Long Term Fiscal Risks New Zealand s case in the context of OECD countries

Transcription

1 Long Term Fiscal Risks New Zealand s case in the context of OECD countries Simon Upton 1 November This paper was prepared with the research assistance of James Beard of the NZ Treasury, currently attached to the NZ Permanent Mission to the OECD and Michelle Harding from the Centre for Tax Policy and Administration of the OECD, who assisted with the revenue and tax elements of the paper. While the paper could not have been written without their assistance, the substantive conclusions and any errors of fact or judgment are the author s alone. Treasury: v1

2 1. Introduction This paper sets out to describe some of the trends and risks that any responsible assessment of the sustainability of New Zealand s fiscal position in the long term cannot ignore. The weight given to them is a matter of political judgment. But that judgment should be transparent. Ignoring these challenges will not make them go away. In section 2, some of the long term social and economic trends and challenges that present themselves in OECD countries are examined. This seems a reasonable peer group against which to calibrate New Zealand s situation. As a mature, developed society that has achieved significant levels of material well-being, it makes sense to compare New Zealand with countries at a similar stage of their demographic and economic evolution. These societies are also democracies that share similar institutional challenges in seeking to promote change. The evolving age structure of New Zealand s population and lengthening life expectancy is described followed by an account of the projected long term growth prospects for OECD countries and trends that impinge on the retention and attraction of skills as well as competition for investment capital. Section 3 asks what these trends mean for fiscal policy in OECD countries and New Zealand in particular. Following a discussion of general fiscal challenges, significant expenditure pressures in relation to pensions, health care and long-term care are described and how other OECD countries are responding to them. This is followed by a consideration of recent revenue trends in OECD countries and how future pressures on the tax system will arise as a result of the demographic trends described. Some thoughts are offered on the adequacy of the revenue base to respond to these pressures and how it might be secured against future shocks. In section 4, a number of higher level risks that could disrupt even a well-managed attempt to accommodate changing demographic and economic conditions are discussed. These include environmental risks, natural disasters and globally systemic economic shocks. A final section attempts to draw some tentative conclusions. 2. Long term social and economic trends and challenges in OECD countries Big demographic trends across the OECD Across the OECD, significant demographic trends relating to ageing, life-expectancy and labour mobility are placing pressure on the sustainability of public finances and work force availability. This represents a closing of the generational window as the baby boomer cohort moved from dependency when they were young through working age and now back into dependency as they enter retirement. A variety of policy reforms have been undertaken by way of response to these demographic trends. This section discusses some of the key trends across the OECD and how these are playing out in New Zealand. In an increasingly globalized economy, New Zealand will not be able to detach itself from a much wider phenomenon which will affect patterns of production, consumption investment, and migration. Equally, New Zealand will be able to learn from the experience and policy responses of these countries as they adjust to these trends. The policy implications of these trends are discussed in a separate section. 1

3 Population ageing will see a smaller population supporting retirees... Across the OECD, countries will see a significant ageing of their populations. In part this is driven by the large cohort of baby-boomers approaching retirement age, but increasing life expectancy and declining fertility rates also contribute to this. By 2050, the average old-age support ratio for the OECD (the number of people of working age per person of pension age) will have halved. New Zealand is in a similar position to many OECD countries with its oldage support ratio falling from 4.7 in 2008 to 2.4 by Even larger falls are expected in some emerging economies such as China, India and Indonesia. Figure 1 Changes in old-age support ratio, Panel A. Old-age support ratio, 2008 (?) Panel B. Decline in the old-age support ratio Number of people of working age (20-64) per person of pension age (65+) Old-age support ratio, 2008 and Turkey Mexico Chile Korea Ireland Slovak Republic Israel Iceland Poland United States New Zealand Canada Australia Czech Republic Luxembourg OECD Netherlands Norway Slovenia Hungary Spain Denmark Switzerland United Kingdom Finland Austria Estonia France Portugal Belgium Greece Sweden Germany Italy Japan Difference Source: OECD (2011a) 2

