Hon Michael Cullen

18 May 2004

Speech Notes

Speech to Chen Palmer & Partners Business and Government Seminar

Level 6, 22 The Terrace, Wellington

I would like to begin by congratulating Mai and Geoffrey and the other partners on the approaching tenth anniversary of this firm. It has been an eventful decade in public law, with five years of National-led government followed by five years of Labour-led government (so far). The firm has become a prominent feature of the Wellington landscape, and an important catalyst for explaining the ways of government to business, and vice-versa.

On the 27th of this month I will be presenting my fifth budget, and - inasmuch as one can say this of a budget in New Zealand - it is one of the more significant and exciting ones of recent history.

Its significance lies in the fact that five years of consistent fiscal prudence have now created a platform upon which other goals can be achieved without unacceptable risks or tradeoffs.

We have taken a cautious approach during our tenure of the Treasury benches, because we have not wanted to fall into the trap that governments in the past have fallen into of responding to the slightest whiff of optimism by committing themselves to spending promises or tax cuts which quickly proved unsustainable.

We have been careful to restrain extra spending to a level that allows us to establish a fair degree of fiscal headroom.

As I indicated in last December's Budget Policy Statement, we have now achieved a degree of financial stability and strength that is remarkable for New Zealand governments in the last few decades, and can start to make some significant, although still cautious, moves towards increasing future spending in areas which impact broadly upon the living standards of many New Zealand families.

Specifically, Budget 2004 will make serious progress on improving the living standards of ordinary low to middle income working families, and also move us further towards goals such as investing in economic development, strengthening public services, securing the incomes of the elderly and upgrading our key infrastructures.

Tonight I would like to explore some of these issues in more depth. But I want to stress that the context for future spending and investment remains fiscal prudence. What Budget 2004 will show is that we can achieve social and economic goals while continuing to chalk up further important milestones in terms of financial stability.

The first thing to observe is that Budget 2004 comes in the context of a New Zealand economy that is essentially strong, although somewhat delicately balanced. We have seen a period of relatively strong growth since 1999; relative both to our performance during the previous decade and to the performance of our major trading partners.

But some major drivers of that growth (specifically the earnings in some important export industries) have stalled in the last year, and although the domestic impact of that fall off has been delayed by hedging contracts and by the impressive head of steam in the domestic economy, it started to depress incomes in the second half of last year and will continue to do so for several quarters.

There are some positive indications of better times ahead. The US economy appears to be recovering strongly, with many of the indicators heading into healthy territory. Nevertheless, the US is still being held back by the combined effect of a large current account deficit and a large federal government deficit. (The latter is of course testimony to the danger of premature tax cutting.)

We are also seeing a strong resurgence in global commodity prices in some key industries. The monthly ANZ World Commodity Price Index, which measures New Zealand's main export commodities in world prices, has seen ten consecutive increases and is now 18 percent higher than in April 2003.

This, in combination with the retrenchment in the value of the dollar from its high in February, should in time flow through to an improvement in export revenues.

The fact is that may take some time. We could characterise the New Zealand economy during 1999 to 2002 as a kind of Tarzan, swinging vigorously through the global economic jungle on the momentum of some helpfully placed vines, in terms of high commodity prices and a low dollar. Those vines have now run out, and though there are others on the horizon, for the next while Tarzan will have to walk.

So most forecasters have been predicting the growth rate to slow to around 2.5 to 3 percent over the next year or so, but then to return to an average of 3 to 3.5 percent per annum over the medium term.

Given this context, what can we expect for Budget 2004?

To begin with the message that nobody seems to want to believe: there is no pot of gold for meeting everyone's pet project.

Like previous years, I am bracing myself for the usual Budget cartoons portraying me, in various poses, like Scrooge McDuck atop a mountain of cash, vehemently fighting to retain every last note and coin against the encircling hordes with their more or less worthy spending plans.

I have to say the joke is getting stale. What is more, it is based upon a misunderstanding of the accounting principles that underlie the budget.

Much of the attention is given to the operating balance published in the government's accounts. The December Economic and Fiscal Update forecast that the operating balance (excluding revaluation and accounting policy changes) for the current year would be just over $5.2 billion, or 3.8 percent of GDP.

Many people see this figure and assume that it is immediately available for either increasing spending or cutting taxes. This is not the case.

The situation is somewhat akin to the AGM of a publicly listed company at which the directors need to explain to small shareholders why the entire operating surplus of the company cannot or should not be distributed as dividends. Two further steps have to be taken.

First, a number of non-cash items - such as depreciation and the retained profits of SOEs - need to be taken out of the equation to arrive at an accurate figure for the sum available for new core Crown expenditure. In the December Economic and Fiscal Update this brought the forecast operating balance for the 2004 financial year to just under $4.8 billion of net cash flow from core Crown operations.

The second modification needed is to take out commitments to capital spending. This includes a variety of items: roading, hospitals, housing, advances on student loans, and contributions to the New Zealand Superannuation Fund.

