Brian Fallow: Future written in red ink

The combination of last week's earthquake and next year's election will test the Government's resolve. Photo / Getty

Want to cheer yourself down? Take a look at the Treasury's newly updated projections for the long-run outlook for the Government's finances.

What the Treasury officials do is take existing policy settings as given, then make projections about big drivers like the age structure of the population and labour productivity growth. They assume the tax take relative to the size of the economy will remain about where it is (29 per cent of gross domestic product).

Then they extrapolate forward, to see what happens to big fiscal numbers like the primary balance (revenue minus spending, excluding interest costs) and the size of the public debt.

It is OK for a few years and then it gets ugly.

Right now, the primary balance is slightly in the black and net Government debt about 25 per cent of GDP.

But if nothing changes on the policy front, and if the projection's assumptions hold good, we would be looking at a primary deficit of 4 per cent of GDP in 30 years' time and net debt of 94 per cent of GDP.

By 2060 the deficit will have widened to 6.3 per cent and the debt will exceed 200 per cent of GDP.

And it is worth remembering that the primary deficit excludes the interest bill on the Government's debt. In reality, it would have to borrow not only to cover the primary deficits, but to pay interest on the growing stock of debt as well. By 2060, on these projections, that would push the operating balance into the red to the tune of 16 per cent of GDP.

That sort of trajectory is not remotely sustainable, especially when most NZ government debt is held by non-residents and the household sector is up to its nostrils in debt.

Such projections are only as good as the assumptions underpinning them, of course.

Some assumptions may be conservative. The projections assume that the net migration gain will revert to a long-run average of 12,000 a year. It is over 70,000 now.

Migration is important when more than a quarter of the current working age population were born in another country.

"Migrants tend to contribute more in taxes than they use in public services, more so than New Zealanders," the Treasury says. "However migrants' positive fiscal contribution declines as they age."

The projections also assume labour productivity will improve at an average annual rate of 1.5 per cent.

Unfortunately, the average over the past decade was just 0.9 per cent. The difference between 1.5 and 0.9 per cent gets pretty material if it continues, compounding for 30-40 years.

But as with migration, productivity has mixed effects on the fiscal position. Lower productivity means a smaller economy and tax base, but also lower wages, making the public service wage bill lower and reducing the cost of NZ Superannuation, so long as it remains indexed to the average wage. It's an ill wind.

So let's assume the errors balance out and take the Treasury projections at face value.

What sort of policy changes would be needed to haul down the trend line of widening deficits? What would it take to eliminate that 6.3 per cent primary deficit projected for 2060?

It would not be easy.

The Treasury document gives only a rough indication of how much difference some of the many possible policy adjustments might make.

On the tax side, raising the GST rate to 17.5 per cent from 2024 onwards would reduce the 2060 deficit from the projected 6.3 per cent to something like 5.2 per cent.

A bigger bite out of the deficit would result from adopting a policy of only adjusting the thresholds in the income tax scale to compensate for CPI inflation. As real incomes continue to rise, that would only partially offset fiscal drag or bracket creep. Such a change - a stealth tax increase - would reduce the 2060 deficit from 6.3 per cent of GDP to around 4.5 per cent.

What about the spending side?

The big driver is the ageing of the population, with implications not only for New Zealand Superannuation but for health costs. Currently, around 38 per cent of the health budget goes to those aged 65 or older, who make up 15 per cent of the population.

If the age of eligibility for NZ Super were increased to 67 by 2024, that might knock about 1 percentage point off the 2060 deficit.

Much bigger savings would be achieved by changing the indexation of NZ Super from the average wage to the consumers price index. That alone would more than halve the 2060 deficit.

But cost of living data released by Statistics NZ this month show superannuitants face a higher inflation rate than the average household (whose spending patterns are reflected in the CPI weightings). A switch to CPI indexation would mean ongoing cuts in the pension's purchasing power. Not exactly a vote winner.

So far, so familiar. What is new about the latest Treasury projections is the consideration given the long-run fiscal savings from the Government's "social investment" approach.

This is the idea that early and well targeted interventions can improve the life prospects of the most vulnerable children. That is not only desirable per se, but should save the taxpayer money in the long run.

Modelling the net fiscal gains, driven mainly by lower lifetime welfare and justice system costs, is tricky, officials concede. They consider a range of scenarios. The more ambitious could shave more than a percentage point off the primary deficit by 2060, a gain comparable to raising GST to 17.5 per cent.

The Government's declared fiscal objective is to get net debt down to 20 per cent of GDP by 2020 and keep it below that thereafter. That would provide a buffer against inevitable future shocks.

It would require that, it says, to return to an operating surplus big enough to meet its net capital requirements, including resumption of contributions to the NZ Superannuation Fund, and ensure consistency with the debt objective.

The combination of last week's earthquake and next year's election will test its resolve.