4 Life expectancy at 65 Life expectancy ate 65 Health outcomes have improved so that people are living longer after retiring... Over a relatively long time period, the average life expectancy of males and females has increased, almost continuously. Figure 2 shows the additional years of life that 65 year old men and women are projected to live. The dark line gives the OECD average while the shaded area is the range. In 2010, a 65-year-old-women could anticipate living a further 20.5 years on average compared with 16.9 years on average for similarly aged men (OECD 2012a). Life expectancy for 65-year olds in New Zealand is slightly above the OECD average with women expected to live an additional 21.2 years and men, 17 years on average beyond the age of 65. Figure 2 also shows that life expectancy at age 65 is expected to continue growing. Based on United Nations projections, life expectancy beyond 65 could increase to 23.7 and 20.1 years by 2050 for women and men respectively. This means, even with recent increases in pension ages across some OECD countries, the expected duration of retirement (life expectancy at normal pension age) will expand on average across OECD counties. For some countries the Czech Republic, Greece, Hungary, Italy, Korea and Turkey the expected duration of retirement will remain constant as changes in pension age are linked to the expected change in life expectancy 2 (OECD 2012b). Figure 2 Life expectancy at age 65 by sex, Highest OECD country (NOR, ISL, JPN) Men Highest (JPN, AUS) Women Highest OECD country (NOR, CAN, CHE, JPN) Highest (JPN) Lowest (TUR, KOR, CZE, Lowest (SVK, TUR) Lowest (TUR) Lowest (TUR) Year Year Source: OECD (2012a) Long term growth prospects The OECD s recently-developed long term modelling framework can give insights into a possible economic future for New Zealand and other OECD countries. The OECD s May 2012 Economic Outlook (OECD 2012b) discusses long term economic projections (about 40 years out) for OECD and selected non-oecd member countries. The projections provide a basis for describing the future evolution of the global economy and where New Zealand might sit within it. Based, inevitably, on a stylised set of assumptions, the OECD s projections illustrate a world in 2060 that would see: 2 Austria, Estonia the Slovak Republic and the United Kingdom have also linked pension age to life expectancy, but only for women. 3

5 New Zealand grow between 2.6 and 2.7 per cent per year in real terms between now and 2060 leading to a GDP per capita of around US$ by Despite a per capita GDP nearly three times its current level, New Zealand would still be below the top echelon of high income countries. New Zealand s ranking would have improved from 23 rd to 16 th highest per capita income in the OECD, with Austria, Korea, France, Ireland, Spain, Italy and Israel experiencing relatively slower growth and slipping behind New Zealand in per capita GDP terms. Australia becoming the third-highest ranking country in terms of per capita GDP New Zealand closing the income gap with Australia but a 20% per capita GDP gap between the two countries would remain. Large shifts in global economic weight arising from rapid growth in the emerging economies such as Argentina, China, Indonesia, India, Russia and South Africa allowing them to narrow the gap with the OECD countries --- although significant gaps would still remain. China being the best performer among these economies and growing richer than countries such as Italy, Greece, Hungary and Portugal. Its per capita income would place it around 27 th position if ranked alongside OECD countries. Demographic developments (ageing and well-life expectancy) driving down the global savings rates in both developed and emerging markets. Economic development in emerging markets could also further depress savings rates in those economies as social safety nets are improved (reducing the precautionary motive for saving) and financial markets develop leading to a greater availability of credit. Upward pressure on global interest rates due to a diminishing supply of savings --- potentially by 1½ percentage points, reducing the incentives for investment and capital accumulation and increasing the cost of service debt, both public and private. Continued high government indebtedness, which is assumed to stabilise over the medium term horizon of the model (the average government debt to GDP ratio is assumed to stabilise at about 128% of GDP compared with just 73% before the crisis). Of course, growth is not automatic. Even in a global setting conducive to steady growth, policy settings would need to be supportive. In particular, given the assumptions that underpin the modelling outcomes, New Zealand s policy settings would be assumed to: see a postponement of effective old-age retirement in line with gains in life expectancy maintain high rates of work-force participation among older New Zealanders continue increasing the average number of years of schooling maintain a business environment that supports continued investment maintain an open international trading environment generate ongoing innovation and productivity improvements that facilitate convergence in total factor productivity If these conditions weren t met, then the expected rate of growth for New Zealand would be lower than described above. A number of possible conclusions are implied by these projections: New Zealand s income gap with Australia and other currently high income, English speaking countries could persist for some time with the result that economically-induced emigration of New Zealanders to those countries will continue to be attractive. As emerging countries become richer, the relative attractiveness of New Zealand in terms of earnings differentials diminishes reducing the incentives for migrants to emigrate to New Zealand. The capacity of global markets to fund New Zealand debt (public and private) will be reduced as ageing trends reduce global savings rates. This will mean higher global 4

6 interest rates, leading to higher debt servicing costs and reduced incentives for investment in New Zealand. Any additional risk premia demanded by markets for fiscal risks will add to this upward pressure on interest rates. There will be greater opportunities to trade with emerging markets as their demand increases with their incomes. But to the extent these economies are more volatile, there could be more volatility in export demand. Government expenditure will be constrained for the foreseeable future, with continued pressure for fiscal consolidation, even before taking account of budget pressures from demographic change. While a model-based projection can give some idea of the relative growth potential for the New Zealand economy, it says little about a number of risks that will likely need to be managed. The OECD describes the output of its modelling as a benign, even optimistic, medium-term outlook for the world economy and cautions that any such exercise is inherently speculative with many layers of uncertainty. Any one of a wide range of risks could see very different results. These include access to skilled labour and investment capital, vulnerability to economic shocks from a range of causes, and environmental and resource pressures. Some of these risks to a benign policy setting as they apply to New Zealand are discussed in the final section of this paper. Increasing competition for skilled labour Reflecting increasing inflows of permanent migrants into OECD countries (OECD 2012c), the share of foreign-born population in total population in almost all OECD countries has steadily increased since 1995 (figure 3). In 2008, the average share of the foreign-born population in total population was 11.7%, with an average increase of 3.2% over period since New Zealand has considerably more foreign-born people in its population, making up around 22% of the total population, an increase of 6.1 percentage points since 1995 the fourth largest increase behind Spain, Ireland and Luxembourg. 5

