oversight

Budget Surpluses: Experiences of Other Nations and Implications for the United States

Published by the Government Accountability Office on 1999-11-02.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Chairman and Ranking
                 Minority Member, Committee on the
                 Budget, U.S. Senate


November 1999
                 BUDGET SURPLUSES

                 Experiences of Other
                 Nations and
                 Implications for the
                 United States




GAO/AIMD-00-23
Contents



Letter                                                                          7


Executive Summary                                                               8


Chapter 1                                                                      23

Introduction

Chapter 2                                                                      34

Countries Developed
Strategies for Surplus

Chapter 3                                                                      52

Countries Have Taken
Actions to Address
Long-Term Pressures

Chapter 4                                                                      61

The Role of Budget
Processes and
Measures of Fiscal
Position During
Periods of Surplus

Chapter 5                                                                      71

Implications




                         Page 1   GAO/AIMD-00-23 Budget Surpluses in Other Nations
             Contents




Appendixes   Appendix I:    Commonwealth of Australia                                     80
             Appendix II:   Canada                                                        99
             Appendix III: New Zealand                                                   130
             Appendix IV: Norway                                                         150
             Appendix V:    Sweden                                                       164
             Appendix VI: United Kingdom                                                 182
             Appendix VII: GAO Contacts and Staff Acknowledgements                       207


Tables       Table 1: Characteristics of the Six Case Study Countries and
               the United States, 1997                                                    30
             Table 2: Projected Growth in Annual Public Pension
               Expenditures as a Percentage of GDP, 1995-2030                             54
             Table 3: Fiscal Outlook for Fiscal Year 1998-99                             125


Figures      Figure 1: From Deficits to Surpluses: U.S. Unified Budget
               Balance as a Percentage of GDP, 1990 to 2009                               10
             Figure 2: GDP per Capita Assuming Non-Social Security
               Surpluses are Eliminated Versus Unified Budget Balance                     18
             Figure 3: Composition of Spending as a Share of GDP,
               Assuming On-budget Balance                                                 19
             Figure 4: Shifts in General Government Financial Balances                    28
             Figure 5: 1998 General Government Gross and Net Debt as
               a Percent of GDP                                                           29
             Figure 6: Change in Average Annual GDP Growth During
               Economic Slowdown of Late 1980s and/or Early 1990s                         35
             Figure 7: 1998 General Government Financial Balance                          38
             Figure 8: Long-term Projections for Pension Expenditures
               and Petroleum Revenues as a Percentage of GDP in Norway                    40
             Figure 9: Ratio of Population Aged 65 and Over to Population
               Aged 15-64, 2000 and 2030                                                  53
             Figure 10: Improvement in General Government Net Debt as
               a Percentage of GDP During the 1990s                                       59
             Figure 11: GDP per Capita Assuming Non-Social Security
               Surpluses are Eliminated vs. Unified Budget Balance                        75
             Figure 12: Composition of Spending as a Share of GDP, Assuming
               On-budget Balance                                                          76
             Figure 13: Commonwealth of Australia Underlying Budget
               Balance, 1982-83 to 1997-98                                                81



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Contents




Figure 14: GDP Growth in Australia, 1983 to 1998                            84
Figure 15: Receipts and Outlays in Australia, 1982-83 to 1996-97            89
Figure 16: Net Public Sector Debt in Australia, Fiscal Years
  1980-81 Through 1998-99                                                   91
Figure 17: Federal Budgetary Surpluses/Deficits in Canada,
  1980-81 to 1998-99                                                       100
Figure 18: Real GDP Growth in Canada, 1981 to 1998                         104
Figure 19: Federal and Provincial-Territorial Net Debt in Canada,
  1980-81 to 1998-99                                                       111
Figure 20: Major Federal Transfers to Other Levels of Government
  in Canada, 1980-81 to 1998-99                                            114
Figure 21: The Canada Health and Social Transfer                           115
Figure 22: Deficit Targets Compared to Actual Results in Canada,
  1994-95 to 1997-98                                                       117
Figure 23: Federal Government Revenues and Expenditures in
  Canada, 1993-94 to 1998-99                                               120
Figure 24: Summary of Spending and Tax Actions in the 1997-98,
  1998-99, and 1999-2000 Canadian Federal Budgets                          122
Figure 25: Budgetary Balance in New Zealand, 1974-75 to 1997-98            131
Figure 26: GDP Growth in New Zealand, 1983 to 1998                         135
Figure 27: Comparison Between Adjusted Cash and Operating
  Balances in New Zealand, 1994-95 to 1997-98                              138
Figure 28: Net Public Sector Debt in New Zealand, 1980 to 1998             143
Figure 29: General Government Financial Balance as a Percent
  of GDP in Norway, 1970 to 1998                                           151
Figure 30: Real GDP Growth in Norway, 1981 to 1998                         154
Figure 31: Long-term Projections for Pension Expenditures and
  Petroleum Revenues as a Percentage of GDP in Norway, 1973
  to 2050                                                                  161
Figure 32: General Government Financial Balance in Sweden,
  1981 to 1998                                                             165
Figure 33: Real GDP Growth in Sweden, 1982 to 1998                         169
Figure 34: Expenditures and Revenues as a Percentage of GDP
  in Sweden, 1970 to 1998                                                  172
Figure 35: General Government Gross Financial Liabilities in
  Sweden, 1981 to 1998                                                     177
Figure 36: Surpluses/Deficits in the United Kingdom, 1980-81 to
  1998-99                                                                  183
Figure 37: GDP Growth in the United Kingdom, 1980 to 1998                  186
Figure 38: Receipts and Expenditures in the United Kingdom,
  1980-81 to 1995-96                                                       191




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Figure 39: Projected Surpluses/Deficits and Actual Results in
  the United Kingdom, 1986-87 to 1993-94                                    193
Figure 40: Actual and Structural Surpluses/Deficits in the United
  Kingdom, 1986-87 to 1998-99                                               198
Figure 41: Projections of Real GDP Compared to Actual Results
  in the United Kingdom, 1988 to 1994                                       199




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Contents




Abbreviations

AME        annually-managed expenditure
CAP        Canada Assistance Plan
CHST       Canada Health and Social Transfer
CPP        Canada Pension Plan
DEL        departmental expenditure limits
EI         Employment Insurance
EPF        Established Programs Financing
EU         European Union
FRA        Fiscal Responsibility Act
GDP        gross domestic product
GIS        Guaranteed Income Supplement
GST        goods and services tax
MMP        mixed member proportional
NAO        National Audit Office
OAG        Office of the Auditor General
OAS        Old Age Security
OECD       Organization for Economic Cooperation and Development
PAYGO      pay-as-you-go
PSBR       public sector borrowing requirement
PSNB       public sector net borrowing
PSNCR      public sector net cash requirement
RAB        resource accounting and budgeting
TFF        Territorial Formula Financing
U.K.       United Kingdom
VAT        value added tax




Page 5                        GAO/AIMD-00-23 Budget Surpluses in Other Nations
Page 6   GAO/AIMD-00-23 Budget Surpluses in Other Nations
                                                                                              Comptroller General
                                                                                              of the United States
United States General Accounting Office
Washington, D.C. 20548



           B-281269                                                                                                   Leter




           November 2, 1999

           The Honorable Pete V. Domenici
           Chairman
           The Honorable Frank R. Lautenberg
           Ranking Minority Member
           Committee on the Budget
           United States Senate

           As you requested, this report reviews the experience of six nations with budget surpluses−Australia,
           Canada, New Zealand, Norway, Sweden, and the United Kingdom. You asked us to determine how
           these nations achieved budget surpluses, used surpluses to address long-term budgetary pressures,
           and adapted their budget processes once surpluses were achieved.

           Like the United States, these nations achieved budget surpluses largely as the result of improving
           economies and sustained deficit reduction efforts. As they entered a period of surplus, these nations
           debated how surpluses should be used and developed unique strategies for using surpluses to address
           national priorities. The experiences of these nations suggest that it is possible to sustain support for
           continued fiscal discipline during a period of surpluses while also addressing selected pent-up
           demands.

           We are sending copies of this report to the Honorable John R. Kasich, Chairman, and the Honorable
           John M. Spratt, Jr., Ranking Minority Member, House Budget Committee and other interested parties.
           We will make copies available to others upon request.

           This report was prepared under the direction of Paul L. Posner, Director, Budget Issues, who may be
           reached at (202) 512-9573 if there are any questions.




           David M. Walker
           Comptroller General
           of the United States




                                      Page 7                           GAO/AIMD-00-23 Budget Surpluses in Other Nations
Executive Summary



Purpose      In fiscal year 1998, the United States achieved a unified budget surplus for
             the first time in nearly 30 years. Budget surpluses represent both the
             success of past deficit reduction efforts and an opportunity to address
             pressing needs. With the arrival of surpluses there has been much debate
             about whether surpluses should be maintained and how they should be
             used. While balancing the budget has been the clear and generally accepted
             fiscal goal for many years in the United States, there is not yet agreement
             on the appropriate fiscal policy during a period of budget surpluses.

             To help inform the current budget debate, GAO was asked to look at other
             countries with recent experience with budget surpluses. During the 1980s
             and 1990s, several advanced democracies achieved budget surpluses.
             Senate Budget Committee Ranking Member Lautenberg, subsequently
             joined by Chairman Domenici, asked that GAO examine the experiences of
             six nations that have achieved budget surpluses−Australia, Canada, New
             Zealand, Norway, Sweden, and the United Kingdom. Specifically, GAO was
             asked to determine (1) how they achieved budget surpluses and what their
             fiscal policies were during periods of surplus, (2) how they addressed long-
             term budgetary pressures, and (3) how they adapted their budget process
             during a period of surplus. GAO was also asked to identify lessons these
             nations learned from their experiences with budget surpluses that might be
             applicable to the United States.



