The 2015 Budget: How will the economy be affected?

Incumbent governments regularly like to claim too much credit when the economy does well, while opposition parties heap undue blame on them when things turn sour. This year’s Budget documents contain the usual self-congratulations for a growing economy and the effectiveness of recent and future policies. The mandatory Opposition invective followed and more can be expected over coming days and weeks!

So, can we disentangle the reality from the rhetoric?

First, the Budget Economic and Fiscal Update (BEFU) figures suggest a national economy performing strongly over the last year from a below-trend starting point – the long legacy of the Global Financial Crisis (GFC). Forecasts suggest this will continue for the next few years – barring any major shocks of course.

But output gap forecasts suggest that by the end of 2015 the economy should be back on its long-term GDP track; that is, at full potential GDP. This would normally imply much less scope for a continuation of the high growth, but the output gap forecast seems at variance with two other key indicators of capacity utilisation—unemployment and interest rates. Unemployment is forecast to remain above pre-GFC levels for several years, while interest rate and inflation expectations show no sign of capacity constraint concerns any time soon.

The recent elevated GDP growth rates have largely come from a combination of the Christchurch rebuild—much of it publicly-funded—and keeping other public spending in check to allow more resources to flow into private sector investment. This year’s Budget promises to persist with both of those boosting factors, but as the economy moves closer to its speed limit, these higher growth rates can’t be sustained.

Nevertheless, over the next 1-2 years, the Budget could potentially impact on the economy in three ways: short-run macro stabilising effects; long-term productivity effects; and microeconomic reform effects.

Short-run macro stabilising effects

While labels such as ‘stable’ and ‘strong’ might describe the national economy, it is clear that regional differences—effectively Auckland’s run-away house prices—have the government worried.

It remains doubtful whether it is sensible for the Reserve Bank to set monetary policy increasingly with a specific focus on Auckland (and its property investors in particular), when this clearly does not represent what is happening across the country.

The fiscal Budget, however, provides a better (if still limited) instrument to target Auckland property prices. The newly announced tax on residential property investment and other housing policies are a clear attempt to target ‘the Auckland problem’. They should do so fairly directly, since they will hit property wherever prices rise rapidly, and if that happens to be Auckland, then the tax effects will be greatest there.

Nevertheless, most economists have argued for years that any house price effects from introducing a capital gains tax are likely to be small and temporary, especially when the tax has very limited scope, as it has in this case. So, these Budget changes are probably best seen more as insurance against a possible adverse future ‘shock’ (most likely to originate overseas if it happens at all) than a concerted effort to realign current regional imbalances.

Long-term productivity effects

Aside from tackling the alleged Auckland ‘housing bubble’ (which is far from demonstrated in my view), if the Budget is to have any impact on longer-term growth it will mainly come through improved productivity performance.

Will the Budget help?

Most economists would argue that long-run trend productivity growth is largely beyond the influence of governments, at least in the market sector. In the long-run, the adoption of new technology, much of it beyond the control of government, drives economic growth and productivity.

But governments in New Zealand can have an impact on productivity growth, at least temporarily, to the extent their policies make it easier or more difficult for New Zealand firms to adopt best-practice technology and so catch-up on the global technology frontier.

This includes the public sector—which makes up around a third of the economy—where productivity can be affected by how the government holds the public service to account for its own performance. In this respect, and on private sector regulation, this government has been strongly focused on making lasting improvements in our productivity performance, though less so in this Budget

In at least one aspect the Budget might actually hinder higher productivity over the longer term. The various policies announced to keep welfare reforms on track and extend the ‘social investment approach’ across Budget headings may help to improve the efficiency and fiscal costs of those public services and benefits.

But, to the extent that this helps low productivity beneficiaries or students into work, it may drag down overall average productivity across the economy. This is not to say they are a bad idea; simply that they may not enhance long-term productivity performance in either the public or private sectors.

Microeconomic reform effects

Previous English Budgets have introduced microeconomic reforms designed to improve the efficiency of the public services, such as through public asset sales or the 10 ‘better public service’ performance targets. This Budget takes some minor further steps in this direction (such as in education and research and development), but which overall seem more like carefully selected sound bite titbits than anything substantive.

In combination with an annual operating allowance held at $1 billion till 2017, the required squeeze on public expenditure will be a hard line to hold, even with any public sector efficiency improvements. And whether ‘real’ public service output is maintained (allowing productivity to rise), or simply falls in line with spending, is unclear. Until we have better measures of public service performance, answering that question is likely to remain elusive.

BEFU 2015 Economic Forecasts