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Treasury Releases December Working Papers

12 December 2003

Immediate Release

Treasury Releases December Working Papers
The Treasury today released eight working papers in the December instalment of its Working Papers series.

This quarter’s set of papers includes:

- Geometric Return and Portfolio Analysis (Paper 03/28)
- The Excess Burden of Taxation and Why it (Approximately) Quadruples When the Tax Rate Doubles (Paper 03/29)
- Three Policy Options for Crown Financial Policy (Paper 03/30)
- Competition Policy in Small Distant Open Economies: Some Lessons from the Economics Literature (Paper 03/31)
- Household Saving Behaviour in New Zealand: Why Do Cohorts Behave Differently (Paper 03/32)
- Reweighting the New Zealand Household Economic Survey for Tax Microsimulation Modelling (Paper 03/33)
- Population Ageing in New Zealand: The Impact on Living Standards and the Optimal Rate of Saving with a Flexible Real Exchange Rate (Paper 03/34)
- Qualifications, Employment and the Value of Human Capital, 1986-2001 (Paper 03/35)

A full list of the abstracts from the eight papers follows.

The papers can all be found at

The Treasury Working Papers series contains work in progress on a variety of economic and financial issues. The series aims to help to increase understanding of Treasury and its work, and to make this work available to a larger audience. The working papers build internal capability, as well as generating more informed debate on key issues. The series has been running since 1998.

The views expressed in the Working Papers are those of the authors and do not necessarily reflect the views of the New Zealand Treasury. The papers are presented not as policy, but with a view to inform and stimulate wider debate.


03/28 Geometric Return and Portfolio Analysis
Brian McCulloch (Treasury)

Expected geometric return is routinely reported as a summary measure of the prospective performance of asset classes and investment portfolios. It has intuitive appeal because its historical counterpart, the geometric average, provides a useful annualised measure of the proportional change in wealth that actually occurred over a past time series, as if there had been no volatility in return. However, as a prospective measure, expected geometric return has limited value and often the expected annual arithmetic return is a more relevant statistic for modelling and analysis. Despite this, the distinction between expected annual arithmetic return and expected geometric return is not well understood, both in respect of individual asset classes and in respect of portfolios. This confusion persists even though it is explained routinely in finance textbooks and other reference sources. Even the supposedly straightforward calculation of weighted average portfolio return becomes somewhat complicated, and can produce counterintuitive results, if the focus of future-orientated reporting is expected geometric return. This paper explains these issues and applies them in the context of the calculations underlying the projections for the New Zealand Superannuation Fund.

03/29 The Excess Burden of Taxation and Why it (Approximately) Quadruples When the Tax Rate Doubles
John Creedy (Treasury)

The ’excess burden' of taxation represents an efficiency loss which must be compared with any perceived gains arising either from income redistribution or the non-transfer expenditure carried out by the government. An important property is that, under certain assumptions, it increases disproportionately with the tax rate. This result provides the basis of a general presumption in favour of a broad-based and low tax rate system: any
exemptions which reduce the tax base inevitably raise the tax rate required to obtain an
unchanged amount of total tax revenue. The aims of this paper are to provide a nontechnical explanation of the concepts of welfare change and excess burden used in the public finance literature, and to demonstrate the result that an approximation to this
burden depends on the square of the tax rate.

03/30 Three Policy Options for Crown Financial Policy
Eric Hansen (Treasury)

Crown financial policy is concerned with how the government manages the Crown’s assets and liabilities. The recently established New Zealand Superannuation Fund, which is projected to grow to around 45% of GDP over the next few decades, highlights that Crown financial policy is likely to become an important economic policy tool with potentially significant implications for New Zealand economic welfare.
Previous work has identified that four objectives should form the main basis for assessing alternative Crown financial policies. Three of the objectives relate to minimising distortionary taxation, time-inconsistency of policy and agency cost of government. However, the absolute and relative importance of these objectives is subject to considerable uncertainty. The fourth objective, which is to avoid exacerbating any existing inefficiencies or creating any new ones, is considered part of the baseline common to all policies.
In this paper a qualitative analysis is conducted to select three high-level policies for detailed quantitative analysis in future papers. The three policies vary in terms of level of risk:
- A low risk policy that places emphasis on time-consistency and agency cost issues while down-weighting the significance of distortionary taxation;
- A medium risk policy that applies a balanced weighting to the three issues; and
- A high risk policy that places emphasis on distortionary taxation while down-weighting time-consistency and agency cost.
Detailed policy targets are specified for the candidate policies in terms of Crown net worth, overall risk/return properties of the Crown balance sheet, and the level and structure of financial assets and public debt. The policy targets under the status quo are presented for comparative purposes.

03/31 Competition Policy in Small Distant Open Economies: Some Lessons from the Economics Literature
Lewis Evans and Patrick Hughes (New Zealand Institute for the Study of Competition and Regulation)

New Zealand is a small open economy that is remote from all major markets. The smallness and remoteness of New Zealand combine to imply that this country has, at least quantitatively, distinctive features for the regulation of economic activity by competition law. The isolation and small size of the economy mean that typically all but exporting firms are small as judged on a world scale, and that domestic markets are small and generally highly concentrated. This paper reviews the economic literature on the implications of an economy’s size and isolation for competition law.
The literature suggests that principles underlying competition law do not change for small economies, but that the application of competition law should be different. In small economies, low regulatory and tax barriers to trade dominate the importance of competition law for good economic performance of domestic markets. In these economies, competition law should focus on economic benefit/detriment evaluations of mergers and trade practices rather than rules of thumb of the sort based on measures of market structure and indicators of competition, or those aimed at prohibiting particular practices per se. Producers’ surplus should not be de-emphasised in the calculation of benefits and detriments in small economies; particularly for activities that relate in any way to (potential) export activity. For any economy, particularly in the presence of competition, cooperation enhances economic performance in specific circumstances. In small economies cooperation can be particularly efficient—for
example, in achieving scale and thereby export performance—although it may entail interaction among a large fraction of players in an industry. The approach that the literature suggests to the application of competition law in small economies places relatively heavy weight on dynamic efficiency as the criterion for competition law design and enforcement. It is squarely in accord with recommendations in the literature on desirable competition law for the so-called new economy.

