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Hon Dr Michael Cullen Speech To AON Function

AON Annual Function
The Wellington Club
The Terrace
6.oopm Wednesday 3 May

Hon Dr Michael Cullen
Minister of Finance
Minister of Revenue

I am aware that there is tremendous interest from your industry in the fund that the Labour Party is promoting as the best way of meeting the future cost of New Zealand Superannuation. I have to report that we are still in discussion with our Coalition partner, and there is not much that I can tell you that will advance your business interests in the proposal.

I get a lot of correspondence on this issue, much of which reflects a continuing misunderstanding of the basis of the policy. Income in retirement has two components: the first tier, basic, universal, government provided New Zealand Superannuation and the second tier made up of the returns on any private savings.

A lot of the correspondence I get, particularly from the insurance industry, is about how to design a regime to encourage private savings to replace New Zealand Superannuation. I am interested in better design of the incentive regime to encourage long term private savings.

I am not interested in a private regime to replace New Zealand Superannuation.
My proposed fund is designed to protect the integrity of New Zealand Superannuation by making the fundamental entitlements – the rate for a couple being at least two thirds of the net average wage, payable from age 65 – financially affordable when the population ages.

I am also told that the best way to encourage private savings is to cut taxes. I doubt that, but it is also an argument that applies to the second tier. Tax cuts undermine the ability of the government to defend the first tier.

Another argument is that we should introduce a compulsory private savings regime. I don’t favour compulsion, but again the issue is about the second tier, not New Zealand Superannuation.

The fund is about the first tier. The logic behind the fund is that there is a window of opportunity – the relative cost of New Zealand Superannuation falls for some years and remains low for at least the next decade.

The annual cost only peaks in around thirty years time, so we have the time, as a country, to save for our collective ageing.

But as for an individual, so for a country. The longer the decision to start saving is postponed, the bigger the proportion of income that needs to be saved in the remaining years.

Your industry knows full well that the big dollars in a superannuation fund are those that came from compound interest on the early savings. A dollar invested today, at compound interest of seven percent a year, is worth almost eight dollars in thirty years time.

I can’t really add value to your deliberations by musing on design options, so will now move on to an area where I have been making more specific progress.

Tonight I am going to break with tradition and share with you some of my experiences to date in pulling together my first Budget.

This is a work in progress report. Discussions with Ministers on a few vote items are still going on. Cabinet has yet to receive a final financial package for signing off. I am not anticipating any slippage in the time line we established for the Budget process. It will be presented in June.

I am giving you this progress report for one basic reason. It is that the new government has set itself six key goals. One of those goals is to restore trust in government. A part of that process is that government needs to be more open.

We have seen that already with Annette King releasing Treasury papers on the health reforms, and Margaret Wilson releasing officials advice on labour market reforms, even when the advice was critical of some aspects of the proposed policies.

My feeling is that in the past Budget processes have been excessively secretive. Of course there are issues of commercial secrecy and financial market sensitivity that need to be respected.
The problem is that under the guise of commercial confidence, too much has been concealed for no other reason than to get maximum public relations impact on release. What I want to establish is a practice of as much and as early a release as is consistent with the genuine requirements of commercial confidentiality.

I am going to give three pre-Budget speeches. This one will look at some of the financial parameters within which detailed spending allocations will be made. The second will canvass the state of the economy leading up to the Budget, and comment on some of the economic policy issues and conundrums the government has to deal with. The third will try and locate the Budget in a broader context of government policy – how it adds value to our distinct political programme, to use the jargon of the moment.

Why do I start, not end, with the financial numbers?
I am doing this because there is a bit of speculative mischief abroad that the government will not be able to resist big spending demands and live within the financial cap it has set for its policy programme.

I am not talking here about the recent Standard and Poors report after their sovereign credit rating review. S&P did flag that it had concerns about the possibility of fiscal surpluses being maintained, but the vast bulk of its negative comment was directed at the structure of the economy, and the resulting external deficit and private foreign debt.

That weighting of comment is not unreasonable.

I am more concerned about reports from financial market sources who “declined to be named” about the nervousness of international investors. These reports are never substantiated or detailed. I have recently returned from an investment promotion trip to Hong Kong, Tokyo and New York. I met with fund managers, introduced myself to them, let them see me, and gave them an opportunity to raise any of these concerns.

I have to report that they are quite relaxed about the financial soundness of the New Zealand Government. As they should be, and I will now explain why.

