From: Foundation for Economic Growth

Our Economy
Public expenditure: Spending habit limits 10 years of fiscal care
By Bryce Wilkinson
Aug 6, 2004, 15:14

It is perhaps too easy to forget the decades of deteriorating fiscal policy that led to the drafting of the Fiscal Responsibility Act (FRA) 10 years ago.

In the 1970s and 1980s government spending mushroomed. The tax system became distorted and inefficient with, among other things, excessive reliance on income tax and a punitive top tax rate of 66%.

Governments had a bad habit of running large deficits, which resulted in a heavy debt burden and credit rating downgrades.

These factors contributed to the economic crisis of 1984. The incoming Labour government did much to improve fiscal policy, especially through sound tax reforms, but it struggled to achieve fiscal discipline and bequeathed its successor a deficit problem that necessitated the spending measures of the 1991 Budget.

In 1994 the architects of the FRA notably then Finance Minister Ruth Richardson sought to bring a greater focus in annual budgets to issues of fiscal prudence and longer-term strategy.

The FRA has contributed to the achievement of sustained operating surpluses, improvements in Crown net worth and, most recently, an AAA credit rating for Crown foreign currency debt by one rating agency.

However, it has not been successful in constraining government spending and taxation, or in imposing meaningful discipline on the quality of expenditure decisions.

Governments in the 1990s failed to achieve their long-term objective of reducing central government spending below 30% of gross domestic product (GDP).

Subsequent governments lifted the target to 35%.

Today, total spending by central and local governments adds up to around 40% of GDP.

Contrary to expectations, the FRA has not led to meaningful debate about the value for money of government spending or the link between budget policy and economic growth.

It is feasible to envisage a reduction of total government spending from about 40% to 30% of GDP.

In a study for the Business Roundtable, Winton Bates estimated that reducing the most ill-justified government spending 10% could add 0.5% per annum to the growth rate for a 10-25 year period a huge contribution to achieving higher living standards.

Since the FRA has been relatively ineffective at curbing government spending growth, an obvious question is whether more explicit disciplines could be introduced.

Tax and expenditure limits have the merit of giving politicians extra protection against vested interest groups and may encourage decisions more closely aligned with the public interest.

Hong Kong, Japan, the Netherlands, Spain, Sweden, Switzerland and the US have had rules aimed at capping spending. So have many US, Australian and Canadian state or provincial governments.

Experience suggests limits have been effective in constraining spending and are conducive to economic growth.

Limitations can be self-imposed by a government, or decided or ratified through referenda.

There is also a case for a super-majority requirement for tax increases, because of the risk that a simple political majority may act in a predatory fashion.

Such a super-majority provision, which could apply to referenda or parliamentary decisions on tax, has parallels in the Companies Act, which requires a major transaction to be approved by at least a 75% majority of shareholders.

Tax and expenditure limits ignore base spending which, in New Zealand, adds up to 95% of the total. As the OECD has noted, this spending is not properly reviewed.

A rigorous review of the quality of base spending needs to be done, and a process put in place for regular reviews in future.

Ten years of experience show the FRA has served New Zealanders well to date, except for the lack of real government spending discipline. Based on overseas experience, tax and expenditure limitation rules backed by citizen referenda and super-majority rules have the best chance of improving spending disciplines.

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Bryce Wilkinson is a director of Capital Economics and the author of Restraining Leviathan: A Review of the Fiscal Responsibility Act 1994 published this week by the New Zealand Business Roundtable

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