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Speech To Public Sector Finance Conference

Speech To 5th Annual Public Sector Finance Conference

Hon Dr Michael Cullen, Minister of Finance

Delivered by Mark Peck MP – Chair of Finance and Expenditure Select Committee

9.10 am, 23 August 2001

Te Papa, Wellington

Financial strategies for the budget and public sector.

I bring greetings from Finance Minister Michael Cullen who, not being able to be here in person, sends his best wishes, apologies and me - to present the first paper at this year's conference.

The conference agenda is understandably focussed on the technicalities and practicalities of public sector financial management. Good public sector performance and accountability structures depend on robust hardware: the Public Finance Act, the Fiscal Responsibility Act and the like. But like any system, it is only as good as the software that is loaded into it. In this case, the software is the calibre of public servants, and it is important at the outset and in the political context of the moment to salute dedication, honesty and integrity of our public service.

The legislative hardware also places requirements on Ministers for sound financial management, but by the same token it is more effective if the Ministerial software is operating effectively. In this case the software involves articulating strategy to the public service, making expectations clear and communicating the more subtle elements of policy priorities and coordination.

It is inevitable that there is some confusion about priorities and expectations when a government changes, and as a general rule that places extra obligations on both parties to make sure that they are hearing each other, not just talking to each other. According to Dr Cullen, by the time of this year’s Budget, those communication channels were operating much more effectively at all levels.

Despite that, there is always the problem of the Budget process itself: in all countries and in all years. Alan Schick comments on the nature of government budgetting in the following terms:

“ In most governments, even the better managed ones, money is doled out on the basis of woefully inadequate information on what was accomplished in the past and what is expected to be achieved in the future. Spending patterns often are frozen by incremental habits and mandatory entitlements that dampen conflict but diminish the budget’s responsiveness to fresh opportunities and new priorities. The evaluation of programmes is spotty, and policy analyses are rarely fed into budget decisions. Budgeting often is a bruising process in which time is short, money is scarce, stress is elevated and few get all they want.”

The bad news is that bugetting is now a twelve months cycle. It has been asked if we have not exacerbated all of these problems Schick identifies by excessive fragmentation of administrative structures and vote allocations. The government has also commissioned the second of its Value for Money exercises to try and see if we can deal more effectively with the evaluation and priority setting processes.

That is for next year’s Budget.

The 2001 Budget reflected the government’s continued commitment to three core objectives: sound financial management, responsive social policies and the transformation of the economy.

There are, however, two features of the Budget that have perhaps not attracted much attention. Firstly, the three objectives – fiscal, social and economic – are complementary, not competitive. Secondly, this government has taken a much longer term view of the structure of its finances than any other that I can recall. This longer term view has been reflected in both our operating balance and our programme of public investment and debt management.

Let me start by stressing the interconnectedness of fiscal, economic and social policy objectives. There has been a tendency for the debate – from both the left and the right – to see these objectives as distinct and to a large degree conflicting. We often hear, for example, that a strong fiscal position either inhibits growth, or, from the other perspective, indicates that less is being spent on social programmes than we can afford.

The growth argument rotates around spending the surplus on education or by generous incentives to research and development and so on, but is more usually linked to tax cuts. I often hear that tax cuts will variously stimulate investment, reward and hence encourgage innovation and reverse the brain drain. The facts, of course, do not bear this out. Our recent experience is that growth, investment, innovation and migration patterns have not been positively associated with rounds of tax cuts, nor negatively associated with stable tax rates.

Some recent, albeit unsought, advice to the government has been that we should cut taxes, run surpluses, increase business incentives and pay off debt as well! Leaving aside the implausible option of spending the same dollar two, three or four times, I think we need to get back to the core message: strong public finances are not growth hostile. There are two key reasons for this.

The first is that a weak fiscal outlook – or even a knife-edge outlook – undermines confidence, and confidence is crucial to investment, innovation and growth. If the perception is that the government’s finances are not under firm management, the risk is that interest rates may rise or tax rates may rise – the form, extent and timing of both being inherently uncertain. That is not a sound foundation for investor confidence.

The second reason is linked to the first. This is that monetary and fiscal policy are linked. A looser fiscal stance will, all other things being equal, imply a tighter monetary stance and vice versa. A rising exchange rate or rising interest rates, or both, will have a much more immediate impact on investment and employment than the somewhat more nebulous growth boost that may (or may not) flow out of tax cuts or direct incentives.

Of course all of this is a matter of degree. How strong a fiscal stance is strong enough? And can it be too strong? The 2001 Budget forecasts a rising operating surplus over the forecast horizon – in this case to the 2005 financial year. They rise, on average, by about half a percent of GDP per year, so that by 2005 the surplus is 2.7 percent of GDP. Is this too restrictive a fiscal stance?