Let me go back to the start of the Budget process. Our legislation establishes a three stage Budget process. The first stage is a pre-Budget Policy Statement. This defines the economic and financial framework within which the Budget will be prepared, and sets out medium and longer term financial intentions.

The BPS was produced under very difficult conditions. The lateness of the election in relation to the Budget cycle meant that the BPS had to be produced in about half the normal time. It had to be produced in half the normal time in a distinctly non-normal year. This was a year of substantial change of government direction and intention, and in an ideal world a good BPS would have required twice the normal time.

The result was that we had to make, and reported that we had made, a number of assumptions and technical provisions in putting it together. The detail was to be considered during the fuller Budget process. I am happy to be judged against the BPS, but want to be fairly judged against the BPS.

The big issue is the spending cap under which the government is operating. We set that at an extra $5.9 billion over our first term of office. In setting that figure we attached two conditions.

The first was to avoid building into basic programmes allocations that depended on sustaining current rates of economic growth. In other words we did not want to make structural spending decisions around financial surpluses that were emerging for cyclical reasons.

The second is that we did not want to compromise the ability of the government to make allocations for predictable increases in spending that would occur in ten, twenty and thirty years time. We did not want to saddle our grandchildren with hard choices of more taxes or fewer services if we were not prepared to face them too.

In the bluntest of terms this meant that the government is not going to spend a growth dividend. I am sick and tired of hearing people say "aren’t you lucky you inherited a strong economy because this makes your job of producing a Budget so much easier." It does not, unless I am going to be reckless and try to use what could be short-term financial advantage for short-term political gain.

That was the hallmark of the previous government that distributed non-sustainable surpluses as tax cuts - and then had to cut back on essentials when confronted by reality.

The $5.9 billion has two basic components. One is that within the spending projected by the last government there were provisions that were not allocated. We will allocate them. The second is that we cancelled the scheduled tax cuts and raised taxes at the top end of the income scale. We were determined to pay for our promises.

The unallocated provisions amounted to $2.7 billion, and the tax reversals generated an additional $3.0 billion over the next three years.

This totals $5.7 billion, out of total projected spending of $5.9 billion.

The result is that expenditure growth is tracking below nominal GDP growth, resulting in falling operating expenses as a percent of GDP.

That was the end target at the time of the BPS, and at this stage of the Budget cycle I can say that it will still be the end target.

The remaining issues are the composition of spending and the timing of spending during the Parliamentary term.

The first priority for the government was to honour its commitment card pledges. Four of those were big ticket spending items: reversing the 1999 cuts to New Zealand Superannuation rates, introducing a fairer student loan scheme, restoring income related rents for low income tenants of state houses and reducing waiting times for surgery.

Two of the other pledges – promoting employment by better support for exporters and small business and cracking down on burglary and youth crime – are a mix of money and process.
The point about the first four is that they impact early in the Parliamentary term. They front end load a big part of the $5.9 billion spending cap. The good news is that they do not generate an uncomfortable escalation of cost.

But they do not entirely meet our intentions in the BPS to move toward at least a more neutral cyclical stance in fiscal policy.

We intend to introduce more stability into the system by maintaining spending and expenditure at steady levels through the economic cycle. But it is fair comment to say the spending impact at the front end of the Parliamentary term is co-inciding with a strong economic upswing, and could be considered pro-cyclical.

In this regard let me make four comments. One is that it is co-incidental, not a matter of conscious policy choice. It would not, in my judgement, have been credible to say to the voters that we made you these promises but because economic conditions are good we will only deliver on them in two years time.

That would certainly contradict our stated aim of restoring trust in government.

Secondly, the big problem with the previous practice was that it fuelled domestic consumption in an upswing which was already being led by rising consumption and increasing household debt.

The end result was a worsening in the balance of payments deficit. This time the expansion has a strengthening export component, and indications are that domestic consumption is beginning to plateau. At the very least, any aggravation of the economic cycle is not aggravating structural imbalances in the economy.

Thirdly, the front-loading of expenditure is the mirror-image of the front-loading of revenue changes. The substantial change to tax rates - netting us about $800 million a year - came into effect on April 1. Clearly no such further revenue change is planned or anticipated for the remainder of the fiscal cycle.

Finally, despite the loading, there will still be a substantial surplus in each of the three years. Technically, the fiscal stance is still contractionary: we are taking more out the economy than we are putting back in.

Let me also add that I have not been tempted to use an economic excuse to revert to election cycle spending. The Muldoon cycle of dish out the bad medicine in the first year of office, rely on short memories and spend lavishly in the run-up to the election was incredibly debilitating economically.

