Michael Cullen speech: Chen and Palmer Seminar: “Issues in the finance portfolio”.

I have been asked to talk about issues in the finance portfolio, and because almost everything that the government does costs or raises money, this is a very wide-ranging brief. I am going to confine myself to three issues: what I should do with the surplus; the problem with financing health; and the main challenges that lie ahead for the next budget. Obviously, all three are linked.

The tradition in New Zealand is to judge budgets on a single measure: the operating balance. Early on in my term I tried to widen the focus of the analysis. The basic problem we had was that the operating balance was – particularly at that stage – a very small number, and that small number was the difference between two very large numbers: total revenue and total spending. Minute changes in revenue or expenditure had huge proportional impacts on the operating balance.

We had also adopted accounting practices that required the revaluation of various assets and liabilities at balance date. Some of these liabilities would only have to be met twenty or fifty years into the future: I am talking about things like long-term accident compensation support and Government Superannuation Fund pensions. The accruals accounting conventions booked all of the changes in future liabilities to the current year. Because the main driver of estimates of future liabilities was changes in interest rates, valuation changes tended to reverse out over the interest rate cycle. The net result was that the reported balance was massively impacted by valuation changes that in all probability would not endure. The reported balance not only hid the magnitude of the underlying strength of the fiscal position, it often distorted the direction in which the underlying balance was moving.

I didn’t want to abandon GAAP principles, for very good reason, but I did want a supplementary indicator that allowed analysts to strip valuation and accounting changes out and look at what was happening with what were essentially changes in the cash flows around current operations. Hence the OBERAC: the operating balance excluding revaluations and accounting changes. The problem with the OBERAC is that in some ways it has been too successful. Almost every media commentator reports a fiscal 2003 surplus of $4 billion dollars, when the actual operating balance is $1.4 billion.

Of course annual financial performance is important, but the commentaries have also failed to grasp the fact that the operating balance, or the OBERAC, or a mix of the two, is no longer the primary goal of fiscal management. They are now a means to an end. The government has changed its primary long-term fiscal goal as managing total debt at prudent levels.

There are a number of reasons for this. It is possible to run surpluses or deficits for short periods without having any significant impact on the government’s ability to spend: it can cover the difference by running down or building up debt. It is when debt becomes too high that problems emerge: too much revenue going to service debt, and, ultimately conditions being imposed before debts are refinanced.

Equally, too little debt can reflect poor financial management. It may be a consequence of neglect of the infrastructure, or of under-funding of education and other social programmes, or – even – of maintaining an excessive tax rate for too long.

We have focussed on total debt, not net debt as the target. The reason is that some of the financial assets we hold are not readily realisable: $5 billion of student loans would fall into that category. We should see other assets as fenced off from day to day operations and the funding of capital works. The Superannuation Fund is in that category: it is designed to meet part of the transition to a new cost structure when demographic pressures bite in twenty years plus time.

Gross debt, or more correctly sovereign-issued debt, is the stuff we have to pay. That is ultimately what we are managing around. It is another question, then, of what a prudent level of debt is.

There are three parts to the answer. The first is what a manageable level of debt is. There is no rocket science here. It is purely a judgement call. We have set debt of 30 per cent of GDP, on average, over the economic cycle as a prudent upper limit. The second issue is where we are in the economic cycle. Timing matters. Stronger growth earlier generates higher surpluses, which lower debt, which reduces debt servicing costs, which contribute to higher surpluses and so on. Finally there is the question of what capital needs are.

So if I am asked “what should I do with the surplus,” my basic response is “see how it aligns with the management of government debt”.

The $4 billion OBERAC is, in crude terms, the difference between cash in and cash out. Accounting conventions mean that contributions into the Superannuation Fund effectively come out of this surplus. Next year we will put $1.9 billion into the super fund. There have also been unrealised paper losses on some government funds like the Government Superannuation Fund and the Natural Disaster Fund. These losses may reverse out as stock markets recover, but they may not, so we do need to be prudent in case they don’t. The future costs of ACC liabilities and GSF pensions are estimated to have gone up. As interest rates change, those estimates may reverse out, but again they may not. We cannot just ignore them. We are also spending significant amounts of money to upgrade the infrastructure: roads, schools, hospitals and the like. Even making allowance for all of that, debt is still tracking below the prudent benchmark of 30 percent of GDP. It is estimated to be 27.3 per cent of GDP at the end of the month, and forecast to slip to 25 per cent in two years time.

This suggests some headroom exists in fiscal settings. It is here that the hard judgement comes into play. Is that lower debt a reflection of the fact that we have underspent on the infrastructure, short-changed social services, or kept taxes up too high, or is it simply a reflection of a reasonably long and strong economic expansion. In the jargon, is it structural – which means I can do something with it – or is it cyclical – which means I would be very foolish to do so?

It is too early to say. The government will have to make that call in setting the high level numbers for the next budget. Part of the call will be whether there are pressures that will eat away at any surpluses and reduce even the structural leeway that we may have. Talk of that inevitably turns to talk of health.

The financing of health is the single largest and most intractable fiscal conundrum that all developed economies face. Health is an intensely personal and immediate concern. Access to health services is therefore an acutely sensitive political issue and one that is custom built for high profile media presentation and for opposition politicians to use to advantage.