Indeed, the capital programme outlined in the December Economic and Fiscal Update for the 2004 year amounted to some $5.9 billion, and as at December, left us short of around $1.1 billion which would need to be financed from new borrowing or from the leftover balance from the 2003 year, which conveniently stood at $1.2 billion.

Those figures have changed somewhat, although we should not be misled by the recent Crown Financial Statements for the March quarter, which showed a very large operating balance of some $7 billion. This is a common seasonal effect caused by the fact that a large proportion of revenue is collected in the first three quarters of the year. It will be reversed to a large extent during the fourth quarter.

The budget will present a new picture of the balance between net cash flows to the core Crown and capital spending. Suffice it to say that there will be no large pot of gold left over.

There is a need to invest in the factors that underlie growth in the economy, such as infrastructure and skills. There is a need to improve capacity in some public services. And we are facing risks that need to be managed.

Our new priorities, as we see additional resources becoming available over the next few years, are centred around a number of objectives:

- Recasting the income support system for low to middle income working families;

- Supporting the export sector;

- Investing in our key physical infrastructure; and

- Investing in workforce skills.

I announced in December that this year's budget would include a significant family assistance package. This is a phased package which will take several years to come into full effect. Nevertheless, it is the largest single set of changes to the benefit system and assistance for families since the benefit cuts of 1991. Eventually around 300,000 households will receive direct assistance from it.

It has three broad aims:

First, it will make work pay, by supporting working families with dependent children, thereby increasing the wedge between benefits and paid work. This is a hoary old chestnut of welfare policy, ensuring that there are very clear returns to be made for sticking to the workforce and acquiring the mid-level skills that our economy needs. Our opponents on the right have always contended that the answer is to push beneficiaries into poverty, pour encourager les autres, as it were. That was the logic behind the 1991 benefit cuts.

Our philosophy, unashamedly, is to design a system that targets assistance to those at the low end of the labour market (and in particular those with dependent children) to ensure that they are significantly better off in work than out. (As an aside, in the process it may take some of the pressure off wages, although that is not its primary intent.)

That leads me to the second aim of the package: ensuring income adequacy for low to middle income families with dependent children. This has always been at the heart of Labour's policy. But while it is a social policy goal, it is also good long-term economic policy and potentially good short to medium term labour market policy.

The fact is that the majority of the workforce of the future is currently being formed in families who will receive assistance from this package. And we know that better, more stable, incomes - along with other factors such as good housing, education and primary health care - create the conditions in which cohorts of skilled and motivated citizens are created.

What is more, as the latest unemployment figures show, our workforce is now almost fully occupied, and many employers are having difficulty finding staff in the low to medium level skills brackets. Our only practical option is to increase labour force participation amongst working age New Zealanders, and that means drawing into the workforce people for whom the financial gains of going to work are still marginal.

By that I mean many sole parents on benefits, partners with childcare responsibilities, or people with children on unemployment benefit. If we can tip the financial balance for those people, they are more likely to offer their skills in the labour market, and this will be better for them in the long term, as well as increasing labour supply (and potentially moderating wage pressures).

This is where the third aim of the package comes in, and that is to support people into work and keep them there. The transition to work has always been a difficult area of policy: how to design an interface between welfare and work that does not pull the welfare rug out from under people the moment they make their first tentative steps into the full time workforce. Fixing that problem requires careful policy design, so as to get the incentives right; but the payback is that we bring people though to the point where they are firmly attached to the labour market, gaining skills and independence, rather than occupying the fringes where they are always vulnerable.

I want to stress that the family assistance package is a phased programme which will take a number of years to come into effect. It sits alongside and complements a number of ongoing initiatives to foster a more skilled and more productive workforce.

Investing in industry training continues to be a key strategy. What the Department of Labour's monitoring of job vacancy advertisements is showing is that our major shortages are in mid level skills. These are the skills that manufacturers need to fill export orders, or distribution companies need to move goods around the country and beyond. We certainly need more biotechnology researchers, but for each one of those we need several lower skilled technicians and machine operators.

That is why we adopted a target of getting 150,000 New Zealanders learning on the job by the end of 2005. We are well on the way to meeting that target, with the number of workers participating in industry training jumping by nearly 20,000 last year to a new record high, and the number of employers involved in the programme also increasing substantially, with around 29,000 firms now on board (up from around 25,000 in 2002).

In the same vein, as I mentioned before, some of the capital expended in this year's Budget will go on student loans. The total student debt recently surpassed $7 billion, and this was met with horror from student groups. We need to see this figure not as a burden but as representing a very substantial investment in the skills of the future workforce. It is, or ought to be, a $7 billion asset for the country.

Our question when taking office was: how good an investment is it? And it was clear to us that for some students it is not a worthwhile investment; that the returns on their training have been ambivalent, essentially because the regime the last government put in place elevated increasing participation above an over-riding concern with quality.