Background   Balancing the budget is a fiscal goal that often commands broad support−at
             least in the abstract−from policymakers and the public alike. The idea of a
             government spending no more than it takes in has a near universal appeal
             across the political spectrum. In contrast, a government running a budget
             surplus−spending less than it takes in−is a goal with less intuitive appeal,
             and a policy that often lacks a natural constituency.




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Executive Summary




Following years of sustained deficit reduction efforts and as a result of
strong economic growth, the United States achieved a budget surplus in
1998 following a prolonged period of deficits.1 During that past 15 years,
there has been a general consensus on the need to reduce budget deficits.
Surpluses are now projected to continue for at least the next 10 years.2 (See
figure 1.) With the arrival of budget surpluses, a new political debate has
emerged: Should surpluses be saved or spent? If they are spent, what
should they be spent on? How should they be allocated among debt
reduction, spending, and tax cuts? Can surpluses be used to address long-
term fiscal pressures? Should the U.S. budget process be modified during a
period of surpluses?




1
 U.S. surplus figures are presented on a unified basis which includes both the on- and off-
budget portions of the budget. The off-budget sector reflects the annual fiscal activities of
the Social Security trust funds and the Postal Service.
2
 Assumes that surpluses are not spent and that budget caps are adhered to through 2002,
after which time they are assumed to grow with inflation.




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                                          Executive Summary




Figure 1: From Deficits to Surpluses: U.S. Unified Budget Balance as a Percentage of GDP, 1990 to 2009




                                          Note: Figures for 1999 and beyond are estimates.
                                          Source: Fiscal Year 2000 Budget of the United States: Historical Tables, Office of Management and
                                          Budget and The Economic and Budget Outlook: An Update, July 1, 1999, Congressional Budget
                                          Office.


                                          The answers to these questions can have important consequences for the
                                          future economic and fiscal health of the United States. On the one hand,
                                          surpluses inspire proposals to allocate funds for current consumption on
                                          both the spending and revenue sides of the budget. On the other hand, the
                                          more of the budget surplus that is saved, the greater the long-term fiscal
                                          and economic benefits. From a budgetary standpoint, surpluses reduce




                                          Page 10                                    GAO/AIMD-00-23 Budget Surpluses in Other Nations
                   Executive Summary




                   debt and lead to a reduction in interest costs, freeing up budgetary
                   resources to be spent on other priorities.

                   Running surpluses can also help to increase economic growth in the long
                   term. A budget surplus increases national saving and leads to an increase in
                   the amount of funds available to be invested elsewhere in the economy.
                   Lower government borrowing also puts downward pressure on interest
                   rates, as there is less demand for available funds. Together, lower interest
                   rates and higher saving and investment increase the capacity for economic
                   growth over the long term.

                   Another benefit of reducing debt is the enhanced ability to meet future
                   needs. The United States faces a significant challenge associated with an
                   aging population that will result in significant spending pressures for public
                   pension and health programs. Reducing debt today can strengthen our
                   nation’s capacity to finance the future burgeoning costs of health and
                   retirement programs.



Results in Brief   Like the United States, other countries achieved budget surpluses largely
                   as a result of improving economies and sustained deficit reduction efforts.
                   As they entered a period of surplus, they also debated how surpluses
                   should be used. The countries GAO studied have generally reached
                   consensus on how they plan to use surpluses, and they have developed
                   unique strategies that address national priorities. As part of their strategies,
                   they have developed explicit goals to guide fiscal policy and have justified
                   their goals with compelling rationales that often pointed out the potential
                   fiscal and economic benefits of continued fiscal discipline. The case study
                   countries generally chose to continue with a fiscally cautious approach,
                   with three countries−New Zealand, Norway, and Sweden−aiming for
                   sustained surpluses. New Zealand and Sweden have focused on the need to
                   reduce debt as a justification for sustained surpluses, while Norway has
                   focused on the need to save for long-term budget and economic pressures.
                   To maintain support for their policies, these three countries have also
                   devoted some portion of their surpluses to tax cuts and/or spending
                   increases, addressing critical needs while still aiming for an overall general
                   surplus.

                   Each of the case study countries has taken actions to address long-term
                   budgetary and economic concerns. For Norway in particular, long-term
                   budget and economic pressures were a major factor leading the
                   government to decide that surpluses were needed to ensure the long-term



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Executive Summary




sustainability of its fiscal policies. For other countries, programmatic
reforms aimed at addressing long-term pressures enacted prior to the
arrival of surpluses resulted in increased fiscal flexibility during a period of
surplus. Over the last two decades, four of the case study countries−
Australia, Canada, Sweden, and the United Kingdom−have reformed their
pension systems, improving their long-term sustainability. As a result, as
these countries entered a period of surplus, their debate focused on other
needs, such as reducing debt or addressing areas affected by past budget
cuts. New Zealand, by focusing on using surpluses to reduce debt, has also
taken action to improve its long-term economic and fiscal health.

Budget process reforms have played a key role in both framing the debate
about surpluses and helping maintain fiscal discipline during periods of
surplus. Each case study country changed its budget process during the
1990s in an attempt to better control spending and/or to guide fiscal policy
decisionmaking. As countries entered a period of budget surpluses, these
reforms played a critical role in guiding fiscal policy and maintaining fiscal
restraint. As part of their new strategies, some countries chose to focus on
measures of fiscal position other than year-end balance to justify continued
fiscal discipline in times of surplus. For example, New Zealand focuses on
its debt to GDP ratio, and Norway uses a structural measure that adjusts
for the economy’s impact on the budget.

Despite the many differences between the case study countries and the
United States, the experiences of these nations can provide helpful ideas to
be considered in our debate on whether to sustain surpluses and/or how to
use them. GAO’s study suggests that it is possible to sustain support for
continued fiscal discipline during a period of surpluses while also
addressing pent-up demands. However, a fiscal goal anchored by a
rationale that is compelling enough to make continued restraint acceptable
is critical. For each country in our study, the goal and the supporting
rationale grew out of its unique economic experience and situation. Many
in the United States have made the case for sustaining at least some portion
of surpluses to help deal with our longer-term budgetary pressures, as
reflected in the current debate over how to save the portion of the surplus
derived from the Social Security program. GAO’s long-term model
simulations illustrate the need for continued fiscal restraint: saving some of
the surplus is necessary along with structural reform of public retirement
and health programs.

The United States is faced with the challenge of making the transition from
a budget regime focused on eliminating the deficit to one that deals with



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                              allocating the surplus between long-term pressures and short-term
                              demands. While eliminating a deficit is arguably self-defining and
                              straightforward, other nations’ experiences suggest that sustaining even a
                              portion of our surpluses calls for a different framework featuring explicit
                              fiscal policy goals and targets to both inform the allocation of surpluses
                              and to promote public acceptance of the choices. Such a framework would
                              include an agreement on appropriate long-term fiscal goals to guide the
                              more specific debate over the relative merits of different priorities−how
                              much of the surplus to devote to reducing debt, increasing domestic
                              discretionary or defense spending, securing existing unfunded entitlement
                              promises, and cutting taxes.

                              As essential as fiscal targets may be for sustaining surpluses, they are not
                              self-evident. Unlike budget balance where a single number may be an
                              appropriate goal, decisions about sustaining a surplus may call for more
                              complex measures. There is no single number like “0” in the surplus world.
                              The debate has already begun over what might replace “0” deficit as an
                              appropriate fiscal policy measure for the United States−and what process
                              might be appropriate to achieve it. The experiences of other nations
                              suggest that sustaining a surplus over time to address our own long-term
                              needs calls for a framework which:

                              • provides transparency through the articulation and defense of fiscal
                                policy goals;
                              • provides accountability for making progress toward those goals; and
                              • balances the need to meet selected pent-up demands with the need to
                                address long-term budget pressures.



GAO Analysis

A Period of Budget            As countries have transitioned from an era of deficit reduction to a period
Surpluses Led to New Fiscal   of surplus they have developed unique strategies for how to use their
                              surpluses. The countries in GAO’s study found it important to set clear
Strategies
                              fiscal goals and to articulate compelling rationales explaining the potential
                              long-term benefits of their policies in order to maintain public support for
                              continued fiscal discipline.

                              In general, the countries decided to continue with a fiscally cautious
                              approach. Three countries−New Zealand, Norway, and Sweden−set a goal



                              Page 13                          GAO/AIMD-00-23 Budget Surpluses in Other Nations
                       Executive Summary




                       for continued annual budget surpluses. The other three−Australia, Canada,
                       and the United Kingdom−set budget balance as their main fiscal goal, but
                       as part of a cautious fiscal strategy that has resulted in them achieving
                       small surpluses. Leaders in these countries pointed to the potential long-
                       term economic and fiscal benefits as a compelling rationale to justify their
                       policies, and there has generally been broad support for continued fiscal
                       discipline during a period of surplus. However, the countries have generally
                       made room for additional spending initiatives and/or tax cuts, in some
                       cases to address perceived needs following a period of deficit reduction.
                       Remarkably, several nations have instituted spending cuts to sustain
                       surpluses during this period.


Addressing Long-term   Like the United States, most countries in our study face significant
Pressures              challenges arising from an aging population. While demographic trends
                       differ among the countries, all are projecting an increase in the ratio of
                       retirees to workers. If current spending patterns continue, increased
                       spending on public pensions and health care threatens to crowd out
                       spending on other important public goods and services.

                       Over the past two decades, the case study countries generally have taken
                       actions that address long-term fiscal pressures expected to arise from an
                       aging population. Surpluses have helped nations enhance future fiscal and
                       economic capacity by reducing debt burdens. By reducing its debt burden,
                       each country has taken a step toward improving its long-term fiscal and
                       economic health and enhancing future budget flexibility. Budget surpluses
                       increase national saving, which can lead to increased investment and
                       productivity, thereby increasing potential future economic output and
                       living standards. Budget surpluses also reduce the government’s interest
                       costs, freeing resources to be spent on other priorities. Furthermore, lower
                       levels of debt can improve a nation’s capacity to borrow and meet future
                       budgetary needs.

