When inflation is higher, it costs more for the government to just stand still – so there will be some tough spending calls to make in election year.
Opinion: For all the jostling to anoint each Budget with the catchiest title, Budget 2022 was undeniably all about inflation – even if the “Inflation Budget” doesn’t have a good ring to it.
Both the Budget itself, and Treasury’s views of the economy heading forward, show just how much of a tightrope it will be to navigate getting on with business in a high inflation environment. They say there’s no such thing as a free lunch – well with inflation, that lunch costs you more but leaves you still feeling hungry.
Give it an inch and it takes a mile
Treasury’s Budget Economic and Fiscal Update (BEFU) paints a grim picture on cost challenges.
“Inflation has surfaced as the principal economic challenge in New Zealand and abroad… driven by strong domestic demand pushing up against constrained supply, which in turn has been compounded by the Russian invasion of Ukraine.”
Inflation is set to remain above the top of the Reserve Bank’s target 1-3 percent until 2025, peaking higher and persisting for longer.
Over the four years prior to Covid-19, the Consumers Price Index rose 6.8 percent in total. Over the four years after the pandemic (to the end of 2023), inflation is expected to have increased by 18.7 percent. Essentially, the higher inflation goes, the longer it looks like it will stay around at an uncomfortably high level.
Cost pressures limit future budget allowances
Higher inflation provides a windfall for the government, with a substantially positive effect on government revenue. Income tax rises as wage increases appear, and higher spending (because prices are higher) increases the GST take. These factors, and more, contribute to the $12.7b increase in Crown revenue over the 2022 to 2025 period compared to the Half Year Forecast in December 2021.
Government expenses are set to rise higher too, in part due to high inflation requiring the government to pay more to maintain the current levels of service to Kiwis. Expenses are now set to be $23.8b higher between 2022 and 2025, partly reflecting this higher inflation.
Funding future cost pressures looks to be a tricky exercise for the government. Each year, costs to government go up, meaning they need to pay more to achieve the exact same result for society.
Treasury estimates that with average inflation of 2 percent per year, funding cost pressures took up around $2.2b in the additional spending – the Budget Allowance – the government gives itself in new money to spend each and every budget year.
But when inflation is higher, it costs more for the government to just stand still. Treasury’s high-level estimates show a $3.5b increase to baseline budgets in 2023/24 is needed just to achieve the same result as the year before.
Trouble is, they might not have that $3.5b in cost increases just lying around. Around $2.0b of the $4.5b Budget Allowance in Budget 2023 is already allocated to Health, Justice, and Natural Resources (the latter two groups being new “clusters” which receive cross-agency funding over three years). Some of this $2.0b includes cost pressures but not all of it.
That leaves $2.5b left in the Budget Allowance to fund new spending – less than the expected cost increases of $3.5b. It’s a complicated calculation.
Effectively, under current settings, there might well not be enough in the next Budget Allowance to fund usual cost pressures needed to maintain current levels of service across what the government provides. Treasury sets out three ways to avoid this situation.
The Government could “reprioritise” (reduce) current existing services and instead fund new programmes. They could look for more savings in current government spending or increase revenues (that’s code for more taxes from somewhere). Or they could increase the Budget Allowance (but that’d have to be funded from borrowing).
Getting the government books to stack up in future years, with high inflation, shows just how limiting higher costs can be. Next year’s Budget will be tight, with limited (if any) additional spending on new projects unless existing programmes are cut, revenue is raised, or more borrowing occurs. There is little room to manoeuvre, and some tough calls to be made.
Enough money, people, and materials to achieve better outcomes?
All of these fiscal challenges of how to find enough funding to maintain current service levels, invest in new areas, and just keep the lights on, underscore the difficulty government has going forward to find the right people, materials, and resources to press ahead.
Across the New Zealand economy, there’s a more constrained ability to deliver, which is keeping inflation higher. The working age population has shrunk. Supply chains remain heavily disrupted. Workers have pressed on regardless, trying to keep up with the frantic pace of action as COVID-19 rolls on and previously paused challenges become live again.
The government recognises these capacity constraints as a greater challenge than before, and in Budget 2022 Finance Minister Grant Robertson noted a need to “calibrate our programme” of spending given limited materials and workforce capacity. It won’t be an easy calibration, and will require some tough – and expensive – choices.