7 Figure 3 Share of foreign-born population as a share of total population Panel A. Foreign-born population, as a percentage of the total population, 2008 (or latest year available) (?) Panel B. Change in the share of the foreign-born population ( ), percentage points Luxembourg Israel Switzerland Australia New Zealand Canada Ireland Austria Estonia Spain Sweden United States Belgium Germany OECD Slovenia Netherlands United Kingdom Greece Norway France Slovak Republic Denmark Italy Czech Republic Portugal Finland Hungary Poland Turkey Korea Japan Chile Mexico Source: OECD (2011b) As well as being a destination country for migrants, New Zealand is also a significant source country for migrants to other countries. Figure 4 shows for OECD countries, the proportion of that country s expatriates residing in other OECD countries. New Zealand ranks second behind Ireland in terms of its propensity to export people. Approximately 15% of New Zealand s native born population reside in other countries. 3 Over 30% of these expatriates had a tertiary qualification compared with about 23% of New Zealand born people that didn t emigrate (Widmaier, S. and J-C. Dumont (2011). 3 The data here is based on census data from around 2005 but is the most recent cross country comparator data available on expatriates. 6

8 % of foreign-born population Figure 4 Expatriates residing in OECD member countries as a percentage of all nativeborn by OECD country of origin (c2005) Source: Database on Immigrants in OECD Countries (DIOC) 2005/06 While New Zealand sees significant departures of highly skilled migrants, immigrants to New Zealand are also well qualified, with over 36% of those born overseas having a tertiary qualification in 2010 (Figure 5). Figure 5 also reflects the increasing proportion of highlyeducated people among immigrants in OECD countries. This mirrors a general increase in education levels in OECD resident populations. It is also reflects shifts in immigration policy settings in a number of countries with a stronger focus on skilled labour migration. Canada, Australia, the UK, Switzerland, Ireland and Luxembourg are among those countries where such shifts have occurred (OECD 2012c). New Zealand has had one of the smallest shifts in the percentage of foreign born population with a tertiary qualification. Figure 5 Percentage of high-educated among the foreign-born population, 2000 and / /2001 Source: OECD 2012c 7

9 Slovak Republic Ireland Poland Mexico Finland Hungary Czech Republic Netherlands Italy Korea, Rep. of Japan New Zealand Denmark Austria United Kingdom Turkey Greece Norway OECD mean Belgium Germany Portugal Spain France Sweden United States Switzerland Canada Australia Luxembourg Percent Figure 6 illustrates the importance for New Zealand of continued inflows of highly skilled immigrants. Once the outflow of highly-skilled New Zealanders is taken into account, the net inflow of highly skilled migrants is close to zero. That is, the inflow of highly-skilled immigrants is balancing those with high skills that New Zealand loses to other countries (a so-called brain exchange rather than brain drain ) (Ministry of Economic Development, Treasury and Statistics NZ 2011). The policy challenge here is to ensure that these migrants are settling quickly and finding jobs that match their skill sets. Otherwise, despite offsetting in- and out-flows, the effective stock of human capital in New Zealand could be declining as a result of these migration trends. Figure 6 Foreign-born people with tertiary education as a percentage of all residents with tertiary education, circa % 40% 30% 20% 10% 0% -10% -20% -30% Immigrants from other OECD countries Emigrants to other OECD countries Immigrants from the rest of the world "Net" immigrants with tertiary education Source: Ministry of Economic Development, Treasury and Statistics NZ 2011 Competition for foreign direct investment Foreign Direct Investment (FDI) represents a source of capital for investment in new and existing activities in host countries. Since 1995, FDI flows have increased globally rising from a yearly average of US$565 billion in the period to US$1525 billion in the period (OECD 2011c). New Zealand has benefited from these increasing investment flows (figure 7). FDI flows have increased significantly since the early 1980s as the economy became more integrated with the international economy. As of March 2010, the stock of FDI in New Zealand stood at $92.4 billion. The biggest investors are from Australia and the United States ($47.3 billion and $10.6 billion respectively) with other significant sources of investment being the Netherlands ($3.8 billion), United Kingdom ($3.5 billion) and Japan ($2.2 billion) (NZIER 2011). 8

