Brian Fallow: Why the Budget will be a miserly affair

Anyone wondering why a belt-tightening Budget on May 20 is inevitable need look no further than the latest monthly Crown accounts.

Two-thirds of the way through the Government's financial year tax revenue, year to date, is nearly 10 per cent below the same period a year earlier, while spending is nearly 4 per cent higher.

If it is any consolation, and it isn't much, New Zealand faces a milder version of the daunting financial challenge confronting advanced economies generally.

In simple terms the problem is this. For years governments' revenues and spending increased at more or less the same pace, and the gap between the two lines was small.

New Zealand and Australia were unusual in running fiscal surpluses and paying down debt, but even for the governments running deficits they were relative small, less than 3 per cent of GDP, so that the associated increase in debt was seen as sustainable.

The Great Recession has changed all that. Spending has continued to grow, and at a steeper pace as the public sector took up the strain when private sector demand wilted.

But the tax base, also known as economic output, dropped with a thud.

The upshot is that even as revenues start growing again it is from that lower base and the gap between spending and revenue has widened markedly.

Those deficits have to be funded and the cost of doing so will gobble up more and more of the tax dollar.

The deterioration is smaller in our case as we started from a position of surplus and the peak-to-trough drop in economic output, 3.3 per cent, while relatively severe by historical standards, was only about two-thirds of the average across the OECD.

Even so the Budget will be a pretty miserly affair, with tax changes which only redistribute the tax burden but do not reduce it, and spending increases limited to $1.1 billion of new money (with as much again in increases from the indexation of transfer payments and some automatic increases built into baselines in such areas as education.)

But it is a fiscal position most Western governments would envy.

Lately there has been a string of dire warnings from the OECD, the Bank for International Settlements and most recently the International Monetary Fund about the need for governments to embark on what in the demure jargon of such bodies is called "fiscal consolidation".

Governments across the developed world face an unappealing set of options: cut spending, raise the retirement age, increase taxes or borrow more and more, driving up interest rates and crowding out private sector borrowers in the process.

It is a beggar's crossroads, that leads to calamity - or at least profound unpopularity - in every direction.

It is a recipe for weaker growth and higher interest rates across what is still the bulk of the global economy. It will inevitably have spillover effects on this country.

The IMF says the global financial crisis has resulted in the largest worsening of the fiscal accounts since World War II. Across the the G7 as a whole, and the United States in particular, government debt is the highest it has been since the early 1950s, relative to the size of the economy.

The major economies' government debt will rise on average by 35 per cent of GDP between 2007 and 2014, according to IMF projections.

"At best, higher deficits and debt will put upward pressure on real interest rates, weakening growth prospects in advanced economies and elsewhere," it says .

"At worst the weak fiscal outlook in advanced economies will lead to concerns that debt will be 'inflated away' or that default is inevitable. If so, debt maturities would shorten, risk premia rise and ultimately refinancing crises could emerge."

Those with stronger fundamentals could benefit from a flight to safety, the IMF says, but the appreciation of their currencies would reduce their competitiveness. "At present markets do not seem too concerned. This may reflect myopia: recent experience has shown that markets often react late and suddenly to persistent disequilibria."

The OECD has a similar view. It expects underlying deficits (ie adjusted for the business cycle and one-offs) to remain at unprecedented levels of 8 per cent of GDP or more in Japan, Britain and the United States next year.

Gross debt will be close to 100 per cent of GDP in Britain, France and the US and well above it in Italy and Japan. New Zealand's, by contrast, is forecast to be 33 per cent of GDP next year.

Does this matter? The OECD concedes that there is limited guidance from economic literature on optimal debt levels. But high debt limits the scope governments have for dealing with the next shock that will inevitably come along requiring countercyclical fiscal action.

And in the meantime as debt levels climb and interest rates normalise, the ballooning cost of debt servicing could crowd out government spending in growth-enhancing things like education, infrastructure and R&D, it warns.

The biggest problem, however, is that this burgeoning debt is occurring when the fiscal impact of an ageing population is looming ever larger on the horizon.

"As frightening as it is to consider public debt increasing to more than 100 per cent of GDP, an even greater danger arises from a rapidly ageing population," says the Bank for International Settlements - the central banks' central bank.

"In our view an important part of any fiscal consolidation programme is measures to reduce future liabilities such as an increase in the retirement age."

The OECD and IMF say the same thing. In New Zealand, of course, the Government refuses even to discuss the issue.

Daunting as the fiscal challenge facing the major Western economies is, the IMF makes the point that countries have met similar targets in the past, New Zealand among them.

Between 1986 and 2001 New Zealand's gross debt to GDP ratio more than halved, from 72 per cent to 30 per cent.

In the four years following 1991's Mother of all Budgets a fiscal adjustment of nearly 6 per cent of GDP was achieved (or endured), which is roughly what is required of the advanced economies if they are to get their public debt under control.

But it was, if memories serves, a pretty grim period. It has enduring effects both socially and in terms of a wider income gap with Australia.

This time the challenge confronts not only little old New Zealand but the Western world as a whole. If it cannot muster the political will to adopt similarly draconian measures the adjustment will just be longer, riskier and more costly.