New Zealand's ageing population is expected to have a significant impact on long-term government expenditure, particularly in the areas of health and superannuation. Recent projections from Treasury's Long-Term Fiscal Model suggest that, under current policy settings, government expenditure (excluding financing costs) will increase by approximately seven percentage points of GDP by 2050. From the perspective of economic efficiency, we consider several methods for financing that expenditure. We find that tax smoothing is significantly more efficient, from a welfare perspective, than balancing the budget. This result is primarily due to our assumption that the assets accumulated under tax smoothing earn an average return over the government's cost of borrowing. This excess return is not without risk. By modelling asset returns and economic growth in a stochastic manner we find that tax smoothing with a diversified portfolio of financial instruments may also reduce year-on-year tax rate volatility. Introducing practical considerations, in particular expenditure creep (where additional government spending is triggered by an improving balance sheet position), tips the scales in favour of a balanced budget approach. Hence, strong fiscal institutions are a prerequisite for achieving the welfare gains from tax smoothing.
Public Finance Tax Smoothing Balanced Budget Demographics and Deadweight Loss