Brian Fallow

The Economics Editor of the NZ Herald

Radical rethink for Budget

A raft of unexpected factors will shape the forecasts for revenue and spending.

GDP growth was three times what the Treasury forecast - until the drought hit. Photo / Brett Phibbs
GDP growth was three times what the Treasury forecast - until the drought hit. Photo / Brett Phibbs

The economic forecasts underpinning Thursday's Budget will need to differ substantially from those the Treasury offered in its half-year update six months ago.

The economy began this year with a lot more momentum than it (or other forecasters) expected. Gross domestic product growth in the December quarter was three times what the Treasury had forecast. But then the drought hit.

The exchange rate is a lot higher than expected, and inflation accordingly lower. Except for house price inflation: house prices are already higher than the Treasury expected them to be in four years' time.

Unemployment is already down to the levels expected two years from now.

And the estimated cost of rebuilding Christchurch has climbed by a third to $40 billion.

All of these factors will affect the forecast track for revenue, in one direction or the other, and some will affect spending as well.

In March the Treasury estimated the drought would reduce real GDP this year by 0.7 per cent from what it would otherwise have been.

The impact on incomes would be mitigated by higher export prices in the case of dairy farmers, but the reverse would be true for the sheep and beef sector. On balance it expects the impact on nominal GDP - a proxy for the tax base - will also be a reduction of 0.7 per cent.

Economic forecasts from ASB this month have real GDP growth slightly weaker in the current March year than the Treasury's pick six months ago, but significantly stronger for the two following years - 3.4 and 2.7 per cent respectively against 2.5 and 2.4 per cent in last December's half-year update.

So far this year the exchange rate has been nearly 5 per cent higher than forecast, which eats into exporters' incomes but also helps explain why inflation is 0.9 per cent instead of the 1.5 per cent the Treasury expected.

Lower inflation affects both sides of the Government's books. It means a lower tax base, all else equal, but benefits the Crown as the largest purchaser of goods and services.

The Treasury expected house prices to rise 6.5 per cent nationwide over the year to March.

In fact the increase (as measured by the Real Estate Institute's stratified index) was 8.6 per cent. That means it has already exceeded the cumulative 1.3 per cent increase expected over the next four years.

The assumption was that because house prices and household debt levels, relative to incomes, are much higher than they were at the outset of the last boom, gravity would assert itself and that momentum would fade. But median house prices in Auckland and Christchurch, which between them account for more than half of all sales, are rising at double-digit rates and house price inflation expectations are at an all-time high.

The housing accord between the Government and the Auckland Council announced on Friday is therefore likely to feature prominently in Finance Minister Bill English's Budget speech.

The risk, however, is that any supply-side response will be too little and too late to prevent a repeat of the mid-2000s dynamic where rising house prices triggered the wealth effect, encouraging homeowners to spend some of the increase in their housing equity so that spending grew faster than incomes and output, fuelling inflation.

Such a prospect could force the Reserve Bank to raise interest rates more than the market currently expects, retarding growth overall.

Meanwhile, the estimated cost of rebuilding quake-devastated Christchurch has risen to $40 billion.

The Government's share of the cost is expected to rise to $15 billion from $13 billion.

But the tax take on the $8 billion of additional spending by the private sector would offset much of the increased fiscal cost.

- NZ Herald

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