I would say not, for two reasons. If we had a stable demographic structure, a structural surplus closer to zero may be more appropriate. The fact is that the demographic structure is changing, and we need to look to that longer term horizon. I will return to this later. The second reason for the current stance is that because of some neglect in the 1990s, there is pressure on capital spending over the forecast horizon. I am not going to pronounce on the overall degree of fiscal tightness that the Budget reflects, but would note, without comment, that one financial analyst argues that the mix on current and capital accounts establishes a fiscal stance that is about neutral. In those circumstances, moving to a stimulatory fiscal stance, at a time when monetary conditions are regarded as being stimulatory, would not be wise macroeconomic management.

I will turn now to the other side of the argument – is there enough headroom to allow more generous social spending? Put another way, is fiscal management hostile to sound social policy programmes? We believe that social security is part the quantum of money spent and part personal confidence that social security is affordable. We do not accept arguments that political parties can, for example, guarantee New Zealand Superannuation on the current formula and at the same time avoid saying how they are going to pay for it. That does not improve social security. It undermines it.

We have, at the moment, a demographic structure that is in transition. In the nineteen fifties and sixties, we had large numbers of young people and relatively few old people. Governments of that day spent money building schools and state houses, paid family benefit and reduced income tax rates for earners with children. In the seventies and eighties, there was a major social shift, particularly with regard to labour force participation. More women stayed longer in the labour market, and returned earlier to it after periods of child raising. Leaving aside the social judgements associated with this, the effect was to boost the proportion of the population of working age that was either in work or seeking work.

During the late 1980s, the nineties and the first decade of this century, then, we have a demographic structure under which there are relatively few young people, relatively few older people, and relatively more people active in the market economy. Hence we have the conditions under which fiscal surpluses would tend to rise. We have wasted them in the past. Firstly with very large producer subsidies such as SMPs, export incentives and Think Big, and then with tax cuts that distributed the surpluses that were starting to emerge.

A cynic would say that it is the historic mission of centre-left governments to repair the fiscal damage that conservative administrations leave them!

It is important, though, not to build up social programmes that are affordable with one population structure but that would not be affordable when that population structure changes in the near and predictable future. That, I repeat, does not improve social security. It undermines it. This confirms my view that sound financial management is not in competition with solid social welfare: it is the very instrument that underpins it.

I have argued that strong public finances are consistent with solid economic performance and robust social security. The third leg of this treble is that economic and social policies are themselves complementary, not competitive.

The traditional view that the economy generates the wealth that social policy consumes is the view that sees economic and social objectives as incompatible. I am pleased to see that this traditional view is in retreat. It is reasonably clear that improved economic performance contributes to improved social policy results. More people in jobs, earning higher incomes clearly improves standards of living. A better performing economy expands the tax base and makes it easier for government’s to finance social services.

It is less clear that this loop works in reverse as well – that a well functioning society contributes to improved economic performance. This, though, is clearly motivating government policy development in a number of areas. Some of the reverse linkages are obvious. A better performing economy allows better funding of education, and a more educated population contributes to improved economic performance.

Work in the Treasury now, though, is identifying a richer connection between the social and the economic. A lot of our social wellbeing is derived from personal networks: friends, neighbours, work colleagues, members of Church and sporting groups and the like. Those networks contribute to improved economic performance in subtle ways; increasing the flow of information without clunky and formal communications systems, improving trust to reduce the highly legalistic and compliance heavy cost structures that would exist in a purely contractualist world and so on.

The integrity of core institutions like the police and the courts have long been established as providing a part of the regulatory framework that makes countries attractive destinations for investors. We are now recognising that trust in government is a positive feature of social wellbeing, and that it adds to the climate of trust that oils the wheels of the economic machine and improves its performance.

The 2001 Budget did start to break down the artifical distinction between the economic and the social. Employment is by far the best social welfare programme ever invented. Education is by far the best route to employment. By putting a focus on education, and by concentrating on creating employment opportunities, the government is shifting emphasis from the negative to the positive and to prevention rather than cure.

Much more work, however, needs to be done to refine the way that programmes are structured and financed in the future.

I want to turn now to the second feature of the government’s financial strategy: its focus on the longer term. There are many aspects of longer term financial management, but most would revolve around the word “sustainability”. Projects and financial arrangements may be sustainable in the immediate future, but can generate decades of corrective action. A good example was the “Muldoon pension” which won an election but produced twenty years of policy turbulence in a vital area of national interest.

Government programmes have to be sustainable in three dimensions: the social, the economic and the environmental. There are major projects under way in each of these areas, and there will be a need to integrate the conclusions and priorities arising from each of them. Today I want to talk about three aspects of longer term financial perspectives: provision for the cost associated with an ageing population, the financing of tertiary education and the government’s management of its debt and public investment activities.