                       Norway is explicitly attempting to use its budget surpluses to address long-
                       term fiscal and economic concerns. The combined effects of an aging
                       population and declining oil revenues are projected to result in an
                       unsustainable fiscal path and eventual economic decline. To address this
                       problem, Norwegian decisionmakers reached a broad consensus on the
                       need to save projected surpluses and established a Petroleum Fund where
                       budget surpluses are deposited and invested to pay for future budget
                       needs.




                       Page 14                          GAO/AIMD-00-23 Budget Surpluses in Other Nations
                             Executive Summary




                             Four other countries−Australia, Canada, Sweden, and the United Kingdom−
                             enacted major pension reforms during the past two decades, which have
                             reduced long-term budgetary pressures and put their pension systems on a
                             more sustainable path. Australia and the United Kingdom carried out
                             pension reforms in the 1980s and 1990s; and as they have entered a period
                             of surpluses, long-term budgetary pressures due to increasing pension
                             costs have not emerged as a major focus of political debates. Canada and
                             Sweden have traditionally accounted for their pension systems separately
                             from the government budget, and their pension fund assets have been
                             invested outside the government. As a result, pension fund surpluses have
                             not been included in their surplus debates. Each country was able to
                             reform its pension system during the 1990s, placing its pension system on a
                             more sustainable path. The United States has not yet engaged in
                             fundmental reforms of our public pension and health systems. Such
                             reforms are necessary to assure the sustainability of these important
                             national programs and to relieve the related longer term budget pressures.


Budget Process Both Guides   The framework for fiscal decisionmaking, which includes both the budget
and Supports Fiscal          process and the way fiscal position is measured, can play a critical role in
                             the ability of a government to maintain fiscal discipline. In an effort to aid
Strategy for Surplus
                             deficit reduction efforts, each country made important changes to its
                             budget process during the 1990s, which were continued and adapted to a
                             period of surplus. As these countries moved into a period of budget
                             surpluses, their budget processes have continued to play an important role
                             in maintaining fiscal discipline and/or in setting fiscal policy.

                             In Norway and Sweden, expenditure limits have continued to play a critical
                             role as they attempt to run sustained surpluses. Bolstered by explicit
                             spending limits, the renewed budget framework has enabled each country
                             to maintain better control over spending during the current period of
                             surplus. As Canada has entered a period of small surpluses, the government
                             generally does not spend projected surpluses until they are about to
                             materialize. The size of Canada’s available surpluses appears low because
                             the government’s projections extend for only 2 years and are based on
                             conservative economic forecasts. To the extent that the economy performs
                             better than forecast, funds become available for new policy initiatives
                             during the fiscal year.

                             The measure of fiscal position is important because it can be used to define
                             a goal and to measure “success.” Zero deficit is generally accepted as one
                             such measure and a signal of the fiscal health of a country. However, during



                             Page 15                           GAO/AIMD-00-23 Budget Surpluses in Other Nations
                              Executive Summary




                              periods of surplus, other measures are necessary to sustain some degree of
                              fiscal restraint. In New Zealand, the statutory requirement that the
                              government establish a “prudent” debt level as a fiscal goal has been
                              critical to its ability to sustain fiscal discipline during a period of surpluses.
                              Specifically, in 1994 the government established a debt goal of between
                              20 and 30 percent of GDP, and set as its fiscal policy to run surpluses until
                              that goal was achieved. In 1996, when it became apparent that the
                              30 percent debt target would be achieved, the government enacted a tax
                              cut and reset its debt target to 20 percent of GDP. Norway focuses on a
                              structural measure of fiscal position, which removes the effects of the
                              economy and petroleum activities, when setting fiscal policy. The
                              government uses this measure to justify continued fiscal restraint during
                              periods of strong economic growth and large budget surpluses. Finally,
                              Canada and Sweden account for their public pension funds separately from
                              the general fund, and as a result, their surplus debates have focused on
                              other issues.


Implications for the United   Like the nations in GAO’s study, the United States has turned years of
States                        deficits into a surplus; but unlike most of these nations, U.S. policymakers
                              have not yet reached agreement on goals and targets to allocate the use of
                              our surpluses. Over the last 15 years, fiscal policy in the United States has
                              focused on the need to reduce−and eventually eliminate−the deficit.

                              Furthermore, pent-up demands for federal policy actions accumulated
                              during years of deficits. Although the United States is still operating under
                              the rules established to achieve budget balance, the advent of a surplus has
                              led to increased pressure for spending increases and/or tax cuts. The
                              legitimacy of the restraints adopted to rescue the nation from deficits is
                              increasingly questioned as surpluses build up. The unified budget reached
                              balance earlier than expected, and the Congress and the President now
                              face the difficult situation of having to comply with tight spending caps
                              designed to eliminate deficits at the same time that the budget is in surplus.

                              The experiences of other nations suggest that it is possible to sustain
                              support for continued fiscal discipline during a period of surpluses while
                              also addressing pent-up demands. A fiscal goal anchored by a rationale that
                              is compelling enough to make continued restraint acceptable is critical.
                              Many in the United States have made the case for sustaining at least the
                              portion of surpluses resulting from annual Social Security surpluses to help
                              deal with our longer-term pressures.




                              Page 16                            GAO/AIMD-00-23 Budget Surpluses in Other Nations
Executive Summary




GAO’s long-term model simulations illustrate the need for continued
restraint: saving some of the surplus is necessary along with structural
reform of retirement and health programs. GAO’s simulations show that
saving a good portion of the projected surpluses would strengthen the
nation’s capacity to finance the burgeoning costs of health and retirement
programs prompted by the aging of our population. For instance, GAO has
estimated that national income would be nearly $20,000 higher per person
in real terms by 2050 if the Social Security portion of the budget surplus is
saved−that is, eliminate the non-Social Security surplus−compared to a
unified budget balance position.3 (See figure 2.) Moreover, there is
widespread recognition in the United States of the need to address long-
term budget drivers−Social Security and Medicare−because even if
surpluses are “saved” and used to pay down debt, growth in these programs
threatens to crowd out discretionary spending. (See figure 3.)




3
 Assumes that permanent unspecified policy actions (that is, spending increases and/or tax
cuts) are taken through 2009 that eliminate the on-budget−non-Social Security−surpluses.
Thereafter, these unspecified actions are projected through the end of the simulation period.
On-budget deficits emerge in 2010, followed by unified deficits in 2019.




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                                         Executive Summary




Figure 2: GDP per Capita Assuming Non-Social Security Surpluses are Eliminated Versus Unified Budget Balance




                                         Note: The “eliminate non-Social Security surpluses” path assumes that permanent unspecified policy
                                         actions (that is, spending increases and/or tax cuts) are taken through 2009 that eliminate the on-
                                         budget surpluses. Thereafter, these unspecified actions are projected through the end of the
                                         simulation period. On-budget deficits emerge in 2010, followed by unified deficits in 2019. The
                                         “eliminate unified surpluses” path assumes that surpluses are not retained, but that the unified budget
                                         remains in balance through 2008.
                                         Source: GAO analysis.




                                         Page 18                                     GAO/AIMD-00-23 Budget Surpluses in Other Nations
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Figure 3: Composition of Spending as a Share of GDP, Assuming On-budget Balance




                                        Note: Revenue as a share of GDP falls from its actual 1998 level to CBO’s 2008 implied level and is
                                        held constant at this level for the remainder of the simulation period.
                                        *In 2030, all other spending includes offsetting interest receipts.
                                        Source: GAO Analysis.


                                        Therefore, a challenge for the United States is to find a way to make the
                                        transition from a budget regime focused on eliminating the unified deficit
                                        to one that deals with allocating the surplus between long-term pressures
                                        and short-term demands. Agreement on appropriate long-term fiscal goals
                                        is important to both inform the allocation of surplus and promote public
                                        acceptance of the choices. For the United States, overall fiscal targets
                                        could guide the more specific debate over the relative merits of different
                                        priorities−how much of the surplus to devote to reducing debt, increasing
                                        domestic discretionary or defense spending, securing existing unfunded
                                        entitlement promises, and cutting taxes. These choices could be
                                        considered within a broader context that considers tradeoffs between
                                        current consumption and saving for the future.




                                        Page 19                                       GAO/AIMD-00-23 Budget Surpluses in Other Nations
              Executive Summary




              The design and use of fiscal targets requires care. U.S. experience shows
              that a target cannot replace agreement on the steps necessary to achieve it.
              In order for any fiscal policy goal to govern actions, it must be grounded in
              a discussion of national needs and the tradeoffs associated with reaching
              such a goal. In addition, selecting the appropriate measures in a time of
              surplus is complicated−indeed a surplus period may call for more complex
              measures. In our nation’s setting, targets could provide a renewed focus for
              fiscal policy geared to monitoring and enhancing long-term U.S. economic
              and fiscal capacity to shoulder the increased obligations associated with
              the retirement of the baby boom generation. Although it is not easy, the
              countries in GAO’s study sought to design a framework strong enough to
              guide action but flexible enough to survive when economic conditions or
              other factors change. In our setting, the current debate over saving the
              Social Security surplus may ultimately yield an agreement on both fiscal
              targets as well as a process for sustaining support for these targets over
              time.



Conclusions   Can the experiences of these nations be translated to the U.S.
              environment? What do their experiences say about the next steps in the
              U.S. debate? First, the failure to define an explicit fiscal path for the future
              has serious downside risks. As GAO has discussed in this and other reports,
              “doing nothing” is not really an option−long-term pressures will overwhelm
              the budget absent reform of public pension and health programs. While the
              debate has begun on how to save a portion of the surplus, until the fiscal
              path for a period of budget surpluses is fully and clearly articulated there is
              a risk of losing the opportunity to enhance our long-term economic
              well-being. A number of the case study countries had already dealt with
              reform of their pension or old-age support programs; this made their task
              easier. This has not been done yet in the United States and so policymakers
              must factor the pressures associated with such programs into any new
              fiscal framework.