10 Figure 7 Flows of FDI into New Zealand US$ m, current prices and current exchange rate Source: : NZIER (2011) As total global flows have been increasing, their distribution has also shifted with increasing amounts of FDI destined for developing countries, particularly in East Asia (figure 8). Figure 8 Foreign Direct Investment inflows, , , and Billions USD at current exchange ratesrates All countries Source: OECD (2011c) OECD countries will be competing for capital and skills in a more populous world in which their overall economic weight will decline by mid-century from a little over half global GDP to below a third (OECD 2012d). Shifting global production towards higher-value, more knowledge intensive products, will see New Zealand facing competition for high skilled 9

11 labour both in terms of attracting immigrants and retaining home-grown talent. In the Asia- Pacific region, the development of east-asian economies will mean these countries become more attractive as destinations for labour and capital, further crowding the market for these factors. These trends will weigh on New Zealand s growth prospects over the next forty years. They also raise challenging policy issues that are at the heart of long term fiscal policy formulation such as the need to balance spending on education and training against demands for spending on pensions and health for an ageing population. The dividend of reduced expenditure on education as the population ages may not be delivered if competitive forces demand ever higher levels of workforce skills. Similarly, the capacity of the New Zealand Government to raise revenue in a world where potential tax bases are highly mobile may be limited. Increasingly scarce factors of production will place pressure on future governments to consider structural reforms that might have been delayed in a more accommodating climate. 3. What these trends mean for fiscal policy in OECD countries The trends described above are already influencing fiscal policy developments in OECD countries. This section describes the general context in which fiscal policy evolved in OECD countries prior to and during the economic and fiscal crisis of the last 5 years. It then proceeds to describe the consequences demographic trends hold for key age-related expenditure items and for the ability of governments to raise revenues. General fiscal challenges Following the five years of economic and fiscal crisis, it is not news that fiscal positions in the OECD are in poor shape. Prior to the crisis government debt levels had already been trending upward in many OECD countries, but the crisis has seen a surge in government debt. In 2011, for the first time, the gross financial liabilities of OECD governments exceeded 100% of total OECD GDP (Sutherland, Hoeller and Merola, 2012). While New Zealand has seen an increase in government debt from nearly 29% to just over 48% of GDP 4 it remains among the quartile of OECD countries with the lowest government debt levels (figure 9), thanks to the low level of debt with which it entered the crisis. Sutherland, Hoeller and Merola (2012) argue that this rapid increase in debt reflects the fact that many countries were insufficiently ambitious in bringing down debt levels after the mild recession in the early 2000s. This positioned them poorly to deal with the subsequent shock brought about by the 2008 financial crisis and its aftermath. The shock triggered a series of contingent liabilities (for example, the bailouts of financial sector firms deemed to be too big to fail) which overloaded already fragile fiscal imbalances. Even in countries with relatively manageable public debt burdens, the assumption of financial sector liabilities turned manageable fiscal positions into unmanageable ones. 4 OECD definition. 10

12 Estonia Luxembourg Norway Australia Korea Switzerland Sweden New Zealand Czech Republic Slovak Republic Finland Slovenia Poland Denmark Israel Netherlands Austria Canada Hungary Spain Germany Belgium United Kingdom France OECD-Total United States Ireland Italy Portugal Iceland Greece Japan % of GDP Figure 9 Government Gross Financial Liabilities Source: OECD Economic Outlook Database 91 The OECD s growth modelling discussed above, explored the possible evolution of government debt under current policy settings. That modelling suggests that debt will continue to trend upward in about a third of OECD countries. Even if countries were to undertake enough fiscal consolidation to stabilise debt-to-gdp ratios by 2030, at least 25 OECD countries will see an increase in their debt-to-gdp ratios over 2011 levels. For the OECD area as a whole, this fiscal consolidation would see the government debt to GDP ratio increase from a pre-crisis level of 74% to stabilise at between % of GDP (OECD 2012b). According to this modelling, the average consolidation required to stabilise debt-to-gdp ratios is just over 2% of GDP (over and above what governments have already announced up until 2013) (Figure 10). However, the consolidation requirement is much larger if the gross debt-to-gdp is to be lowered, requiring in the order of 4.7% on average across the OECD for the ratio to be brought down to something like 60% by For New Zealand, the OECD estimates a fiscal consolidation requirement of about 1.9% of GDP would be required to stabilise the Debt to GDP ratio, at 55% in 2030, or 2.2% of GDP to lower it to 50%. 11