Those were the three areas that were prominent in the 2001 Budget and the commentary on it.

I have already talked about the need to go beyond defining entitlements to New Zealand Superannuation and to say how they are to be paid for. The 2001 Budget started the process of transferring a part of the operating surplus into a fund that will assist future governments in meeting the costs of the demographic transition. Some of the criticisms of the fund highlight the difference between parties with a short-term fiscal focus and this government with its more distant fiscal horizon.

The first question, of course, is whether we can afford it. The answer to that is yes. Over the four years ending 30 June 2005, the government projects operating surpluses of $10.5 billion in total, compared with proposed NZSF contributions of $6.1 billion. There is almost twice the level of surplus needed to cover contributions.

I will come back to the spurious argument that we can only afford it by borrowing the money we are putting into the fund. The public sector borrowing requirement – and the resulting debt profile – is the end result of a complex set of decisions. For example, borrowing to put $80 million into the “People’s Bank” was based on a business case that indicated that the government would make money on this investment in the long run. Borrowing to retire hospital debt is justified because the government can borrow more cheaply than individual hospitals, so the money available for health goes further. Some borrowing is necessitated by timing – such as the need to modernise defence equipment falling due over the next five years.

In some years, the net effect is that the dollar level of debt will rise and in others it will fall. Just as we should not hold back on NZSF contributions if nominal debt rises, so we should not increase the rate of contribution if it falls. This is precisely what I mean by taking the longer view and not being driven by short term opportunism.

What then, about the Green claim that the current scheme is affordable? This is classic denial. The argument rests on the flimsy logic that what matters is the ratio of those of working age to those who are dependent on the employed. Because the number of old does not rise much more markedly than the fall in the number of young, the dependency burden is manageable.

This is not so for three reasons. Firstly, in fiscal terms, it is the cost to the government that matters. Much of the cost of supporting young people is “privatised” (parents pay for them). The government meets almost all of the cost of supporting older people. It is estimated that seventy percent of the income of single 65+ people and sixty percent of the income of couples 65+ came from NZS. Treasury estimates that it costs the government almost four times as much to support a 65+ as it does to support an under 16 year old.

Secondly, it would be highly risky to base a long-run fiscal strategy on an assumption of stable per capita spending on the young. I would imagine that the demands of the modern technological age are such that as the numbers of young people reduce, we will be spending more per head on each of them to maintain the value of the nation’s human capital.

Finally, as the population ages, it is possible to imagine that the cost per head will rise as new health interventions become possible and longer life spans increase the cost of long-term frail care.

I like to put it this way. If the Greens are right, and we don’t need the Fund, in thirty or so years time we will have many good uses to put the money to. If the Government is right, but we followed the Green’s advice, what will we do? That is the essential difference between a longer term financial management regime and the hand to mouth systems that got us into trouble in the past. This is particularly important in areas where the emerging cost pressures are largely predictable. Demographic structure is one such area.

Those aged over 65 are expected to increase from 12 percent of the population to 25 percent by 2051 and to 27 percent by 2061. Much of the growth is in the older age cohorts – over 75 and over 85. At the moment, 5 percent of the population is over 75 and by 2051 this will have trebled to 15 percent. Hence a doubling of the over 65s is accompanied by a trebling of the over 75s, and an even greater proportionate growth of the over 85s. All of this has major implications for other spending such as on health and personal support for the elderly.

Our decisions on tertiary education also focus on the longer term, but with a different rationale. In this case it is the longer term skills needs of the economy and the longer term employability of the future workforce that are the main considerations.

The present tertiary education system was designed to lift participation in post school education and training. It did that by constructing a demand driven funding regime, that gave strong incentives to providers to increase throughput. The system has succeeded in lifting overall participation rates to levels consistent with those of other developed countries, although there is room for improvement in some areas, especially by Maori and Pacific peoples.

The problems that exist are of overall quality, relevance, duplication and cost effectiveness. There is a lack of course differentiation, a proliferation of degree courses, unnecessary competition, the underproduction of key skills across a wide range, and some employer dissatisfaction.

The root cause is the pressure that providers are under to generate student numbers. That inevitably means advertising for students and promoting high volume low cost courses, rather than the full spectrum that might be both wanted and needed. We will not solve this problem within existing structures or using existing funding arrangements. That is why the government has developed a Tertiary Education Strategy. All publicly funded providers and industry training organisations will be subject to a system of profiles and charters that set out their strategic direction and activities.

The new system will lead to significantly enhanced coordination and much greater clarity of purpose in the sector. It will point the way towards producing the skills we need, at the level of quality we must have, and in an efficient and cost-effective manner.

I am going to end this presentation by looking at public investment and the government’s management of its debt. As I mentioned earlier, this has become an area of some confusion given the argument about borrowing to put money into the superannuation fund.