              As the United States considers how to use surpluses to address our own
              long-term needs, the other nations’ experiences suggest a framework
              which:

              • provides transparency through the articulation and defense of fiscal
                policy goals;
              • provides accountability for making progress toward those goals; and
              • balances the need to meet selected pent-up demands with the need to
                address long-term pressures.



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Executive Summary




As the United States moves from deficit to surplus, it will be important for
policymakers to reach agreement on a clearly defined and transparent
fiscal policy framework that makes sense in light of both the current
pressures and the long-term projections. In order for this framework to
succeed in setting a broad set of principles to guide fiscal policy
decisionmaking, the rationale for it must be explained and defended.

Within this new framework, clear fiscal policy goals should be articulated.
As with the other countries in GAO’s study, these goals should not be rigid
fixed targets to be achieved on an annual basis. Rather, they should consist
of broader goals defining a future fiscal policy path for the nation. The
goals can provide an accountability framework strong enough to guide
annual budget targets but flexible enough to survive when economic
conditions and other factors change. Without this balancing of needs, the
strains on the enforcement regime become too great and the discipline to
follow a glide path to achieving national goals may be weakened. In other
countries these goals included reducing the burden of national debt,
maintaining international investor confidence, and increasing the national
saving rate. Although the prospect of a loss in international investor
confidence is not as threatening to the United States as it might be for other
nations, goals and measures relevant to our own long-term fiscal outlook
need to be explored. Such goals would go beyond “0” budget balance to
focus on such issues as debt burden, questions of intergenerational equity,
and contributions of fiscal policy to net national saving. The use of
structural measures of fiscal position might help keep fiscal policy focused
on the underlying fiscal position of the federal government, excluding
temporary cyclical economic trends.

The surplus presents an opportunity to address the long-term budget
pressures presented by Social Security and Medicare. If we let the
achievement of a budget surplus lull us into complacency about the budget,
then in the middle of the 21st century, we could face daunting demographic
challenges without having built the economic capacity or program/policy
reforms to handle them. A new fiscal framework for a period of budget
surpluses would be of great value to policymakers and to the U.S. public as
the nation embarks on a period of budget surpluses. Such a framework
could go a long way towards ensuring that future debate on what to do with
surpluses is focussed on issues that are most critical to advancing the
future economic well-being of the nation.

Developing consensus on a new fiscal goal and putting in place a
framework to support such a goal is not easy. Other nations’ experiences



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Executive Summary




illustrate, however, that reaching consensus on using surpluses is possible.
However, GAO would note that our nation has made measurable sacrifices
of current needs for future goals when those goals were defined in
compelling enough terms. A surplus offers the United States a unique
opportunity to revisit the framework under which budgetary decisions are
made and to address selected critical short- and long-term needs.




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Chapter 1

Introduction                                                                                               Chapte1
                                                                                                                 r




                          During the 1980s and 1990s, several advanced democracies achieved
                          budget surpluses. Several of these countries have been able to sustain
                          surpluses over a period of several years and have set a fiscal policy goal
                          calling for sustained surpluses. They have been able to justify sustained
                          surpluses despite obvious difficulties associated with continued fiscal
                          restraint. A discussion of how and why these countries were able to justify
                          continued fiscal discipline can provide insights to U.S. policymakers as
                          they continue to debate fiscal policy during the current period of projected
                          budget surpluses.

                          Senate Budget Committee Ranking Member Lautenberg, subsequently
                          joined by Chairman Domenici, asked that we examine the experiences of
                          six nations that have achieved budget surpluses in the 1980s and 1990s−
                          Australia, Canada, New Zealand, Norway, Sweden, and the United
                          Kingdom−and to identify lessons these nations learned from their
                          experiences with budget surpluses that might be applicable to the United
                          States.



The Politics of Running   Balancing the budget is a fiscal goal that often commands broad support−at
                          least in the abstract−from policymakers and the public alike. The idea of a
a Budget Surplus          government spending no more than it takes in has a near universal appeal
                          across the political spectrum. In contrast, a government running a budget
                          surplus−spending less than it takes in−is a goal with less intuitive appeal,
                          and a policy that often lacks a natural constituency. During periods of
                          surplus, a government hears many calls for new spending or tax cuts. This
                          may reflect in part a reaction to a period of restraint and the often difficult
                          steps taken to eliminate deficits. In the face of these calls to respond to
                          deferred demands, it can be difficult for politicians to justify running a
                          surplus.

                          The politics of surplus are very different from the politics of deficits.
                          During a deficit reduction period the goal is clear and political decisions
                          tend to focus on the mix and severity of spending cuts and tax increases
                          needed to bring the budget into balance. While there may be disagreement
                          over the detailed actions to be taken and how long it should take to achieve
                          balance, there is generally agreement on the goal of balance. During a
                          surplus period, the political debate focuses on whether surpluses are
                          needed at all. If consensus is reached on the need for surpluses, then
                          agreement can be reached on how long they are needed and how large they
                          should be. The answers to these questions are not obvious as there is no
                          single goal with the intuitive appeal of a balanced budget or zero deficit.



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Chapter 1
Introduction




While most economists agree that there are economic and fiscal benefits of
running a surplus, these benefits are longer term and must compete with
current needs. The potential economic benefits of running a surplus
include lower real interest rates, a larger pool of domestic savings to
finance productive investment, and, ultimately, improved prospects for
higher economic growth and living standards in the future. Running
surpluses can also lead to budgetary benefits, including lower interest
payments and increased future budgetary flexibility. Consequently, it may
be politically difficult to justify sustained surpluses because the benefits
will occur in the future and/or there is not always a strong political
constituency to support these goals. Furthermore, these benefits must be
weighed against calls for spending increases or tax cuts, which are usually
supported by organized political advocates and can have more immediate
political benefits.

Support for retaining a surplus can be further weakened by the fact that
many countries achieve surpluses after several years of painful deficit
reduction efforts. Popular programs may have already been cut and/or
taxes raised to achieve surplus. Electorates willing to accept relatively tight
fiscal discipline to achieve balance may be unwilling to continue to do so
when there is “excess” money at the end of the year. This “fiscal fatigue”
can greatly increase the pressure to “spend” the surplus. Consequently,
governments that adopt a surplus goal often allow a portion of surpluses to
be used for spending increases or tax cuts.




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                   Chapter 1
                   Introduction




The Benefits of    Countries with budget surpluses can expect to receive both fiscal and
                   economic benefits. From a budgetary standpoint, the fact that surpluses
Running a Budget   reduce debt means that the associated interest cost falls, freeing up
Surplus            resources to be spent on other priorities.1 A high interest burden tends to
                   lead to even higher deficits and debt, which, in turn, contribute to rising
                   interest costs−creating a “vicious cycle” of increasing deficits and debt.
                   Replacing deficits with surpluses reduces debt and begins a “virtuous
                   cycle” where lower levels of debt lead to lower interest payments−possibly
                   at lower interest rates.2 These lower interest payments in turn lead to larger
                   potential surpluses and/or increased budget flexibility.

                   Running surpluses can also help to increase economic growth in the long
                   term. A budget surplus increases national saving, and leads to an increase
                   in the amount of funds available to be invested elsewhere in the economy.
                   Lower government borrowing also puts downward pressure on interest
                   rates, as there is less demand for available funds. Together, lower interest
                   rates and higher saving and investment increase the capacity for economic
                   growth over the long term. Increased national saving results in increased
                   private investment and raises productivity, thereby increasing future
                   economic output and living standards.

                   Another benefit of reducing debt is the enhanced ability to meet future
                   needs. Many countries face the challenge of an aging population that brings
                   with it significant spending pressures for pension and health programs. As
                   their populations age, countries face a declining number of workers
                   relative to retirees at the same time people will live longer in retirement. If
                   these countries enter the period of the baby boom retirement with large
                   debt loads, the relatively smaller working generation would face a twin
                   challenge of supporting the pension and health care needs of retirees and
                   paying the interest expenses on a large debt. Reducing debt today can
                   increase a nation’s fiscal capacity to afford future budget pressures. Thus,
                   budget surpluses can have an important effect on intergenerational equity
                   by helping countries prepare for future challenges.

                   1
                    There is not always a one-to-one relationship between the size of a budget surplus and the
                   amount of debt reduction due to accounting differences between the two measures. Debt is
                   a cash measure of the government’s borrowing needs. Measures of budget surpluses
                   sometimes include non-cash items, such as the subsidy amount of government loans instead
                   of the cash value of those loans.
                   2
                    Just as deficits put upward pressure on interest rates, a period of budget surpluses should
                   relieve this pressure. Lower interest rates then reduce interest costs.




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                         Chapter 1
                         Introduction




                         Also, surpluses can have a positive impact on investor confidence because
                         of the long-term fiscal and economic benefits that could result and because
                         surpluses can be perceived as an indicator of good fiscal management.
                         Increased investor confidence can lead to lower interest rates and reduce
                         the cost of borrowing.

                         Finally, using surpluses to reduce debt burden allows a country to be better
                         equipped to handle future economic shocks. If debt is at a manageable
                         level, countries have a greater ability to increase borrowing during
                         recessions. If debt is at a high level, there is the risk that additional
                         borrowing will be at higher interest rates as investors demand a premium
                         to cover the risk of nonpayment.



