Far-reaching reform of the tax system and a much tougher approach to Government spending than the Budget foreshadowed will be necessary if New Zealand is to narrow the income gap with Australia and other developed countries, the Treasury says.

The economy is seriously under-performing, it says in a report to ministers titled "Getting Started on Closing the Income Gaps".

Both Government and private consumption has run well ahead of income, while business investment has been relatively modest.

Debt levels are high, and land and house prices probably unsustainable.

The Budget was underpinned by an expectation that the recession would trigger a process of rebalancing which would put the economy on a more sustainable path, but that is not panning out.

Instead of the expected 25 per cent fall in real house prices, they are heading back above their 2007 peaks, aided by strong net immigration.

The reorientation of the economy away from consumption towards production and exports is likely to be slower and weaker than had been hoped and that would mean overseas debt reaching even higher levels than those the Budget had forecast (over 100 per cent of GDP) and which the Treasury doubts are sustainable.

"At best our current medium-term economic prospects appear to be fragile, unbalanced growth. There is little in the current policy mix that would make a material difference in terms of closing the income gap."

What would, the Treasury argues, is a combination of ambitious tax reform and "front-loaded fiscal consolidation" - code for belt-tightening in Government spending that goes well beyond the $1.1 billion cap on new spending adopted in this year's Budget.

"You have the opportunity for once-in-a-generation reorientation of the tax system," it told ministers.

"If the opportunity is embraced, far-reaching tax reform could make a powerful contribution to jump-starting a process that, over a decade or two, could close the income gaps."

The less ambitious the approach to other taxes like GST, land tax and capital gains tax, the harder would be the required choices about where to concentrate income tax reductions.

Structural reform could not begin and end with tax, however. Also in the Treasury's sights are privatisation of state-owned enterprises, pricing not only carbon emissions but water, and a greater role for external capital in the dairy and meat processing sectors.

Since 2002, New Zealand has had the fifth-highest rate of increase in Government spending in the OECD.