Calculating the extra tax needed

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Labour’s proposed "New Zealand Superannuation Fund - Calculating the extra tax needed.

Wednesday, November 17th 1999, 12:00AM

by Philip Macalister

The following estimates the amounts that might be needed to achieve Labour’s objective of "guaranteeing" the future security of New Zealand Superannuation. Labour’s policy statement issued in March 1999 says that the proposed New Zealand Superannuation Tax will smooth the costs of New Zealand Superannuation over the next 50-60 years:

"The full rate of New Zealand Superannuation Tax will be set so that at a constant level it will be sufficient to fund New Zealand Superannuation over a sixty year timeframe. In order to ensure that there is no increase in the level of personal taxation, New Zealand Superanuation tax will be phased in over time if the fiscal situation makes that necessary." (Labour’s policy statement Security in Retirement)

What follows tries to estimate how much "New Zealand Superannuation Tax" will be needed. It also illustrates some of the issues that are involved in calculating the amount required to achieve Labour’s objectives.

1. Sensitivity: the first point to note is that the numbers are extremely sensitive to the underlying guesses. Partly, that’s because of the very long time periods involved. It’s also to do with the interdependence of a number of the financial drivers.
2. Key guesses (economists would call these "modelling inputs" or "exogenous assumptions"): the gross cost of New Zealand Superannuation is now about 4.9% of GDP ($5.1 billion). Based on estimates made by the 1997 Periodic Report Group, that gross cost is expected to rise to about 11.7% of GDP by 2050 (the net cost, after income tax recovered, will be about 9% of GDP).

The present cost is about 13.2% of the government’s total expenditure. The calculations assume that this current cost stays constant as a proportion of GDP throughout the period and that any eventual increases in the real cost are looked after by the Fund through the "New Zealand Superannuation Tax". The Fund will be used to pay for the benefits of any net increase in the number of New Zealand Superannuitants after 2002.

The calculations assume that New Zealand Superannuation for a married couple will be a net 65% of the net national average ordinary time wage and paid to all New Zealanders over age 65 (no income test). The single person’s benefit is about 64% of the married couple’s rate (allowing for the split between single and "single living alone" benefits).

To build up the suggested Fund, more will have to be paid up front than at present. The calculations assume that the extra amount to fund the build-up will start in 2001 and will be $300m in year 1, $700m in year 2, $1bn in year 3 and will top out at the required long-term rate in year 4.

In the calculations, GDP grows by a nominal 3.5% a year on average over the next ten years with 1.25% coming from productivity, 1.5% from inflation and the rest from population growth. Over the remainder of the 50 year period, the rate of GDP growth will diminish as the population reduces.

The objective of the calculations is to produce an annual amount that will, after the initial build-up period of three years, smooth the amount of tax needed to pay for New Zealand Superannuation. That’s what Labour says the Fund is for.

The Fund is assumed to earn 8% a year (about a real 6.5% a year after inflation) or about 4.5% a year more than GDP growth. That return is assumed to be tax-free.

3. Result: By 2004, the amount needed by the proposed New Zealand Superannuation Fund will be $3.7 billion a year (in today’s money). That will then represent 3.1% of GDP in 2004. In other words, the total tax take will need to be 36.5% of GDP rather than the 33.4% that would be required for Labour’s other policies. The current tax take is 32.5% of GDP.

Some benefit payments will start in the Fund’s early years but will increase significantly from about 2011 as the first baby boomers start reaching age 65. The amount in the Fund will peak in 2035 at $105 billion (in today’s money). To put that number into perspective, the financial net worth of all New Zealand households at 30 June 1999 (excluding housing) was estimated at $97.6 billion (WestpacTrust Household Savings Indicators).

4. Other issues: Real growth in the economy of more than 1.25% a year will increase the amount required by the Fund. That’s because the New Zealand Superannuation benefit is linked to wages; wages will grow with the economy and they will be increasing at a faster real rate than the calculations have assumed.

Higher than 6.5% real investment returns earned in the Fund will reduce the amount needed.

However, collecting more taxes to yield the required "New Zealand Superannuation Tax" will reduce growth for two reasons:

· First, there are the dead-weight costs imposed by higher taxes – this means that higher taxes tend to reduce output because, by themselves, they tend to distort behaviour.

· Secondly, there is the "crowding out" effect. Growing the economy is what really matters when we think of national strategies to cope with our ageing population. We should expect the private sector to make more effective use of the extra $3.9 billion (needed to pay for the "New Zealand Superannuation Tax") to grow the economy than the government will achieve through the Fund.

The impact on the balance of payments will be negative during the Fund’s build up as the contributions are sent to overseas fund managers.

The portfolio mix of the proposed Fund raises another set of difficulties – should it be a traditional "growth" portfolio (dominated by shares) or should the cash flow smoothing objectives of the Fund indicate a larger proportion of bonds?

Depending on the answer to this last issue, the assumed 8% nominal return on the Fund’s assets is arguably generous over a 50 year timeframe. A lower assumed return will significantly increase the amounts required to be paid into the Fund.

Tax raises another set of problems – will the Fund be a taxpayer? If not, what will that do to local markets when there will be a huge tax-exempt player competing against tax-paying "private" funds.

The calculations assume that there is nothing left in the Fund by 2050 (which is when most current population and demographic projections end) but the last tranche of baby boomers will still be alive then so there will need to be a higher initial contribution required to provide for those "excess" costs after 2050.

The impact on the asset values of western baby boomers’ retirements will probably be negative for the Fund as they start realising their retirement savings at about the same time.

 

These calculations should be read in conjunction with the paper "What's wrong with Labour's New Zealand Superannuation Fund proposal?"

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