applied even when it is clearly irrational and illogical at the margins then either

(a) there is “gaming” to repackage Budget bids in capital form, or in other ways, or

(b) there is a revolt against any perceived tyranny, and the “dam” bursts.

As long as the purpose of the counting limit - achievement of fiscal objectives consistent with standards of prudent fiscal management - is met, there is scope to amend it at the margins.

For reasons of credibility, it is better to do this in a logical and explicit way, and to explain why the limit has been updated, rather than to present any deviation as “slippage”.

This leads back, then, to a focus on the end purpose of the counting limit : achievement of expense/GDP, operating balance, gross and net debt and net worth targets.

It is in these areas that the true financial test has to be applied to this year’s Budget.

The economic environment we are operating in is uncertain. The government has inherited a public sector with substantially eroded capacity. There are pressing social problems that have to be addressed.

The challenges of the modern economic world suggest that governments need to spend more on education, science, innovation and economic development.

Despite all of these things, the Budget that I am close to finalising looks set to produce the lowest level of expenditure, as a percent of GDP - and that is the relevant measure of size of government - since the late 1970s. That is a remarkable figure. We will also report the lowest level of net government debt in relation to GDP since the 1980s.

On both financial management and economic management fronts the Budget will report solid performance. It is important that it does so. This government has put a great deal of store by rebuilding our social base. It has to be seen as the government of economic management as well.

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