The Organisation for Economic Co-operation and Development's report on New Zealand illuminates the dilemma facing the Government as it prepares next month's Budget.

On the one hand, the OECD warns that the recession, which the Government keeps saying it wants to "take the sharp edges off", will be deep and protracted.

On the other, it sees little room for further fiscal stimulus and looks instead to the Reserve Bank to deliver more relief.

The OECD report, released on Thursday, highlights a trio of problems facing the Government's accounts - and therefore the taxpayer. Two are of long standing, one is new.

First is the ageing of the population, with its implications for higher health and superannuation costs in the future. Both pension and health spending are expected to grow faster in New Zealand than in the OECD as a whole, it says, taking up an additional 8.2 per cent of GDP by the middle of the century.

Second is the underlying underperformance of the economy in terms of productivity. Some of that, the OECD concedes, may be put down to being small and remote, but some of it might be improved by better policy.

It offers some suggestions relating to tax policy and infrastructure, including port consolidation.

The third, and new, factor is the recession. The OECD's forecasts are gloomier than most but if it is right, over the course of last year, this year and next year the economy will shrink a cumulative 2 per cent. Normally it would have grown by perhaps 10 per cent over that period. Inflation should be lower as well.

So the tax base by the end of next year will be significantly smaller than might have been expected, by tens of billions of dollars, leaving the Government with a permanent downward shift in the revenue track.

In addition, steeply rising debt, as deficits replace the fiscal surpluses of the past 14 years, will add to the taxpayer's interest bill.

This leaves the Government with a delicate balancing act, the OECD says. It has to ensure fiscal policy is not a drag on the economy, which would be self-defeating.

"On the other hand it must avoid deficits becoming so entrenched that markets lose faith and either the Government or the banks, or both, find it materially more difficult or more costly to issue debt."

The problem there is that the country as a whole, as distinct from the Government, is already heavily in debt to the rest of the world, to the tune of 93 per cent of GDP even after allowance for New Zealand investment abroad.

Much of that is the legacy of the housing boom, in which house prices doubled since 2000 but incomes, of course, did not. Between 2000 and 2008 the ratio of house prices to disposable incomes rose by two-thirds, more than in any of the 18 other developed countries for which comparable figures exist, the OECD says.

The need to repair household balance sheets after that binge is a major reason the OECD expects private consumption to fall 0.6 per cent this year and remain flat next year.

It also leaves the country's external accounts in a parlous state at a time when international investors have become very risk-averse.

"With massive new issues of sovereign debt hitting the markets simultaneously as Governments almost everywhere expand deficits, the New Zealand Government could find itself well down the funding queue, if the sound fiscal position underpinning New Zealand's strong credit rating were to be impaired," the report says.

The boost to economic demand from fiscal policy already in train - a cumulative 5 per cent of GDP over the current and coming financial years - is relatively large by international standards, the OECD says, and already at the limits of prudence.

It is vital, it says, that next month's Budget presents a credible medium-term programme that will re-establish a

structural surplus, and a surplus large enough to cope with the pressures of an ageing population.

Failing that, "the Government would need to begin to scale back future health and pension spending".

The OECD suggests raising the eligibility age for New Zealand Superannuation to 67, and perhaps higher later if longevity continues to improve, and adjusting the pension in line with inflation, not increases in the average wage.

It also calls for the privatisation of state-owned enterprises.

"We agree with the need for fiscal consolidation so that we don't end up with both large public and private debt," said Finance Minister Bill English.

"But some of their stuff about asset sales, of course we are not that interested in, or playing around with super."

English agrees with the need for improved financial performance in the health sector. "The health budget has virtually doubled in the past eight or nine years and it isn't producing twice as much health services. There's a big challenge there to get more out of existing resources."

The OECD report describes rising health care costs as the biggest threat to long-running fiscal sustainability.

It recommends moves to competition among public hospitals and with private providers, and a greater role for private health insurance.

More broadly, closing the substantial income gap with most other OECD countries will critically depend on boosting productivity growth.

Since 1985 New Zealand's growth in multi-factor productivity has been the third weakest in the OECD, at about a quarter of the rate of its peers.

Investment in physical capital per worker is only 63 per cent of the OECD average.

"A major goal should be to create a more welcoming environment for business and labour, with fewer distortions to saving, investment and work incentives," it says.

It recommends lowering the corporate tax rate at least enough to catch up with the OECD average and, as fiscal circumstances permit, reducing the gaps between the company, trust and top personal tax rates.

The distortionary costs of taxation could be reduced by shifting the tax mix towards more efficient taxes such as GST.

English said the only tax issue the Government was working on at the moment was whether it could afford to go ahead with the income tax cuts it had promised for next year and the year after.

The Treasury has argued that the current tax system is over-reliant, in a globalised world, on taxing company profits and personal income, especially of the richest 10 per cent of taxpayers who provide about half the income tax take.

"Shifting the tax bases around is a longer-term issue we are not focused on right now," English said. "In the shorter term the focus is on reducing tax rates and the fiscal stimulus but, longer term, efficiency at raising is going to become a big policy focus."

No decisions have yet been made about the next two years' tax cuts.

"We have said we would like to do them if they are affordable. We have to look at the debt impact because the [December] projections had debt rising indefinitely. We said that wasn't acceptable," he said. "We have ruled out a number of things that would have an impact on that debt. We are going to maintain entitlements, for instance. So that means we have to pay quite a bit of attention to where we do have some discretion."

Opposition Leader Phil Goff said the OECD's forecast that the economy would remain in recession through the rest of the year before recovering only hesitantly next year was at odds with Prime Minister John Key's view of an aggressive recovery beginning late this year or early next year.

Two-thirds of the fiscal stimulus which had taken place already was in Labour's Budget last year, he said.

He noted the OECD's observation that tax cuts tend to be less effective than increased Government spending (if judiciously chosen) as a boost to demand.

The tax cuts at the start of this month were especially impotent, Goff said, as they were targeted at those on higher incomes who would be more inclined to save them than spend them.

"I expect the Government will not go ahead with the tax cuts [promised for 2010 and 2011] which ironically will leave most New Zealanders worse off than they would have been under Labour's package," he said.

Goff reject the calls to sell state assets.

"Nor would we suggest loading on to people an extra burden of GST in order to cut company tax and tax on higher incomes. That's simply unrealistic and unacceptable."


The Paris-based OECD delivered its biennial report on New Zealand's economy on Thursday.

It suggests:
* Raising the age of eligibility for NZ Super and unlinking it from the average wage.
* Lowering company tax and the top income tax rate but raising GST.
* Privatising Air New Zealand, KiwiRail, KiwiBank, Solid Energy and the three state-owned electricity generators.
* Overhauling funder/provider relationships in the health sector.
* Making more use of the toll roads and congestion charging.