KEY POINTS:
Michael Cullen will deliver his ninth Budget next week against the background of the weakest economic conditions since Labour took office in 1999.
Lately pretty much all the economic news has been bad.
The housing market is cooling fast, to the point where some new homeowners face hypothermia.
The average mortgage rate is expected to go higher before it starts to fall.
The widespread switch to fixed-rate mortgages funded overseas, which for a few years allowed borrowers to laugh off increases in the Reserve Bank's official cash rate, now reveals its negative flipside.
It will take much longer than it used to for the mortgage belt to feel the benefits when the bank starts to cut the OCR.
About $45 billion of mortgage debt comes up for refinancing over the next year, on to rates which right now are about 1.5 percentage points higher than borrowers have been paying - representing about an 18 per cent increase in their mortgage bill.
When you combine that with relentless price increases at the petrol pump and food price inflation running at 6 per cent, it is little wonder Statistics New Zealand is expected to confirm today that retail sales shrank in real terms in the first three months of this year.
The economy shed 29,000 jobs in the March quarter, the steepest quarterly decline in employment for nearly 20 years. Business and consumer confidence are in the pits, and dairy prices have been falling for several months. All of this has led the financial markets to bring forward their expectations of when monetary policy will begin to ease.
Most market economists expect Reserve Bank Governor Alan Bollard to have started cutting rates by the end of September, and swaps-market pricing implies a one-in-three chance that he will go at the next opportunity on June 5. By then he, like the rest of us, will know the extent, timing and distribution of the Government's tax cuts. He will know what it plans to do on the spending side.
Not exacerbating inflation is one of the four tests for tax cuts the Government has set itself.
Deferring the entry of transport fuels into the emissions trading scheme ought to give the bank more headroom to accommodate the inflationary impacts of tax cuts.
The bank had said it would look through the first-round effects of the scheme; its concern was rather what higher headline inflation would do to inflation expectations and the risk of a wage-price spiral. At best that issue has been deferred for a couple of years.
And while it may be blessed relief for motorists, it deprives the Government of more than $800 million in revenue in the mean time.
It illustrates a broader dilemma: the very things that make tax cuts more timely from an economic growth standpoint and less risky from an inflation standpoint leave the Government with less room to manoeuvre from a fiscal standpoint.
But it started with a lot of fiscal headroom.
The half-year economic and fiscal update issued six months ago factored in personal tax cuts of $1.5 billion from April 1 next year.
Even allowing for the usual $2 billion a year in new discretionary spending, that still left it with operating surpluses of about $4 billion a year, or 2 per cent of gross domestic product, over the next four years.
Out of that the Government has to fund capital items such as contributions to the New Zealand Superannuation Fund, infrastructure spending and student loans.
So it was still expecting to run cash deficits - but small ones, less than $1 billion a year.
That would see the ratio of gross Government debt to GDP fall from 18.5 per cent now to 15.5 per cent in 2012. Its self-imposed measure of fiscal prudence is to keep that ratio "broadly stable at around 20 per cent of GDP".
So a fair amount of fiscal headroom there, you might think, especially as the forecasts already pencilled in $1.5 billion of tax cuts.
Those forecasts, however, are six months old and they are predicated on an economic growth outlook that with the benefit of hindsight looks distinctly optimistic.
In particular the fallout from the US sub-prime mortgage debacle has grown a lot more menacing since then.
The sharpness of the decline in the local housing market, and its knock-on effects on consumer spending, may have surprised them a bit as well.
They were already expecting a marked decline in growth of nominal GDP (real activity plus inflation - a reasonable proxy for the tax base).
From growth of 7.3 per cent in the March year just ended it was expected to slow to to 5.4 per cent this year and not much more than 4 per cent over the next two years. At least the front end of that forecast is bound to be revised down in next week's Budget.
As a rule of thumb, 1 per cent less growth in nominal GDP over each of the next two years would cut the Government's revenue by $1.1 billion over the coming fiscal year and $1.7 billion the year after.
Add to that the revenue foregone by deferring the inclusion of transport in the emissions trading scheme.
And the cost of buying Toll's railway and ferry operations, the thick end of $1 billion, brings the Government that much closer to its self-imposed borrowing limit.
The bottom line? It would probably be unwise to count on much more than $2 billion worth of tax cuts at the front end of what is likely to be a multi-year programme.
As for how it will be structured, another of the Government's tests is that it should not increase inequality.
That suggests it is not thinking about lowering the top rate, even though a lot of economists would say that is where tax cuts would do most good for investment and jobs.
Cullen has also ruled out introducing an Australian-style tax-free zone at the bottom of the tax scale, or changes to the GST regime.
A couple of billion dollars spread fairly evenly across the broad middle of the tax scale would be worth about $20 a week. Meanwhile the tax gap with Australia has just got wider since Treasurer Wayne Swan's Budget on Tuesday.
At the moment you have to earn more than $195,000 a year before you pay a higher proportion of it in income tax in Australia than you would here.
This calculation, courtesy of Deloitte, ignores the exchange rate and complications such as Working for Families tax credits and ACC levies here, Medicare and capital gains tax there. From July 1 that tipping point moves out to $240,000, and by 2013 it will be $1.6 million.
Maybe Simon Moutter, Auckland Airport's new chief executive, should start by installing more seating at the departure gates.