13 JPN USA GBR GRC FIN OECD NZL SVK CZE EST IRL PRT CAN ISR LUX POL SVN NLD DNK SWE KOR FRA AUT ISL CHE DEU EA15 AUS BEL HUN ESP ITA Percentage point of GDP Figure 10 Consolidation required to meet alternative debt targets Debt Stabilisation Debt ratio to 60% Source: OECD Economic Outlook 91 long-term database Achieving fiscal consolidations of this magnitude will be challenging. Previous consolidation efforts have been more successful when growth has been strong. In the current climate, the importance of structural policy adjustments to support competitiveness and growth becomes that much more important (Sutherland et al 2012). How governments achieve these levels of consolidation will require careful consideration of the mix between expenditure reductions and tax increases. Hagemann (2012) examines the best instruments for achieving consolidation. expenditure side, he suggests focusing on: On the looking for efficiency gains through adopting best-practices in health care and education improving decision making on infrastructure spending through greater use of costbenefit analysis and private sector involvement reforming entitlement programs. On the revenue side, Hagemann (2012) suggests focusing attention on: broadening tax bases by eliminating costly tax expenditures, particularly those that distort economic decision-making; and raising revenue through greater reliance on environmental taxes (including auctioning Emission Trading Scheme (ETS) permits), user fees for government services, taxes on immovable property and well-designed financial sector levies. Sutherland et al (2012) estimate that for New Zealand, a combination of reducing expenditure on family-related social transfers and disability benefits, increasing efficiency of health services and primary and secondary school education, restoring public-private sector pay relativities and auctioning ETS permits could yield around 9.8 % of GDP contributions to the fiscal position. Nearly half of this comes from auctioning ETS permits. 12

14 Longer term fiscal consolidation plans will also need to take account of the effect of the demographic and economic trends and risks discussed above. The following section discusses the implications of the above-noted trends for key expenditure and revenue items. (i) Significant expenditure trends and responses The ageing trends discussed above have, and will continue to have, an impact on fiscal positions in all OECD countries. At times the ageing trends have reduced fiscal pressures. As the baby boomer generation moved from youth dependency to working age, fiscal positions over the past 5 decades benefited from a demographic dividend as the task of educating those under 18 years reduced. Easton (2012) estimates that the size of this fiscal dividend for New Zealand associated with ageing could be in the order of around 1% of GDP per year over the last quarter of a century. The important point he makes is that while fiscal pressures have benefited from this ageing effect, it won t last forever. As Figure 11 shows, three major areas affected by population ageing pensions, health and long-term care are likely to be a significant source of fiscal pressure in some key developed G20 countries. These age-related expenditures are forecast to grow faster than national income in all of the economies shown in Figure 11. At current rates and under current policy settings, they will exceed one-fifth of GDP in seven of those economies by Figure 11 Fiscal pressures from ageing populations Projected pension, health and long-term care expenditures as a share of GDP Expenditure (% of GDP) 25 Pension Health Long-term care France Italy Germany EU27 New Zealand Japan Turkey United Kingdom Korea United States Canada Australia Source: OECD 2011d and author s calculation for NZ Governments across the OECD are being forced to confront these expenditure trends in order to ensure the sustainability of public finances, while still trying to meet expectations of service delivery in these areas. In this section we discuss policy responses in OECD countries in the three expenditure areas discussed above. Pension expenditures National pension systems are designed to meet a number of objectives --- adequacy, fiscal sustainability, incentives to work, administrative efficiency and diversification of risk (OECD 2012a). These objectives are interrelated but can be in conflict. In particular, adequacy and sustainability must be balanced off so that public pensions aren t so high that they are 13

15 unaffordable but at the same time provide adequate income for retirees to avoid widespread poverty amongst the elderly (OECD 2011d). Increasing longer term fiscal pressures from ageing populations alongside more immediate fiscal concerns arising from the crisis make this balancing act more difficult. How should OECD governments respond to this challenging task? The OECD suggests that there are a number of policy reforms that could help maintain retirement-income adequacy without jeopardising fiscal sustainability. Firstly, in a world where people are healthier and living longer, the OECD emphasises policies to encourage people to work longer. Reforms to pension ages and linking pension levels to life expectancy are two areas where policy change can increase the incentive for people to work longer. Increasing pension ages There is a definite trend across OECD countries for a later pension age. Figure 12 shows how the pensionable age has changed across OECD countries since 1949 and how it is expected to change under current legislated changes. Following a period of declining pensionable ages up until the 1990s, there has been a steady increase for both men and women (with a greater increase for women reflecting policies to equalise pension ages in a number of countries). The average pension age for men has increased from 62.7 in 1999 to 63.3 in 2010 and is projected to increase 65.6 by 2050 under current policy settings. For women, the average pension age is expected to increase to 65 by Figure 12 Normal pension ages by sex, Under current and announced policy settings Source: OECD 2012a In 2010, three OECD countries had pension ages of 67. Of the remaining 31 countries, sixteen have since legislated increases in the pension age for men out to 2050 and twenty have legislated to do so for women. By 2050, 13 countries will have increased their pensionable age to 67 or above (all but one of these for women as well as men). Figure 13 shows that while 65 remains the predominant age at which people normally draw their pensions, 67 is becoming the new 65 (OECD 2012a). 14