Why the Experiences      The United States is currently entering a period of projected budget
                         surpluses for the first time in many years.3 Since the arrival of surpluses in
of Other Countries Are   1998, there has been much debate about whether surpluses should be
Relevant to the United   maintained and how they should be used. To better inform our current
                         debate, it is instructive to look at other countries with recent experience
States                   with budget surpluses. How did they reach consensus on the use of
                         surpluses? What strategies did they employ to carry out their fiscal policy
                         during a period of surplus? Have they taken steps to address their
                         long-term budgetary pressures? How have they used their budget process
                         to maintain fiscal discipline during a surplus period? The answers to these
                         questions offer important insights as the national debate continues.

                         We chose six case study countries−Australia, Canada, New Zealand,
                         Norway, Sweden, and the United Kingdom−because they have all recently
                         experienced budget surpluses. Admittedly, the six case study countries
                         differ from the United States in many ways. They are all smaller and more
                         dependent on foreign trade. The role of the central government varies from
                         country to country. Two countries−Australia and Canada−have a federal
                         system similar to ours, while the other four countries have unitary systems,
                         with the central government playing a key role in financing local sector
                         activities. When all levels of government are combined, the case study
                         countries generally have a larger public sector than the United States.



                         3
                          Prior to 1998, the United States has achieved budget surpluses in 8 years since the Great
                         Depression. The most recent surplus occurred in 1969, and the longest period of surpluses
                         lasted 3 years from 1947 to 1949.




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                        Introduction




                        Another key difference is that all six case study countries have
                        parliamentary systems of government. Some might express skepticism
                        about the transferability of experiences between different systems of
                        government. Parliamentary systems are thought to facilitate controversial
                        political action by consolidating power in the hands of the governing party.
                        In contrast, the U.S. system’s separation of powers is thought by some to
                        present leaders with greater obstacles to political agreement. Yet imposing
                        sacrifice, even during a period of surplus, is a difficult task for any
                        democratically elected government. Furthermore, coalition or minority
                        governments can form in some case study countries resulting in
                        confrontation and controversy between the coalition partners. Coalition or
                        minority governments routinely must seek the support of other political
                        parties in order to enact legislation, and as result can act in a similar
                        fashion to our system of separate legislative and executive branches.

                        Each of these differences can have an impact on the relative need for
                        surpluses and the ability to achieve and sustain them. However, despite our
                        differences, the experiences of these countries provide many important
                        lessons for us to consider as we continue with our current budget debate.
                        Like us, they achieved budget surpluses largely due to sustained deficit
                        reduction efforts and a period of strong economic growth. They are all
                        democracies with modern economies. Most face many of the same long-
                        term challenges associated with an aging population as we do.



Fiscal History and      As of 1998, each of the case study countries has a budget surplus. Norway
                        and New Zealand have had surpluses since 1994, the longest periods of
Condition of the Case   sustained surpluses among the case study countries. The other four
Study Countries         countries achieved budget surpluses in either 1997 or 1998. Four of the six
                        case study countries achieved budget surpluses in the late eighties and then
                        returned to deficits in the early nineties. (See figure 4.)




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                                         Chapter 1
                                         Introduction




Figure 4: Shifts in General Government Financial Balances




                                         Note: Data for 1998 are estimates. General government financial balance accounts for all levels of
                                         government.
                                         Source: OECD Economic Outlook 65, June 1999.


                                         Debt burden varies from country to country. As of the end of 1998, general
                                         government gross debt as a percent of gross domestic product (GDP)
                                         ranged from a high of nearly 90 percent in Canada to less than 35 percent in
                                         Australia and Norway. General government gross debt includes the debt of
                                         the central government and all sub-levels of government, such as states and
                                         provinces, counties, and cities. However, it is also instructive to look at net
                                         debt, which accounts for government owned financial assets, such as
                                         loans, stocks, and bonds, because it provides a better picture of the



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                                        Chapter 1
                                        Introduction




                                        government’s net financial impact on the economy. As of 1998, general
                                        government net debt ranged from a high of about 60 percent of GDP in
                                        Canada to a low of about negative 47 percent in Norway−meaning that
                                        Norway owns more than enough financial assets to completely pay off its
                                        debt. See figure 5 for each country’s most recent general government gross
                                        and net debt figures.



Figure 5: 1998 General Government Gross and Net Debt as a Percent of GDP




                                        Note: Data for Norway, Sweden, the United Kingdom, and Australia are estimates. Net debt includes
                                        government financial assets, such as loans, stocks, and bonds. Norway’s net debt is negative because
                                        it owns more financial assets than it has debt outstanding.
                                        Sources: OECD Economic Outlook 65, June 1999, and New Zealand Treasury.




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                         Chapter 1
                         Introduction




Economic and Fiscal      The case study countries are smaller, more reliant on trade, and have a
                         larger public sector than the United States. (See table 1.) The United
Characteristics of the   Kingdom has the largest population of the case study countries while New
Case Study Countries     Zealand has the smallest, with a population about 1/16 the size of the
                         United States. The economies of the case study countries are also smaller,
                         with the United Kingdom the largest at about 16 percent of the United
                         States economy and New Zealand the smallest at less than 1 percent of the
                         United States economy. The economies of the case study countries are
                         more dependent on trade than the United States with exports as a
                         percentage of GDP ranging from almost two times to more than four times
                         that of the United States.



                         Table 1: Characteristics of the Six Case Study Countries and the United States, 1997

                                                         Population                                      Public Sector
                                                    (in thousands)                  GDP      Exports           Outlays
                                                                          (billions $US)    (% GDP)           (% GDP)
                         Australia                            18,532               392.9        15.6              33.5
                         Canada                               30,287               607.7        35.5              42.3
                         New Zealand                           3,761                65.0        21.8              38.9
                         Norway                                4,393               153.4        31.6              43.6
                         Sweden                                8,848               227.8        36.4              62.3
                         United Kingdom                       58,105              1,282.9       22.1              41.0
                         United States                       266,792              7,824.0        8.8              33.6


                         Note: Outlay figures are for all levels of government.
                         Sources: OECD Economic Outlook 65, June 1999 and various countries’ OECD economic surveys,
                         1999.


                         Public sector spending for all levels of government as a percentage of GDP
                         is smaller in the United States than in any of the case study countries
                         except Australia, which has about the same level of public spending. This
                         generally reflects a larger role for the governments of the case study
                         countries. For example, the case study countries provide universal health
                         care coverage for their citizens and many provide more generous social
                         benefits.

                         A large public sector can affect fiscal position and fiscal policy in
                         significant ways. Generally, a larger public sector results in wider swings in
                         fiscal position corresponding to swings in the economy. Programs that are



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                         Chapter 1
                         Introduction




                         economically sensitive−such as unemployment benefits and income taxes−
                         add to the size of deficits during downturns and surpluses during periods of
                         strong growth. These economically sensitive programs act automatically to
                         stabilize the economy by increasing aggregate demand during weak periods
                         and decreasing demand during periods of strength. The larger these
                         so-called “automatic stabilizers” are relative to the economy, the larger the
                         swing in fiscal position can be. For example, Sweden with public sector
                         outlays accounting for about two-thirds of the economy, went from a deficit
                         of over 12 percent of GDP in 1994 to a surplus of nearly 2 percent of GDP in
                         1998.



Definition of a Budget   In its simplest definition, a surplus is an excess of revenue over spending in
                         a given period. However, definitions of revenue and spending vary among
Surplus                  countries, and to compare across countries we used OECD data wherever
                         possible. OECD data are presented on a general government basis, which
                         includes the aggregate fiscal balances of all levels of government in that
                         nation. In analyzing the experiences of the individual nations we focused
                         on the measure of fiscal position used by the central government, which
                         formed the basis for policy debates. The definition of budget balance varies
                         significantly from country to country, and can have an impact on the nature
                         of the budget debate during a period of surplus. For example, Canada
                         excludes surpluses in its public pension system from its primary measure
                         of fiscal position. More detailed information on the measure of fiscal
                         position used by each of the six countries is provided in appendixes I
                         through VI, and chapter 4 contains a discussion of how the different
                         measures can have an impact on the budget debate.



Objective, Scope, and    Senators Domenici and Lautenberg asked us to review the experiences of
                         six countries that had achieved budget surpluses. Specifically, they asked
Methodology              us to

                         • determine how these countries achieved a budget surplus and
                           developed fiscal policies in periods of surpluses,
                         • determine how other countries have addressed long-term budgetary
                           pressures and adapted their budget process during a period of surplus,
                           and
                         • identify lessons these nations learned from their experiences with
                           budget surpluses that might be applicable to the United States.




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Introduction




To accomplish these objectives, we reviewed OECD data on the case study
countries’ fiscal position, and in each country we interviewed officials and
analysts familiar with their government’s actions. We also interviewed and
obtained documentation from government officials to better understand
how countries developed fiscal strategies during periods of budget
surpluses. We interviewed and obtained data and information from public
policy critics, academicians, journalists, and members of political
opposition parties to obtain their views. We reviewed a wide array of
reports and economic analysis on fiscal and economic policy in general and
on the specific case study countries. Experts from each case study country
reviewed the appendix on their country, and experts in comparative public
policy reviewed our analysis and findings. The reviewers generally agreed
with our work, and we have incorporated their comments where
appropriate.

In this report, we present significant fiscal policy actions taken by the six
countries, either in terms of size, political importance, or economic impact.
While the report does not fully detail all of the economic policies of the
case study countries, we outline elements of the economic situation and
policies which best helps explain how the countries chose their particular
fiscal path.

Our work was conducted in the six case study countries and Washington,
D.C., from March 1998 through October 1999 in accordance with generally
accepted government auditing standards.




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Page 33   GAO/AIMD-00-23 Budget Surpluses in Other Nations
Chapter 2

Countries Developed Strategies for Surplus                                                            Chapte2
                                                                                                            r




                      In the case study countries, the early 1990s were characterized by slow
                      economic growth and large budget deficits. In response, policymakers
                      enacted structural reforms and deficit reduction packages designed to
                      improve economic and fiscal performance. As each case study country
                      approached budget surplus in the 1990s, its government was faced with a
                      decision about how to approach fiscal policy. The previous period of slow
                      economic growth and large budget deficits continued to play a critical role
                      in shaping how the case study countries approached surpluses, and they
                      generally chose to continue on fiscally cautious paths.