Underspending on capital projects – whether it is a new prison, equipment for the defence forces, hospitals or roads – is a classic case of being able to save money today but only at the cost of bigger problems in years to come. This government is determined to avoid the capital neglect that characterised the previous administration. Proper budgetting for capital expenditure, setting the priorities and coordinating the implementation are all areas of weakness in our current fiscal planning process. It is an area that we are working on and I am confident that we will end up with major improvements in this dimension of public sector financial management.

It has to be said that just as governments can have too much debt, so can they have too little. Too much debt diverts too large a portion of future government revenue to debt servicing. Too little debt means that there are capital spending decisions that have the potential to improve economic and social performance and realise our national potential that remain on the shelf.

I want to touch on whether rising debt levels is a bad thing; structural changes in debt management; and how investment management is changing.

As I mentioned earlier, the Government’s fiscal policy is focused very much on the long-term with the need to manage future fiscal pressures associated with the ageing population and the higher levels of spending this is likely to require.

In a nutshell, key elements of the Government's fiscal policy are about creating rising surpluses, building up assets in the New Zealand Superannuation Fund and keeping gross debt levels at around 30 percent of GDP.

Turning to the question of whether the debt burden is rising – New Zealand’s public debt is low by historical and international standards. We have settled on fiscal policy targets that maintain this position.

The Government’s net debt target is 20 percent of GDP and gross debt target, 30 percent of GDP. Current forecasts indicate that we are achieving our target levels over the next ten years, even with the much higher capital spending we introduced last budget.

What this clearly does not mean is that the Government has a numerical target level of debt. There is no “optimal” debt ceiling limit that must not be breached. Indeed, rising nominal debt is not a bad thing when considered in the context of an expanding economy.

Much gain has been made in reducing debt levels through the early 1990s in response to the extremely high New Zealand public debt levels. This was achieved in no small part by state sector asset sales. This Government certainly has no intention of taking New Zealand back to the situation of an unsustainable debt burden, but equally it wishes to reinvest in the existing asset stock. The change in policy from “prepare for sale” to “continue to own” has meant that as far as the SOEs are concerned, the focus is on maximising the value to the Crown of these strategic assets.

There has been much comment since the release of the Budget 2001 forecasts that the Government’s nominal debt is rising. And if debt is rising why is the Government investing in the New Zealand Superannuation Fund? As Dr Culeen has repeatedly stated, the Government is not borrowing to specifically fund the New Zealand Superannuation Fund, the Government is aiming to run surpluses to accumulate assets. If there was no New Zealand Superannuation Fund I don’t think we would be trying to maintain such high levels of surpluses. The very people who criticise borrowing also propose more spending and tax cuts.

This means that borrowing would still be increasing in nominal terms whether there was a super fund or not. It all depends on what else was done with the money. But I want to dispel the myth that the Government’s debt burden is rising. It is not. As a share of the economy, the debt burden is not rising. Nominal debt can and currently is forecast to increase – but this does not mean that the Government is expanding its share of the New Zealand economy through debt accumulation.

Using debt to finance the balance sheet has always been a principle of sound fiscal management practice in the private sector. It remains equally applicable in the public sector. It shares the cost of investment over time and reflects the longer-term benefit such capital spending brings.

This brings me to a key change in the structure of debt management. Previously the health sector was able to borrow directly from the private sector. The policy “backstop” behind allowing private sector debt financing was the expectation that the private sector lenders scrutiny of performance would outweigh the additional costs of borrowing – aiding in the overall incentives regime of the relevant Crown entities.

The Government has decided that with district health boards, while there may be some benefits from continuing to allow private sector borrowing, it is unlikely that such benefits would outweigh the additional costs to the Crown, nor would the benefits be sustainable in the movement of the health boards away from a commercial focus.

The same has occurred in the housing sector with the New Zealand Housing Corporation.

Therefore health and housing debt is to be refinanced by the Crown as the private sector debt matures. Any new borrowing is also to be sourced from the Crown.

Overall there is no change to the total Crown balance sheet, just a reorganisation of who is directly borrowing – in this case the Crown borrows instead of district health boards and the Housing New Zealand Corporation. However, it does mean that such refinancing adds to the Government’s gross debt levels over the next ten years by over $2 billion and is one of those factors that therefore increases the Government’s domestic bond programme requirements.

This was a very broad topic, and I have only been able to touch on some issues. I want to leave you with two conclusions. My comments have tried to underscore the basic message that this government is a sound financial manager.

It manages its money well not out of any doctrinaire commitment to a minimalist state but because that is a necessary condition for strong economic performance and robust social programmes.

It manages its finances over the longer term, and eschews short term political expediency as a basis for funding decisions. It does this despite the fact that Lord Keynes reminded us that in the long run we are all dead.

What Keynes forgot is that governments never die. We manage for our children as well.

Thank you.

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