16 Figure is the new 65 Number of OECD Countries Men Pensionable age Number of OECD Countries Women < Pensionable age Source: OECD 2012a Linking pension levels and life expectancy Several OECD countries have introduced an automatic link between the level of the pension and life expectancy. These arrangements mean that the level of the pension people receive will fall as people live longer, unless they choose to retire later (OECD 2011d). The OECD (2011d) suggests that these arrangements would result in the level of the pension being 15-20% lower for people retiring in 2050 compared with those drawing their pensions in These policies may also mean that the adequacy of pensions may be jeopardised so fiscal savings may be offset to some extent by increased expenditure on safety nets designed to avoid poverty in retirement. While New Zealand moved relatively early to lift the pension age to 65, the relative lack of action since then (see figure 14) stands in contrast to other OECD countries. Figure 14 Limited change in New Zealand s pension age relative to life expectancy NZ life expectancy at NZ Superannuation age Source: Based on OECD calculations and data. 15

17 A number of OECD countries have taken additional steps to encourage working longer. These include tightening conditions for receiving pensions early, in-work tax credits and exemptions from social security contributions, and tightening pathways for the unemployed into retirement. Alongside increasing pension ages, these additional measures mean that nearly all OECD countries are taking action to ensure that people work longer (OECD 2012a). A second way of balancing adequacy and sustainability is through the greater use of targeting retirement income provision to the most vulnerable. Many countries have increased the redistributive aspects of their public pension schemes. For example, Finland, France and Sweden protected low earners from the full force of pension cuts in the aftermath of the crisis, while Australia and the UK have targeted some of the saving generated by higher pension ages to target increases in the pension rate toward low income retirees. The third solution the OECD suggests is to encourage greater private saving for retirement to augment or make up for reductions in the public pensions. New Zealand s Kiwisaver and the recently introduced scheme in the UK are two examples of policy reforms in this vein. Other countries have adjusted tax incentives and moved toward government cocontributions to private schemes, targeted toward low income earners. The OECD argues that, while the public sector s role in providing incomes in old age will remain very important, it is inevitable that it will diminish. Indexation (the way that pensions are adjusted to reflect changes to the cost and standard of living) potentially offers a fourth way of adjusting the current balance between adequacy and sustainability. Here, trends within the OECD are less clear with some countries such as Norway moving to less generous indexation policies, while others have been more generous over the shorter term by overriding current indexation rules to provide larger pension increases in response to weak demand caused by the financial crisis. Some others, such as the United Kingdom have moved permanently to more generous indexation arrangements (OECD 2012a). One of the interesting findings from OECD research in this area is that while most countries have some form of indexation arrangements, practice over a long period of time has shown that governments have systematically over-ridden these rules to adjust pensions by larger or smaller amounts than suggested by these rules. Health expenditures In 2009, OECD countries spent on average 9.6% of their GDP on health with over 70% of this funded from government budgets (OECD 2011e). This proportion of expenditure has increased steadily since 2000 as health spending per capita outpaced GDP growth by more than two to one (4.0% versus 1.6%) (Figure 15). Since the early 1990s, health care spending per capita has increased by over 70% in total and the OECD projects that public health spending could increase by between 3.5 and 6 percentage points of GDP by 2050 (OECD 2010) 16

18 Figure 15 Annual average growth in real per capita expenditure on health and GDP, (or nearest year) Annual average growth rate in real health expenditure per capita (%) 11 9 Rate of growth in health expenditure greater than growth in GDP (per capita) KOR SVK ITA 7 IRE New Zealand 5 GBR NLD BEL ESP FIN CAN OECD DNK SWE 3 USA AUS MEX NOR JPN FRA AUT DEU CHE ISL 1 PRT ISR LUX CHL HUN SVN CZE POL TUR GRC EST Rate of growth in health expenditure less than growth in GDP (per capita) Annual average growth rate in real GDP per capita (%) Source: OECD 2011b New Zealand is in the upper third of countries in terms of expenditure on health, devoting 10.3% of GDP, close to the OECD average but still well below the highest spending country, the United States, which spent over 17.4% of GDP on health (figure 16). New Zealand s rate of growth has been among the top third of OECD countries with an annual average rate of growth of 4.8% between 2000 and 2009 (OECD 2011e). Of the total health spend, public health expenditure is approximately 6.5% of GDP in New Zealand. OECD projections suggest that this could increase to between 8.3% and 10.1% of GDP by