                      As countries have transitioned from an era of deficit reduction to a period
                      of surplus, they have developed unique strategies for how to use their
                      surpluses. Case study countries have found it important to set clear fiscal
                      goals and to articulate compelling rationales explaining the potential
                      benefits of their policies in order to maintain public support for continued
                      fiscal discipline. These countries have generally recognized the importance
                      of competing priorities and have devoted some portion of their surpluses to
                      tax cuts and/or spending increases rather than attempting to reserve the
                      entire surplus for debt reduction. Some nations have been able to sustain
                      surpluses for several years and have taken the difficult step of enacting
                      cuts to maintain surpluses. The budget process has played a critical role
                      guiding fiscal policy and/or supporting continued fiscal discipline.



Factors That Shaped   The political debate surrounding a budget surplus was influenced greatly
                      by the economic slowdowns and budget deficits of the late 1980s and early
the Surplus Debate    1990s. Each country we studied experienced a significant economic
During the 1990s      slowdown during this period, generally coinciding with a broader
                      worldwide economic slowdown. (See figure 6.) In several countries the
                      slowdown became severe. Sweden, for example, experienced
                      3 consecutive years of negative growth beginning in 1991. In other
                      countries, including New Zealand and Norway, there were prolonged
                      periods of below-average growth.




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                                        Chapter 2
                                        Countries Developed Strategies for Surplus




Figure 6: Change in Average Annual GDP Growth During Economic Slowdown of Late 1980s and/or Early 1990s




                                        Source: OECD Quarterly National Accounts, Number 3, 1998, and OECD National Accounts, Main
                                        Aggregates Volume I, 1960-1996.

                                        In several case study countries, a loss of investor confidence in fiscal and
                                        economic health added to the economic downturn, and fiscal and monetary
                                        policies were tightened in reaction to investors pulling money out of the
                                        country. Policymakers were limited in their ability to respond to an
                                        economic slowdown because they were forced to take procyclical actions
                                        to win back investor confidence. For example, both Norway and Sweden



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Countries Developed Strategies for Surplus




were pursuing a policy of fixed exchange rates when a drop in investor
confidence resulted in downward pressure on currency valuations. To
support the value of the currency, each country raised interest rates, which
had the effect of further slowing the economy. New Zealand and Sweden
received credit downgrades due to concerns over their economic and fiscal
health. Interest rates rose as a result, increasing the cost of borrowing and
causing the economies to slow further. Also, several countries took actions
to reduce budget deficits during the economic downturn, which slowed the
economies further. These events made decisionmakers keenly aware of the
need to sustain foreign investor confidence in their economic and fiscal
policies.

The economic slowdowns of the late 1980s and early 1990s were a major
factor leading to the reemergence of large budget deficits in the case study
countries. In four countries, deficits followed a period of budget surpluses.
For these countries, spending increases and/or tax cuts made during a
period of surplus also contributed to the reemergence of deficits. The
reemergence of large budget deficits was seen as a step backward
following years of progress reducing budget deficits.

In reaction to slow economic growth, large budget deficits, and a drop in
investor confidence, leaders in the case study countries took actions to
restore fiscal and economic health. In general, the pervasive philosophy
was that in order to sustain economic growth, inflation rates had to be kept
low and stable and efforts taken to reduce budget deficits. To show their
commitment to reducing inflation rates, five case study countries set
explicit inflation targets and increased the independence of the central
bank to respond to inflationary pressures. Each country also renewed
deficit reduction efforts and implemented budget process changes to
reinforce their commitment.

Several countries enacted large deficit reduction packages in response to
the large deficits that had built up. For example, in 1994, Sweden enacted a
deficit reduction package amounting to 7 percent of GDP over 4 years.
Similarly, in 1994, the Canadian government introduced a package reducing
the deficit by over 3 percent of GDP over 4 years, while the New Zealand
government reduced its budget deficit by more than 4 percent of GDP from
1991 through 1993. In the other countries, the deficit reduction packages
were relatively smaller and more gradual.

Leaders in each country enacted difficult spending cuts and/or tax
increases in their efforts to bring the budgets back into balance. The New



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Chapter 2
Countries Developed Strategies for Surplus




Zealand government cut fiscal year 1991-92 net spending by 10 percent
from the level projected in October 1990 and delayed implementation of a
campaign promise to eliminate an unpopular surcharge on public pensions.
Australia reduced expenditures in health, education, and employment
services. Canada cut the federal workforce by 15 percent and cut back aid
to provinces significantly, which had the effect of reducing spending on
health care. Likewise, Sweden enacted a deficit reduction package that
included reductions in subsidies for medical and dental care, indexation of
certain taxes, and increased contribution rates for the unemployment
benefit system.

A strengthening economy combined with deficit reduction efforts
contributed to a significant improvement in fiscal position in each of the
case study countries. By 1998, all of the case study countries had achieved
a budget surplus. (See figure 7 for the fiscal position as of 1998 for each
country.)




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                                        Chapter 2
                                        Countries Developed Strategies for Surplus




Figure 7: 1998 General Government Financial Balance




                                        Source: OECD Economic Outlook 65, June 1999.




Countries Developed                     As noted in chapter 1, balancing the budget is a fiscal goal that often
                                        commands broad support from both policymakers and the public alike. In
Fiscal Strategies for a                 contrast, a government running a budget surplus−spending less than it
Period of Surplus                       takes in−is a goal with less intuitive appeal, and a policy that often lacks a
                                        natural constituency. As case study countries entered a period of budget
                                        surpluses, decisionmakers had to decide what their fiscal policy goals
                                        would be. The previous period of slow economic growth and poor fiscal
                                        condition continued to influence fiscal policy.

                                        As each country entered its current period of surplus, it has developed
                                        unique strategies to help ensure continued fiscal progress. Leaders in these
                                        countries have developed fiscal goals to help guide budgetary decisions



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                               during a period of surplus. In general, the case study countries decided to
                               continue with a fiscally cautious approach. Three countries−New Zealand,
                               Norway, and Sweden−set a goal for continued budget surpluses. The three
                               others−Australia, Canada, and the United Kingdom−each set balance as its
                               main fiscal goal, but as part of a cautious strategy that has resulted in them
                               achieving small surpluses.

                               Leaders in these countries have pointed to the potential economic and
                               fiscal benefits as a compelling rationale to justify their policy, and there has
                               generally been broad support for continued fiscal discipline during a period
                               of surplus. Often, countries retained features of their budget process
                               designed to aid deficit reduction efforts. The case study countries have
                               generally made room for additional spending initiatives and/or tax cuts,
                               sometimes to address perceived needs following a period of deficit
                               reduction. Remarkably, several nations have instituted expenditure cuts to
                               sustain surpluses during this period.


Three Countries Aim for        New Zealand, Norway, and Sweden have each set sustained surpluses as
Budget Surpluses               their primary fiscal policy goal. Following a period of economic and fiscal
                               crisis, broad consensus was reached on the need for sustained surpluses.
                               Leaders in these countries chose to pursue surpluses to address long-term
                               fiscal and economic concerns, reduce debt, and/or sustain investor
                               confidence in their fiscal management.

Norway Aims for Surpluses to   Norway has established a goal of sustained surpluses in order to build up
Address Long-term Fiscal and   savings to address long-term fiscal and economic concerns resulting
Economic Concerns              primarily from an aging population and declining petroleum revenues.
                               (See figure 8.) Norway projects both a near doubling of retirement benefits
                               from about 7 percent of GDP currently to about 15 percent of GDP by 2030
                               and a parallel decline in oil revenues from about 8 percent of GDP to less
                               than 1 percent over the same period. Also, Norway is concerned that
                               economic growth could decline in the long run if a strong petroleum
                               industry crowds out investment in other industries. The combined effects
                               of an aging population and declining oil revenues are projected to result in
                               an unsustainable fiscal path and eventual economic decline. This long-term
                               problem has been clearly communicated to policymakers and the public
                               and has developed as a primary rationale for their current fiscal policy of
                               sustained surpluses.




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Figure 8: Long-term Projections for Pension Expenditures and Petroleum Revenues
as a Percentage of GDP in Norway




Source: Statistics Norway and Norwegian Ministry of Finance.


In the mid-1990s, Norwegian decisionmakers reached a broad consensus
on the need to save projected surpluses to pay for future budget needs and
to help increase long-term economic growth. Surpluses were projected to
result from increased oil revenues and a strengthening economy. To ensure
that surpluses were saved, the government created the Government
Petroleum Fund, in which surpluses were to be deposited to help pay for
future pension costs.1 The fund’s assets are invested in foreign stocks and
bonds to help reduce inflation and upward pressure on the exchange rate.
Low inflation and a stable exchange rate help to keep Norway’s exports
competitive with other countries. If Norway allowed excess petroleum
revenues to remain in the domestic economy, it could result in higher levels
of inflation and an appreciation in the value of its currency. As a result,
non-oil industries would become less competitive over time as the price of
their goods and services would rise relative to foreign competitors. This is
a major concern to policymakers because Norway projects that petroleum
output will decline early in the 21st century, and Norway will have to rely


1
 The government decided not to use surpluses to pay off debt. It wished to keep a domestic
debt market active in case it needed to increase borrowing, and by paying off debt it would
keep petroleum money in the domestic economy, possibly adding to inflationary pressures.




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                               more on its non-oil industries to generate economic growth. If those
                               industries lose their competitiveness now, it could have a negative impact
                               on long-term economic growth when the petroleum industry declines.
                               Consequently, policymakers in Norway have come to view surpluses as
                               critical to the long-term fiscal and economic health of the country. The
                               Government Petroleum Fund has become a symbol of the importance of
                               saving for future needs.