That is what our tertiary reforms are attempting to fix. We are beginning to see amongst our tertiary institutions a much broader culture of quality, part of which is responsiveness to industry. Of course, we value education for its own sake; but programmes of study that are informed by partnerships with industry or with local business communities are in fact better learning opportunities and produce qualifications that are a better match with the competencies that prospective employers are seeking.

Another major area for new spending is in assistance to business, and in particular assistance for our export industries. Much of the Budget package has already been announced and includes:

- $26 million over four years to enable New Zealand Trade and Enterprise to boost its offshore efforts;

- $35 million over four years to market specialised business sectors offshore;

- $42.6 million to deepen Investment New Zealand's offshore representation and funding, increasing their capacity to find offshore companies to partner growing New Zealand companies;

- $40 million over four years for the education sector to develop stronger offshore relationships to protect and promote export education; and

- Funding for New Zealand participation in the Aichi Trade Expo in Japan.

We are continuing to grapple with the problems with our infrastructure. The Budget itself does not contain anything new on this front, but I wanted to mention it because I know it is important to many of you here.

This is a battle with several fronts, some of them more bloody than others.

Earlier this year we confirmed a very substantial roading package that will go a long way towards fixing Auckland's perennial gridlock, within the constraints of available funding and the practical issues around construction. Significantly, we have managed to create decision-making structures there that should put an end to the sad legacy of buck-passing and petulance which has hampered Auckland transport planning in the past.

On electricity supply we have resolved a number of key problems, and prepared a major piece of legislation, the Electricity and Gas Industries Bill, which is currently before Select Committee. But the forward agenda remains full and challenging.

We have secured reserve generation capacity through the Whirinaki plant which is on track.

Achieving security of baseload supply remains a concern. The recent pessimistic forecasts about the future of the Maui gas field have placed additional pressure on gas exploration and the nest of issues that go with it. We need to make sure we are sending the right signals to attract the kind of middle level players who are likely to be best suited to the task.

Some work is progressing on this front, and announcements will be made later in the year.

Meanwhile it seems unlikely that there will be more major new hydro power generation in the near future (due as much to the cost of development as to any concerns about the difficulties of working through planning processes). Obviously wind generation offers great potential as a secondary source; but for a variety of reasons - aesthetic and financial - we are unlikely to become a landscape bristling with wind turbines on every spare ridge.

That leaves coal, which has its enemies and its proponents. The key factor there, as elsewhere, is balancing the cost of extraction and of investing in cleaner technology with the price the market will bear and the need to guarantee our commitments under the Kyoto Protocol.

So, to return the Budget, the family assistance package and a number of smaller initiatives to increase capability in important parts of the public sector, will have the effect of tightening the forward fiscal position. There will be no additional slack, with the result that other parts of the public sector will be operating strictly within baselines for the foreseeable future.

Our commitment to long term financial stability remains and will be strengthened in the Budget. This will be seen in further contributions to the New Zealand Superannuation Fund. At the end of the 2003 financial year the Fund had assets of around $1.9 billion, and that is forecast to rise to $3.9 billion in the current financial year, due to further contributions and some retained earnings. On current forecasts, by 2008 the Fund will have assets of over $15 billion, or around 9 percent of GDP.

The important point to grasp about the Fund is that it is primarily an exercise in long term management of fiscal pressures. It is designed to smooth the fiscal cost of a basic public superannuation scheme, to avoid a situation where future governments face impossible choices either to increase taxes, increase debt or tamper with the elderly's entitlements and conditions.

By 2040, for example, the Fund will be in a position to offset the current cost of superannuation by about a third. If that cost were to be borne by taxpayers of the day it would be a very significant impost, severely constraining the options available to the government of the day.

As further confirmation of the fiscal prudence that underlies this year's budget, I want to say a few words about the debt target. This was alluded to in last December's Budget Policy Statement.

The current debt target is to manage total debt at prudent levels, with, in the longer term, gross sovereign-issued debt below 30 percent of GDP on average over the economic cycle. This has in fact been the debt target since the current government came into office in 1999.

The previous government had established a 30 percent of GDP target when the Fiscal Responsibility Act was passed in 1994, and had reduced it to 25 percent in 1999. When we came into office that year we made the judgement that the Crown finances and the state of the economy could not sustain that lower target, so we restored it to 30 percent of GDP.

This year, gross sovereign-issued debt is forecast to fall to 25 percent at the end of 2004. This makes a 30 percent target somewhat meaningless, except that it implies that the Finance Minister has an option of using additional debt to finance the Crown's activities. That is an option I do not intend to take up, as will become apparent on Budget day.

To sum up, Budget 2004 comes from the heart of the social democratic tradition, although its flavour is definitely post-Keynesian. It marries a programme aimed at long term social wellbeing (centred upon labour market participation by a skilled and secure workforce) with a programme of long term economic and fiscal stability.

It is in many ways the Budget I have been building towards for the past five years, and I am confident that, as the large majority of working families come to understand what it means for them, they will see how superior it is to the alternative political visions that are on offer.

Thank you.

ENDS

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