Returning now to the balancing act – some of my colleagues might say kneecapping – that went on during the rest of the Budget round. If "X” - $5.9 billion over three years – is a modest number and “Y” – the commitment card pledges - is quite a large number, “X-Y” – all that is left for the whole of the other policy initiatives that a new government wants to fund - is going to be a relatively small number.

Here let me pay tribute to my colleagues. Patience and realism have been the hallmark of the Budget negotiations.

I must, though, record my irritation, annoyance and anger at some the unavoidable spending pressures that I inherited. If there is a small amount left for discretionary initiatives, any extra claim on the money has a large proportionate impact. What we did inherit was a raft of such claims.

The basic premise that I was working from was that the fiscal forecasts allowed for what is know as baseline increases – in other words if there are school roll increases in the pipeline these are costed into the projected spending levels. The $5.9 billion extra was for initiatives over-and-above this.

What I hadn’t realised was that some of the so-called baseline figures had factored into them undeliverable spending reductions. What was worse was that those spending reductions were absolutely unrealistic and unsustainable.

Let me give you four examples. The Inland Revenue Department has had its funding cut to and through the bone in recent years. Yet incredibly the so-called business as usual baseline envisaged a further $30.4 million reduction in the 2000-01 year.

Letting that stand was not an option. IRD would have had to discontinue some critical legal actions on important test cases, make a lot of staff redundant and abandon significant work on tax evasion. Response times for correspondence and phone enquiries would have increased. And after all of that I, as Minister of Finance, would have been an estimated $170 million out of pocket!

So here I had this innocuous baseline that said you can spend as per projected fiscal outlook, but lose $170 million of revenue, or increase allocations to IRD just to get them back to where they are now. It is ludicrous.

You have all heard about the Police and INCIS. In addition to that there is a $60 million a year shortfall to maintain existing Police operations. The government had factored in a cut of about $30 million in border control costs on the assumption that a user charge regime would be introduced. But no legislation to do this had been passed or even proposed. The children and young persons service could not maintain operations without a major refunding.

These four are absolutely core government functions. We cannot abandon effective control of the border – just look at the damage that is being done with the bee mite even with existing controls. Imagine cutting $30 million and then looking to find some user charges to plug the gaps. What risk does that expose our key industries to? We have to have an effective Police force. We have a young persons service that is badly stretched. We have nothing if we do not have the revenue to pay for it.

Yet these core functions were baseline funded on a decreasing allocation of some $150 million a year. That is only the start of the under allocation for existing government operations. I could add full funding for the teacher pay parity settlement, serious under-funding of Te Papa and the Symphony Orchestra, and the large capital shortfall for defence.

These skeletons in the cupboard collapsed to form a $200 million a year plus pile of bones. And those bones were radio-active. They glowed in the dark. They could not be ignored. They have added intense pressure to the “X-Y” residual that I referred to earlier.

At this stage, the unforeseen under-allocated baselines look like displacing some of our intended new initiatives and postponing others. They cannot displace or postpone all of them. By way of example, in this day and age it is little more than reckless irresponsibility for a modern state not to have a robust bio-diversity strategy. That is neither discretionary nor deferrable.

The response during the Budget process has been three-fold. Some of the unavoidable extra concealed spending has been brought forward into the first year. This has meant that allocations for the out years have been squeezed.

We will try to increase the headroom available to us by intensifying the value for money campaign and reallocating resources from low priority projects.

I am quite relaxed about the rescheduling. It is always important to put these things in perspective. The government spends about $38 billion a year. Fractions of a point of a percent adjustments do not represent fiscal slippage. What is important is the end result.

For me, the end result is that as we move towards the tidying up stages of the Budget cycle I can identify three huge successes.

The first is that the collective fiscal discipline of the Coalition government has been tested and has withstood the test. The second is that we will post surpluses largely in line with those in the BPS, even though when the BPS was pulled together it had to be on the basis of assumptions and some technical provisions.

Finally, we have created a very strong platform for budget cycles still to come. Once the structural realignment of spending is complete, by facing up to and correcting absolutely non-sustainable base line funding cuts that were factored into pre-election projections and by incorporating commitment card pledges into new baseline spending, the public accounts will be clean and clearly sustainable.

At that stage, we will be in a position to align our fiscal stance with the state of the business cycle taking further pressure off monetary policy.

Ever since I was appointed Minister of Finance I have said that I am a fiscal conservative and a member of a fiscally prudent government. In reporting to you on budget progress tonight, it gives me pride to be able to say I am still both.

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