                               The ability of the government to maintain fiscal discipline during a period
                               of surplus has come under increasing pressure. Fiscal policy stance
                               remained tight through 1997, with the cyclically adjusted deficit, excluding
                               oil, declining from over 7 percent of GDP to less than 3 percent−a major
                               fiscal tightening by international standards.2 Following the 1997 elections, a
                               weak minority coalition took over the government, and proposed to use a
                               portion of the surpluses to increase spending on pensions and family
                               allowances in its first budget. A sharp decline in oil revenues in 1998 led to
                               a sharp decline in the budget surplus, including oil revenues, from about
                               7 percent of GDP to about 4 percent of GDP. Financial markets became
                               concerned over the relatively easy stance of fiscal policy, resulting in strong
                               downward pressure on Norway’s currency. Furthermore, a tight labor
                               market has led to increased inflationary pressures. The government
                               remains committed to maintaining surpluses, but it may be difficult for a
                               weak minority coalition government to maintain fiscal discipline in light of
                               the pressures that have emerged since 1997.

New Zealand and Sweden Aim     Both New Zealand and Sweden have set sustained surpluses as their
for Surpluses to Reduce Debt   primary fiscal goal in order to reduce debt burden, which increased greatly
Burden and Maintain Investor   during the previous deficit period. New Zealand’s general government gross
Confidence                     debt reached a peak of nearly 65 percent of GDP in 1992, while Sweden’s
                               debt climbed to over 80 percent of GDP in 1994. Surplus goals were also
                               adopted to regain investor confidence after a loss of confidence in the early
                               1990s led to a credit downgrade and/or currency devaluation.




                               2
                               Norway’s budget is in deficit if the effects of oil revenues’ economic growth are excluded.




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As each country neared a budget surplus, decisionmakers decided to set
sustained surpluses as their main fiscal objective. In New Zealand, this goal
took the form of an explicit goal to reduce debt burden by running
surpluses. In 1994, New Zealand enacted the Fiscal Responsibility Act
(FRA) which put in place a framework to guide fiscal decision-making.
FRA was enacted in part to address concerns that a recently enacted
electoral reform could weaken political resolve to sustain fiscal discipline.3
FRA requires the government to set a prudent debt level, and to attempt to
run budget surpluses until the goal is achieved. A debt target provides an
additional measure of fiscal health and provides justification for continued
surpluses.

FRA has played a critical role in New Zealand’s ability to sustain fiscal
discipline during its current period of budget surplus. Initially, in 1994, the
government set a goal to reduce net debt to between 20 and 30 percent of
GDP from over 40 percent. The government committed the entire budget
surplus to debt reduction, but promised to cut taxes once the debt target
was achieved. In 1996, when it became apparent that the 30 percent debt
target would be achieved, the government enacted a tax cut and reset its
debt target to 20 percent of GDP.

FRA has continued to play a critical role following the first election under
the new electoral system. Following the 1996 election, a coalition
government formed for the first time in many years. The minority partner in
the coalition government was a strong advocate of new social spending,
while the larger National party, which had held the previous majority
government, was a major advocate of continued debt reduction and tax
cuts. Nonetheless, under their coalition agreement the new government set
continued surpluses and debt reduction as its overall fiscal policy. As a
compromise, they agreed to delay planned tax cuts 1 year and implement a
spending package while still allowing for continued surpluses. In 1998, the
minority partner left the coalition government and the National party
continued as a minority government. The government has retained the
previously agreed to debt target to justify continued fiscal discipline. In the
fall of 1998, when budget forecasts showed that the budget would go into a


3
 In 1996, New Zealand’s electoral system was changed from a first-past-the-post system, in
which the candidate with the most votes won the seat, to a mixed member proportional
(MMP) system, in which seats were awarded to political parties in rough proportion to their
share of the popular vote. MMP was put in place to address concerns that smaller political
parties were not adequately represented in Parliament. As a result, the likelihood for
coalition and/or minority governments increased greatly.




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deficit, largely as a result of the Asian economic crisis, the government
enacted a package of spending cuts and scaled back the previously
promised spending increases to sustain surplus. Consequently, the
government is projecting rough balance in the operating budget for fiscal
year 1999-2000 and operating surpluses starting in fiscal year 2000-2001.

Similarly, the Swedish government has also set a goal of sustained
surpluses to reduce debt and to maintain investor confidence. Of the case
study countries, Sweden experienced the most severe economic downturn
and the largest budget deficit during the 1990s. In reaction, the government
ended its fixed exchange rate policy, enacted a large deficit reduction
package, and reformed the budget process to better support fiscal
discipline, putting in place multi-year expenditure limits for the first time.
In 1997, when it became apparent that the budget was nearing balance, the
government set a goal for surpluses of 2 percent of GDP in order to help
retain investor confidence in its policies and to ensure continued progress
toward debt reduction.




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                           By setting an explicit goal and keeping to expenditure limits, the Swedish
                           government has been able to maintain fiscal discipline during the early
                           stages of its current surplus period. Specifically, the government
                           established expenditure limits for 1998 that would allow it to gradually
                           achieve its surplus goal. However, due to continued strong economic
                           growth and other technical factors, Sweden achieved its surpluses earlier
                           than expected.4 As larger than expected surpluses are projected, the
                           government has reiterated its commitment to the previously agreed to
                           expenditure limits. At the same time, the government has been able to
                           increase spending somewhat because of the way the expenditure ceilings
                           work. Under Sweden’s new budget process all open-ended appropriations,
                           mostly to entitlement programs, were abolished, making all expenditures
                           subject to annual reviews. To provide a buffer against forecasting errors in
                           these programs, the government built a “budget margin” into the
                           expenditure limits. Thus, to the extent economic and budget forecasts turn
                           out to be accurate or better than expected, the government can increase
                           spending up to the amounts allowed under the expenditure ceilings.5 Since
                           the expenditure ceilings have been in place, the economy has
                           outperformed the forecasts, freeing up additional room for spending.

                           In 1999, actual spending was projected to breach the expenditure caps. The
                           government reiterated its commitment to the expenditure caps and
                           proposed cutting spending by about 1 percent to stay within the caps,
                           including cuts to labor market programs, agriculture, and health care. Due
                           to concerns over its international competitiveness−Sweden has among the
                           highest overall tax levels among OECD countries−the government has also
                           proposed a package of tax cuts aimed mostly at low and medium income
                           workers.


Three Countries Aim for    Upon achieving surplus, Australia, Canada, and the United Kingdom each
Balance Upon Achieving a   set a fiscal policy goal of balance. However, each country has developed a
                           cautious fiscal strategy, which has resulted in them achieving small
Budget Surplus
                           surpluses in the near term. The budget process has continued to play a key


                           4
                            For example, in 1998, the government incorporated the National Pension Fund’s real estate
                           holdings, which resulted in an upward adjustment of the financial balance due to
                           government accounting rules.
                           5
                            If budget or economic forecasts turn out to be overly optimistic, then the government
                           would presumably be forced to take action to stay within expenditure limits by cutting
                           spending. There is some additional flexibility to borrow against future year expenditures.




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                             role in each country’s ability to limit spending and tax actions following the
                             arrival of surpluses. In general, their spending and tax actions have been
                             taken to address perceived needs arising from their previous deficit
                             reduction periods.

Australia Aims to Maintain   Australian policymakers have focused on the need to increase national
National Saving              saving and long-term economic growth to guide their fiscal policy
                             decisions. The government was particularly concerned that continued
                             deficits could act to reduce national saving, which had fallen in the early
                             1990s by more than 5 percentage points below the average of the prior
                             three decades. This is of major concern to policymakers because Australia
                             has had to rely on foreign sources of capital to finance private investment.
                             Concerns arose about Australia’s prospects for long-term economic growth
                             if it had to depend on foreign sources to make up the saving-investment
                             gap. As the fall in national saving closely tracked increased public sector
                             borrowing, policymakers committed to fiscal policies aimed at restoring
                             national saving by reducing government borrowing. With the government
                             running balanced budgets instead of deficits, more resources would be
                             available for private sector investment.

                             Consequently, the current government in Australia has set a fiscal goal of
                             balanced budgets over the economic cycle to ensure that, overtime, the
                             Commonwealth general government sector “makes no call” on national
                             saving, and therefore does not detract from national saving.6 For example,
                             one of the justifications for establishing mandatory private pensions was to
                             increase national saving.7 Currently, the government is aiming for budget
                             surpluses for the medium term to coincide with a strong economy.

                             Since 1996, the “Charter of Budget Honesty” (the Charter) has played a
                             critical role in framing Australia’s fiscal policy stance. The Charter set out
                             principles for the conduct of sound fiscal policy and put in place


                             6
                              The government took “balance over the cycle” to mean that it would run surpluses during
                             periods of economic growth to increase budgetary flexibility and allow the government to
                             better respond to future economic shocks.
                             7
                              In 1992, the Commonwealth government passed the Superannuation Guarantee Act making
                             it mandatory for employers to offer retirement benefits, in the form of employer-funded
                             pension programs, to their employees. Under the Act, employers make contributions to
                             individual pension accounts of the employees’ choosing. By 1996, approximately
                             89 percent of public and private sector employees were covered by superannuation, with
                             the remaining 11 percent of the work force falling below the income threshold where
                             superannuation started to apply.




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institutional arrangements designed to improve discipline, transparency,
and accountability in the formulation of fiscal policy. Specifically, the
Charter established the following five principles for sound fiscal
management: (1) to maintain prudent levels of debt, (2) to ensure that fiscal
policy contributes to national saving and moderates economic fluctuations,
(3) to pursue a policy of stable and predictable tax burdens, (4) to maintain
the integrity of the tax system, and (5) to ensure that policy decisions
consider impacts on future generations. The framework of the Charter
allows flexibility for the government to define its medium-term fiscal
strategy and short-term fiscal goals in such a way as to fulfill these
principles.