19 United States Netherlands ¹ France Germany Denmark Canada Switzerland Austria Belgium ² New Zealand Portugal Sweden United Kingdom Iceland Greece Norway OECD Ireland Italy Spain Slovenia Finland Slovak Rep. Brazil Australia Japan South Africa Chile Czech Rep. Israel Luxembourg ³ Hungary Poland Estonia Korea Mexico Turkey Russian Fed. China India Indonesia Figure 16 Total health expenditure as a share of GDP, 2009 (or nearest year) % of GDP Public Private In the Netherlands, it is not possible to clearly distinguish the public and private share related to investments. 2. Total expenditure excluding investments. Source: OECD Health Data 2011; WHO Global Health Expenditure Database Rising expenditure on health is driven by a number of potential factors: a rising share of older age groups in the population technological development and rising healthcare prices and rising incomes leading to an increasing preference for health (health as a so-called superior good) --- although the empirical evidence on this is mixed (OECD 2006). With a greater share of older people in the population, there will be a natural boost to expenditure as the amount of health spending per person rises with age. However, there are potentially two offsetting effects that could mitigate this increase. Firstly, longevity gains could be translated into additional years of good health rather than more years of ill-health reducing the health cost per person. There is some evidence of this healthy ageing occurring in a number of OECD countries (OECD 2006). Secondly, major health costs tend to come towards the end of life, so the impact on health costs of having more older people living longer would not be as great as if health expenditure were incurred more evenly over the later years of life. Countries are trying a variety of measures to contain costs, broadly classified as: macroeconomic cost-containment measures caps on budgets, price controls, limiting the growth of medical professionals (through limits on the number of medical school places, limiting the supply of hospital services, eg limiting the number of acute-care beds in hospital, greater cost sharing); and micro-level cost efficiency measures better gate-keeping, separation of purchasers and providers, contracting out, enhancing competition between hospitals (OECD 2006). Macroeconomic cost-containment policies have limits and involve difficult trade-offs for example containing wages while at the same time attracting young and skilled workers into 18

20 the system (and in New Zealand s case, reducing the incentive for a highly mobile workforce to migrate off-shore). Similarly, controlling prices in the face of technical progress creating new products and treatments is difficult and limiting supply leads to unpopular waiting lists. (OECD 2006) Micro-level measures are often difficult to implement. Recent OECD research suggests that there are significant fiscal and health benefits to be generated if countries were able to improve their efficiency toward the best practice. In this case the fiscal savings could average in the order of 2% of GDP (in 2017 levels). In New Zealand s case, these savings could be as much as 2.6% of GDP. This OECD research also showed that there are a variety of different ways of organising health systems and no one model stands out as superior. Generating efficiency gains is unlikely to be achieved by a single big-bang reform, but through incremental reforms of existing institutional arrangements (OECD 2010). A couple of things stand out from OECD research in the health policy field. Firstly, there is no simple or clear prescription for containing costs and even if there were, it is not clear that societal preferences would support them, especially if cuts to service availability and quality are required. The second point is that even if the fiscal savings discussed above were achievable, the reality is that most countries, including New Zealand, will need to be living with increasing healthcare budgets over the next 30 to 40 years. Long term aged care costs By 2050 the proportion of the population aged over 80 years is projected to increase to nearly 10% compared to just 4% in It is not surprising then that the OECD (2011d) describes long term care as the policy frontier of demographic shift. It expects policy attention to be increasingly focused on this issue as ageing populations, advances and medical technology and social and labour market changes all place pressure on supply and cost. Across the OECD, countries devote between 1 and 1.5% of their GDP to long term care but this is expected to rise significantly over the next 40 years. OECD and EU modelling suggests that expenditure on long term care could at least double, possibly triple depending on the level of dependency of the ageing population, the cost of delivering care and the availability of family care. In New Zealand s case, the projected increases could be more significant. This modelling shows that in New Zealand, expenditure on long term care could increase from 1.4% (in the 2006 reference year) to 3.9%, assuming a similar level of dependency and availability of informal care. If however, the supply of informal care is reduced and all new beneficiaries had to be accommodated in residential care, then the expenditure could increase to as much as 6.2% in 2050 (Colombo et al 2011). As shown in figure 17, New Zealand would see one of the highest rates of increase in expenditure among OECD countries. 19

21 Figure 17 Projected annual growth in long term care expenditure relative to GDP Demand driven Cost driven GDP 5% 4.5% 4.1% 4.1% 4.4% 4.6% 4.8% 4% 3.8% 3.6% 3.4% 3.4% 3.3% 3% 2.6% 2% 1% 0% Australia Canada Japan United States New Zealand OECD-EU Source: Colombo et al 2011 Across the OECD most long term aged case arrangements rely on a high degree of informal care care provided by family or other social networks. Some striking facts give some sense of where issues with the sustainability of current arrangements might emerge from: about two-thirds of informal carers are women between 70% and 90% of people providing care are family members the size of the family care workforce is at least double the size of the formal care workforce in OECD countries and New Zealand is among a small group of countries where the ratio of informal to formal carers exceeds ten to one. Trends such as fewer children per family, increased family breakdowns, increasing labourforce participation by older people and women will likely put increasing pressure on the supply of informal carers that underpin current long term aged care arrangements. These pressures all suggest the risk to the cost of providing long term care lies on the upside. There are no simple answers to addressing the challenges posed to systems of long term care. Responses will need to include a mix of policies that: bolster the supply of informal care provided (eg through financial incentives, better support services such as respite care) foster healthy ageing bolster the size and productivity of the formal care workforce promote self-care, through prevention and adoption of new technologies reassess the balance of cost sharing within generations and between the public and private sectors (Colombo et al 2011). (ii) Significant revenue trends and responses The demographic trends discussed in section 2 also have impacts for revenue policy; both in ensuring that the tax system is sustainable in the face of the resulting expenditure demands and also in examining the impact of the tax system itself. 20