03/32 Household Saving Behaviour in New Zealand: Why Do Cohorts Behave Differently?
Grant Scobie (Treasury) and John Gibson (Waikato University)

The aim of this paper is to add to the understanding of saving decisions by households. The saving behaviour of households is found to differ depending on the birth cohort of the household head. This paper seeks to explain why this pattern might exist. It is based on an analysis of synthetic cohorts derived from unit record data taken from the Household Economic Survey (HES) for the March years 1984 to 1998. The need to use synthetic cohorts arises as the HES is not a longitudinal panel survey, but rather a time series of independent cross-sectional samples. We use a range of regression models to separate out the effect of age, birth-year cohort and year on saving rates. The typical saving rates for the cohorts born between 1920 and 1939 are found to be significantly lower relative to the younger and older cohorts studied. This pattern of cohort effects is robust to the inclusion of conditioning variables; to the trimming from the sample of households with either negative or very large ratios of savings to consumption, and to different definitions of saving. Some exploratory investigation supports the hypothesis that changes in the economic and policy environment help explain the different saving behaviour of different birth cohorts. Tentative results suggest that more “favourable environments” are associated with lower rates of lifetime saving.

03/33 Reweighting the New Zealand Household Economic Survey for Tax Microsimulation Modelling
John Creedy

This paper reports a reweighting exercise for the New Zealand Household Economic
Survey, which is the basis of the Treasury's microsimulation model, TaxMod. Comparisons of benefit expenditures in a variety of demographic groups, along with population data, reveal that TaxMod estimates differ substantially from totals based on administrative data, when the weights provided by Statistics New Zealand are used. After describing the method used to compute new weights, the calibration requirements are reported. These relate to the age structure of the population and the number of beneficiaries for Unemployment Benefit, Domestic Purposes Benefit, Invalid's and Sickness Benefits and Family Support and Tax Credits. The revised weights and expenditure estimates are reported and the resulting distribution of income examined. The new weights are found to produce much improved expenditure estimates, without distorting the resulting income distribution. The effects of reweighting are demonstrated using a simple policy simulation.

03/34 Population Ageing in New Zealand: The Impact on Living Standards and the Optimal Rate of Saving with a Flexible Real Exchange Rate
Ross Guest (Griffith University, Australia), Grant Scobie and John Bryant (Treasury)

The purpose of this paper is to extend the simulation analysis of population ageing in Guest, Bryant and Scobie (2003). In that paper a single-good Ramsey-Solow model was calibrated for New Zealand and used to simulate the impact of population ageing on optimal national saving and average living standards over the next 100 years. There are several innovations in the present paper. One is to allow for tradable and non-tradable goods and thereby to introduce a real exchange rate. Changes in the real exchange rate due to population ageing produce substitution effects between tradable and non-tradable goods, in both consumption and investment. Other innovations in this paper are an outward-looking model of utility, a proportion of rule-of-thumb consumers, and a vintage capital model. The simulations of population ageing are conducted by first deriving a range of demographic projections from alternative assumptions about fertility, mortality and immigration. The resulting series for population and employment by age group are weighted to account for age-specific labour productivity levels and consumption demands. The model is solved by finding optimal paths of investment and consumption from an initial steady state to a new steady state following a demographic shock. The sanguine assessment of the impact of population ageing on living standards and national saving in Guest, Bryant and Scobie (2003) remains intact following the extensions applied to the model in this paper. That is, the cost of ageing is equivalent in its effect on living standards to an annual loss of labour productivity growth of about a quarter of one percent over the next 50 years. It is likely that a temporary increase in the current rate of national saving of less than one percent of GDP, lasting for a few years followed by declines in the rate of national saving, would optimally smooth out the effects of population ageing on living standards in New Zealand.

03/35 Qualifications, Employment and the Value of Human Capital, 1986-2001
Dean Hyslop (Treasury), Dave Maré and Jason Timmins (MOTU)

This paper summarises the changing nature of qualifications across the working age population in New Zealand over the period from 1986 to 2001, and investigates the relationships between the changing qualification distribution and employment and income. First, the results confirm that there was a general upskilling of the population, as measured by formal educational qualifications. Second, we examine patterns of qualification change and employment growth measured in job groups, and find that the upskilling of the population occurred across a wide range of job-groups. Also, although the results show the employment growth was strongest in job-groups with high initial levels of skilled workers, employment growth is only weakly related to upskilling. Third, we decompose the change in the value of human capital into contributions due to changes in the qualification mix, changes in the (economic) returns to qualifications, and the interaction between these two factors. The value of human capital increased by 20% over the period: about 75% of this increase can be attributed to increasing incomes holding constant the mix of qualifications, 15-20% to an increasing skill mix, and the residual to interaction effects.

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