Health technology is exploding. New frontiers are opening up daily, and the range of technological options available on each frontier is expanding rapidly. Many of the new treatments and interventions are enormously expensive. The populations of most high income economies are ageing. This cocktail of more people, needing more health care, with more and more expensive options coming available to provide that care, the costs of providing it rising daily, stirred by media reactions to popular sentiment and shaken in the cauldron of political discourse is – well – intoxicating.

In the last decade, there has not been a single year in which spending on health did not rise by more than government spending as a whole. The result was that in the 1993 financial year, health absorbed 15.6 per cent of government spending. In the current financial year we estimate that it will absorb 18.4 per cent. That is not a minor fiscal realignment. It is a massive structural shift. Health’s slice of the fiscal cake has risen by 45 percent in only a decade. Projections are that by 2006, health will be receiving 19.7 per cent of total government spending. That will represent a 60 per cent increase on the 1993 share of government spending.

These are mind-boggling numbers. And yet there is a constant refrain about the under-funded health system, running health on a shoe-string and such like. It is almost accepted as a fact that health has been short-changed, when the record shows that health has been a fiscal winner every year for over a decade regardless of the composition and colour of the government in office.

It is the one thing that eludes me as Minister of Finance: not so much getting health spending under some sort of fiscal control, but how a systematic and sustained diversion of public resources into health seems in a mysterious way to have been accompanied by continued claims of apparent dissatisfaction with the level of that funding.

The bad news is that looking out, I can only see this fiscal pressure getting worse. I offer my sympathies in advance to the Minister of Finance of 2051. Let me explain.

Health needs vary over the life cycle. That is just a fact. Our mothers need a reasonable degree of health care before we are born. We need a reasonable degree of attention until we are five. After that, health needs are modest until we reach the late fifties, when costs start to rise inexorably, and rise very sharply from the 70 plus, and especially from the 85 plus age range.

To give you a feel for this, Treasury estimates that people over 65 make up 12 per cent of the population but consume 39 per cent of health spending. People over 75 make up 5.5 per cent of the population but use 26 per cent of the health vote.

At the moment, the demographic structure is benign in relation to that age profile of need. By historical standards we have relatively few young people, and low fertility rates – in spite of Mai Chen’s best efforts, for which congratulations and best wishes are due. By future standards we have relatively few older citizens. In demographic terms, these should be the cheap years for the health system. By 2051, the proportion of the population over 65 will double. The proportion over 75 will treble. I am not even going to try and do the maths.

The existing array of health provisions has a demographic cost escalator of rather large proportions built into it. What this means for the finance portfolio is that there is a need to discipline expectations and to manage within the rather substantial allocations, and the very substantial increases in those allocations, that have taken place over the last decade. How is another matter.

Internationally, there is a very close correlation between the amounts spent per head on health care, and per capita GDP. There are some outriders, like the USA which spends a lot more on health even in comparison to its higher national income, and Japan, which spends less: presumably because it has a relatively healthy population. The general rule is that as we get richer, we spend more of the extra income on health.

In international terms, New Zealand is already a little above the line: we spend a bit more on health that would be expected in international terms given our current level of national income. And this is despite a relatively favourable demographic structure.

The challenge, therefore, is to grow the health budget by seeing it as a dividend from a better performing economy rather than grow it by wringing even more out of a limited fiscal pool. The fact that New Zealand society has to face up to is that even arithmetically, we cannot go on forever increasing health spending faster than government spending as a whole.

Assuming that we have some consolidation around spending and a degree of confidence that there is a small structural surplus, what are the priorities for Budget 2004 and beyond? There will be a need to continue to build up activity in the core areas of the government’s programme: education, innovation and economic development. In addition to that, we have to make advances in modernising the infrastructure.

Infrastructure is an interesting and complex area. It is vital for social as well as economic reasons. It is, however, provided by a mix of private sector, local, regional and central government initiatives. There are different ways to finance infrastructural development and different ways of recovering the costs of providing services, including, of course, recovery of costs from those who use the service, tolls, fees, levies and the like. Where central government is involved, an upgrade of the infrastructure impacts on the government’s borrowing programme and debt burden in the first instance. For how it affects the operating balance, see all of the above.

This is a vital area but one on which work is very much in progress. The government has set up a high level committee of Ministers – which I chair – to develop policy and coordinate initiatives on infrastructure issues. I have to say that to date we have been driven by the short-term imperatives of the electricity crisis. It is precisely because infrastructure development is inherently long-term with very extended lead times involved, that we must move beyond crisis driven responses to infrastructural inadequacy.

The second area for policy development is income support to families. Our current structure of income supports is a mix of historical accident and band-aid patch-ups. It does remarkably well for a remarkably large section of the population. It is, though, time for a rethink.

The rethink must take account changes in social organisation and work practice so that the family support regime is relevant to the New Zealand of the next twenty years, not the last twenty. I also think that we need to learn from previous modernisations of systems like education, or health. We must not see change in the way supports are delivered as a way to save money. Inevitably, stresses on resources have meant that over time, those operating systems have got the most out of any efficiency gains that might have been inherent in them. If we are serious about a better functioning family support regime, we have to be prepared to put a reasonably healthy amount of new money into it.

As ever, the two big design problems will have to be tackled. Firstly, how to spend money without it going to what economists call the intra-marginal unit: what you and I may see as people who do not need it. Secondly, how do we raise the level of support without deepening and extending poverty traps.

Tough issues. They will be enough to keep me occupied between now and next May. For the present, it is over to you to keep me occupied with questions and comments until the end of this seminar.

Thank you.

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