22 Recently, OECD countries have, on average, reduced taxes on wages and corporate income at a gradual pace, and are increasing reliance on indirect taxes such as VAT and other indirect taxes (table 1). Wealth continues to be taxed lightly in OECD countries, although increasing ability to track capital income means that this may be able to be taxed more directly in the hands of its owners in the future. Despite the fiscal crisis, these trends seem to be continuing, although perhaps at a slower pace. In many OECD countries, changes at the lower end of the income scale to tax-free thresholds or to the lower marginal rates have been introduced to reduce the tax burden on lower income earners, while recent changes in some countries to increase rates applying at the upper end of the income distribution have been driven by perceived equity concerns. In practice, concerns about the impact of the tax system at the lower end of the income scale, and concerns about the mobility of the upper end of the income scale, often result in the vast bulk of taxes being paid by middle income earners, which creates further equity issues. Table 1 Revenue shares of the major taxes in the OECD area 5 Percentage points of total tax revenue % % % % % % Personal income tax Corporate income tax Social security contributions and payroll taxes Property taxes VAT Sales tax Other consumption taxes (including excises) Other Source: Based on OECD calculations from Revenue Statistics 2012 (OECD 2012e) Recent tax changes in New Zealand mirror the trends observed in the wider OECD. Personal and corporate tax rates have both been reduced over the last 4 years; and indirect taxes have increased with the increase in the GST rate in 2010 and the increases in the excise rates for alcohol and tobacco. Combined, these changes have meant that over the last 30 years, the tax mix has shifted from income taxes toward taxes on consumption (figure 18), although income taxes continue to dominate. Although the mix of tax revenues is changing, as a percentage of GDP New Zealand s tax revenue has also decreased from 2007 to 2012 at a faster rate than other OECD countries. 5 Including social security contributions paid by the self-employed and benefit recipients (heading 2300) that are not shown in the breakdown over employees and employers. 2 Including certain taxes on goods and services (heading 5200) and stamp taxes. 21

23 Figure 18 Revenue shares of the major taxes in New Zealand; % 90% 80% 70% 60% 50% 40% 30% 20% 10% Property taxes Other consumption taxes (including excises) Sales tax GST Corporate income tax Personal income tax 0% Source: Based on OECD calculations from Revenue Statistics 2012 (OECD 2012e) The demographic trends identified above will influence the design of tax systems in OECD countries. For example, the increased ageing rate of New Zealand and other OECD countries is likely to increase the demand for skilled labour in these countries. Labour, which is already mobile, particularly in New Zealand, is likely to become more so. The tax system can play a part in increasing OECD countries competitiveness for labour: attracting, retaining, and developing labour; as well as providing incentives for older workers to remain in the labour force; although the tax system is only one factor influencing the competition for labour. The tax system can influence incentives to acquire skills, and as income taxes reduce the return on investment in education, can influence decisions to invest in education or to relocate after an education is obtained. Similarly, an ageing labour force will mean that revenues from income tax and GST are increasingly dependent on New Zealand Superannuation payments due to the proportion of both taxes that will be funded from NZS payments. It will also mean that the GST base will become more important for equity, as the base of this affects households differently depending on their propensity to save and to own property. New Zealand evidence suggests that older age groups are more likely to save, and to own their own home, which means that on average, they pay less in GST than other age groups. This means that other sources of revenue, such as taxes on immovable property or on inheritances may become more important as an alternative source of revenue. It is not just demographic trends that will likely influence tax system design. As preferences continue to shift toward better environmental outcomes, including those in relation to pollution, climate change and resource scarcity, the tax system may be required to accurately price the impact of resource use or of harmful emissions on the environment. Resource rents and environmental externalities represent a largely untapped source of revenue which may be seen as attractive for fiscal consolidation purposes. Currently, New Zealand s tax system taxes energy use relatively lightly; and only fuels used for transport are effectively taxed (see figure 19). The New Zealand Emissions Trading Scheme also covers a proportion of emissions but leaves other significant sources of emissions outside the scheme. 6 Property taxes include local body rates as well as the land tax (until its abolishment). 22