ASSESSING FISCAL RISKS THROUGH LONG-TERM BUDGET PROJECTIONS

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ASSESSING FISCAL RISKS THROUGH LONG-TERM BUDGET
PROJECTIONS

• Paal Ulla
• Budgeting Public Expenditures Division
• Public Governance Territorial Development
  Directorate (GOV)
• Sydney, Australia, June 2006

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Why long-term projections?

• Reasons for stronger emphasis on long-term
  projections
• Macroeconomic stability stabilization supported
  by monetary policy
• Planning on the core functions of the public
  sector
• Efficient use of public resources
• Transparency is needed in a globalized financial
  market
• Fiscal sustainability

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Is there a need for worry

• Income will be doubled in the next 40 years, so?
• Yes, there is a need for worry
• It is the demographic structure not the income
  level, that creates the problems.
• Higher tax rates may reduce the incentives to
  work even with higher income.
• It will take time to adapt to the demographic
  changes, which give a need for lower public
  employment.
• These challenges will appear in 5-10 years.

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Alternatives for growth in total factor
productivity
A. Net lending public sector
A. Real income per capita, 1000 NOK
Source Ministry of Finance, Norway
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Issues Addressed

• How to produce long-term projections?
• What are the uncertainties?
• What to learn from long-term projections to
  secure sustainability and avoid fiscal risks?

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Sustainability

• Debt sustainability when a borrower is expected
  to be able to continue servicing debt without
  large changes to the revenues and/or spending
• However, economic theory does not indicate the
  maximum level of debt (or taxation)
• You do not know if you are in an unsustainable
  position until you are there.
• Fiscal risks are best met by fiscal sustainability

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Long-term revenues projections

• Purpose to get a realistic view of available
  resources
• Growth in taxation based on GDP
• Growth adjusted for
• Income tax on transfers from public sector to
  households such as pensions
• Capital income rise at the expense of labour
  income, fringe benefits, tax exemptions
• Wealth-based taxation, quantity-based excises

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Long-term expenditure projections

• Discretionary spending
• Mandatory spending
• Reserves for new programmes
• One-off expenditures
• Interest payments

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Projecting present expenditures

• Demographic forecasts
• Discretionary spending
• Mandatory spending

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Unknown future expenditures

• Reserves for new programmes
• One-off expenditures

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Sources of uncertainty

• Economic assumptions
• Macroeconomic long-term modelling
• Demographic assumptions
• Labour market participation
• Productivity
• Specification of programmes for public revenues
  and expenditures
• Interest rates

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Macroeconomic long-term modelling

• Equilibrium in the long run
• When will we reach equilibrium?

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Demographic assumptions

• Fertility rates
• Immigration
• Life expectancy

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Labour market participation

• Labour market participation depends on
• Age and gender
• Cultural factors
• Future income
• Pension reforms as a solution?

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Productivity

• Little gain in nominal spending because real
  wages increase in the public sector
• There may be some gain for the public sector
• Productivity in the public sector may reduce
  public employment
• Productivity in the private sector may reduce the
  prices on goods and services

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Main uncertainties in the projections

• Main
• Demographics, life expectancy
• Labour market participation rates
• Productivity, pension reforms
• Interest rates
• Fertility rates in the even longer run

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Time horizon

• Cover the problems and the solution baby boomers
  indicate at least a time horizon of 40-50 years
• Will there be a constant increase in expenditure?
• The uncertainties in the demographics increase
  because accumulated increased longevity and
  projections include fertility rates not yet
  observed

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Projections in some countries
United Kingdom 50-year projection included in the yearly pre-budget documents in December
United States 75-year projection in the yearly budget proposal
Australia Productivity Commission Research Report gives projections to 2044-45
New Zealand Will present their first report in June 2006
Norway Special report in 2004 with projections to 2060
Germany First report in June 2005 gives projections to 2050
European Union European Commission and Economic Policy Committees report in February 2006 gives projections up to 2050
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What do long-term projections tell us so far?

• Many countries will have to raise taxes even if
  they reduce spending
• The growth in the total expenditure must be
  curbed pension and health care reforms
• There will be a shortage of labour, capital
  deepening of public sector may be needed
• Debt has to be reduced in some countries
  otherwise they will need a primary surplus to
  avoid rising debt

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How to avoid fiscal risks in the future

• Handling uncertainty
• Incorporating long-term considerations into the
  yearly budget process
• Specifying public expenditure programmes
• Shifting uncertainty to the private sector
• Reducing the debt (interest payments)

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Important documents

• Projecting OECD Health and Long-Term Care
  Expenditures What are the Main Drivers (OECD
  2006, ECO/WKP(2006)5)
• Joaquim Oliveira Martins, Frederic Gonand, Pablo
  Antolin, Christine de la Maisonneuve, Kwang-Yeol
  Yoo The Impact of Aging on Demand, Factor
  Markets and Growth (OECD Economic Working Papers
  No. 420, ECO/WKP(2005)7)
• Jean-Marc Burniaux, Romain Duval and Florence
  Jaumotte Coping with Ageing  A Dynamic Approach
  to Quantify the Impact of Alternative Policy
  Options on Future Labour Supply in OECD
  Countries, ( OECD Economic Department Working
  Papers No 371, 21. June 2004)
• Working Party No. 1 on Macroeconomic and
  Structural Policy Analysis, Labour Force
  Participation of Groups at the Margin of the
  Labour Market Past and Future Trends and Policy
  Challenges, (OECD ECO/CPE/WP1(2003)8, 22.
  September 2003) (Includes 3 annex.)
• Economic Policy Committee, European Commission
  The impact of aging on public expenditure
  projections for the EU25 Member States on
  pensions, health care, long-term care, education
  and unemployment transfers (2004-2050) (Special
  Report No 1/2006, DG ECFIN, Brussels, 14 February
  2006)