In fiscal year 1997-98, Australia achieved a small budget surplus, and, with
the fiscal year 1999-2000 budget, the government forecasts surpluses for
the next 4 years.8 The government’s medium-term fiscal strategy, developed
as required by the Charter, is to balance the budget over the cycle, which
means a short-term goal of running surpluses during the projected period
of expansion. Also, the government currently has a goal to eliminate net
debt by fiscal year 2002-03 from its 1998-99 level of about 11 percent of
GDP.

Within this goal of surpluses for the short term, the government has made
room for new selected spending increases and selective tax cuts. The fiscal
year 1998-99 budget proposed spending initiatives totaling nearly
A$10 billion through fiscal year 2001-02, with a large portion dedicated to
health care. The government has also decided to use a portion of its
projected surpluses to help finance a major tax reform, which was passed
in 1999. The tax reform package included the introduction of a national
goods and services tax (GST) along with a reduction in income tax rates for
individuals. A GST has been proposed several times in Australia’s recent
history but has failed to pass due to concerns over its regressiveness.
However, the government was able to pass the GST in 1999 due, at least in
part, to the availability of budget surpluses that could be used to pay for
income tax rate cuts used to offset the impact of the GST.




8
 Beginning in 1996 the Australian measurement of the surplus/deficit changed from a cash
basis to an “underlying” balance basis, which excludes the net effects of advances, such as
loans, and equity transactions, such as sales and purchases of capital assets, from the
calculation of surplus/deficit. If a cash measurement is used, Australia achieved a small
surplus in fiscal year 1996-97.




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Canada Aims for “Balance or   Upon achieving a surplus, Canada set as its fiscal goal to achieve “balance
Better”                       or better” and has kept its “prudent” budget practices in place to better
                              ensure that it meets its goal. These “prudent” budget practices were put in
                              place in support of the government’s effort to eliminate deficits and include
                              a shortened forecast period of 2 years, the use of conservative economic
                              estimates, and a contingency fund to be used for unforeseen events or debt
                              reduction. The effect of these practices has been that Canada has met or
                              exceeded its fiscal goals. During a surplus period, the effect has been to
                              limit the ability of the government to spend surpluses until they materialize.
                              Thus, Canada has adopted a cautious allocation strategy, waiting until
                              additional resources are nearly certain before introducing small-scale tax
                              cuts and spending increases.

                              The Finance Department uses assumptions for interest rates, and
                              sometimes economic growth, that are intentionally more conservative than
                              private sector forecasts. This cautious forecasting policy has been in place
                              since 1994 and was based on a recommendation from a panel of
                              economists convened in late 1993 to advise the government on fiscal and
                              economic issues. The panel’s recommendation was underscored by a
                              private sector analysis that found that the government’s economic
                              assumptions in the 1980s and early 1990s tended to be overly optimistic.
                              Under the current government’s cautious approach, the Finance
                              Department’s economic assumptions have often been more pessimistic
                              than actual outcomes.

                              The contingency reserve is an annual amount that is built into projected
                              spending, but is not allocated to any specific program. It is an accounting
                              mechanism used to supplement the government’s cautious forecasting
                              policy, rather than an actual cash fund. Under the current government, this
                              reserve is not available to fund new initiatives. Instead, it serves solely as a
                              buffer against unanticipated developments, such as an adverse change in
                              the economy. If the government’s budget projections are on target (or
                              overly pessimistic), the reserve acts to reduce the deficit or increase the
                              surplus. For example, in fiscal year 1998-99, the government projected a
                              balanced budget. This balanced budget estimate assumed that the
                              CAN$3 billion contingency reserve would need to be spent to compensate
                              for shortfalls in the projections. If the budget forecast is exactly on target,
                              the government will actually realize a CAN$3 billion surplus that will be
                              used to reduce debt. For example, in fiscal year 1998-99, the actual fiscal
                              result was close to the target, and Canada realized a surplus of
                              CAN$2.9 billion, which it used to reduce debt.




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The final element in the government’s cautious approach is a short forecast
horizon; it publishes detailed projections for only 2 years. Prior to the
current government, the Finance Ministry used a 5-year budgeting time
frame for setting fiscal policy and repeatedly failed to meet its deficit
targets. In contrast, since fiscal year 1994-95, the current government has
consistently bettered its 2-year fiscal targets. While using a short forecast
period is not necessarily a more prudent approach to budgeting, the
government explains that its short horizon is a response to the inherent
sensitivity of longer-term forecasts to future economic developments.
Another important reason for the shorter forecasts is that during a period
of deficit reduction, they focus attention on making cuts today rather than
delaying action until tomorrow. During a time of surplus, shorter forecasts
can reduce the temptation to spend projected surpluses. On the other hand,
a short-term budgeting time frame does not disclose the full long-term
impact of policy decisions.

As it has entered a period of budget surpluses, the government has
continued to rely on a cautious approach. Excluding the contingency
reserve, the Finance Ministry does not publicly project budget surpluses.
The government’s current fiscal goal is, at a minimum, a balanced budget−a
strategy that it refers to as “balance or better.” However, the contingency
reserve implies that the actual target is a surplus of at least CAN$3 billion,
about 0.3 percent of GDP. The government has acknowledged it anticipates
budget surpluses by introducing the “Debt Repayment Plan.” The plan is an
explicit statement that the government’s cautious approach could result in
budget surpluses and that the contingency reserve would be used to reduce
debt. The 1999 Budget Plan states that “the level of debt in relation to the
ability to service the debt (the debt-to-GDP ratio) is still too high [at about
65 percent of GDP]−both by historical Canadian and international
standards. . . . Reducing the debt-to-GDP ratio must remain a key objective
of the government’s fiscal policy.”9

While the government is committed to using a modest amount of budget
surpluses for debt reduction through the contingency reserve, it also uses
surplus revenues for new spending and tax cut initiatives. This strategy of
dividing surpluses between debt reduction, tax cuts, and new spending was
articulated during the government’s 1997 reelection campaign. At that time,
the government stated that it would devote 50 percent of budget surpluses


9
 The Budget Plan 1999, Government of Canada, Department of Finance, February 16, 1999,
p. 52.




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to new spending and the other 50 percent to a combination of tax cuts and
debt reduction. Analysts we interviewed stated that this allocation
framework applies to surpluses over the full parliamentary term and will
not necessarily be followed on a year-by-year basis.

In both the fiscal year 1998-99 and 1999-2000 budgets, the government
introduced a number of new selected spending and tax initiatives. The
Finance Ministry estimates that these initiatives will cost the government
about CAN$50 billion cumulatively from fiscal year 1997-98 to 2001-02. On
the spending side, these initiatives have focused on health care and
education. The tax changes include an increase in the amount of income
that low-income earners can receive on a tax-free basis, the elimination of a
3 percent surtax, an increase in the Child Tax Benefit, and a reduction in
employment insurance rates for both employers and employees.

In launching new policy initiatives, the government has adopted a
philosophy that generally avoids committing resources before they
materialize. Typically, the government does not introduce new spending or
tax cuts until late in the fiscal year when a surplus becomes apparent. The
fiscal year 1999-2000 budget explained this approach and its rationale as
follows:

“Central to [the government’s] planning approach is the notion that spending initiatives and
tax cuts will be introduced only when the government is reasonably certain that it has the
necessary resources to do so. This protects against the risk of having to make hasty, and
potentially damaging, corrections to the budget plan, such as announcing tax relief one year
and then having to raise taxes the following year.”

In line with this cautious approach, the government has generally shied
away from both large-scale spending commitments and major tax cuts. In
addition, the government has enacted nonpermanent spending initiatives,
showing its preference for limiting future commitments. An example is the
Canada Millennium Scholarship Fund. The full cost of the fund−a
nonrecurring CAN$2.5 billion−was booked in fiscal year 1997-98, though
scholarships will not be awarded until 2000.10 The government has also
made many nonpermanent investments for health care, research, and
education, addressing some of the areas cut back the most during the
previous period of deficit reduction. This cautious strategy for allocating


10
 It should be noted that the Office of the Auditor General argued that this transaction
should have been booked in the year it occurred, and as a result the federal surplus figure
for 1997-98 was understated by CAN$2.5 billion.




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                               extra resources is supported by the Finance Ministry’s use of conservative
                               economic assumptions, which tend to understate the resources available
                               for spending.

United Kingdom Aims to         The current government has developed a new framework for fiscal policy
Increase Investment Spending   that reflects “lessons learned” from the United Kingdom’s past experiences.
                               The fiscal strategy emphasizes a greater focus on the structural budget, a
                               more explicit distinction between current and capital spending, and firm
                               multi-year spending ceilings that will not be subject to annual review. The
                               current Labor government’s fiscal strategy is guided by two rules: (1) the
                               “golden rule,” under which borrowing will not be used to finance current
                               spending (that is, total spending excluding investment), and (2) the
                               “sustainable investment rule,” which promises to keep net public debt as a
                               share of GDP at a “stable and prudent” level (which the government
                               currently defines as below 40 percent). Both rules are to be applied over
                               the economic cycle, allowing for fiscal fluctuations based on current
                               economic conditions.

                               Under the “golden rule,” the government is aiming for operating balance,
                               allowing for deficit financing of capital investment. The government
                               defines investment as “physical investment and grants in support of capital
                               spending by the private sector.”11 Investment spending was significantly
                               restrained under the previous deficit reduction efforts, and, as a result, the
                               current government has made boosting public investment a major priority,
                               proposing to nearly double it as a share of the economy−to 1.5 percent of
                               GDP−over the course of the current Parliament. While investment spending
                               is a priority, the “sustainable investment rule” is intended to ensure that
                               financing such spending does not result in an imprudent rise in debt.

                               A sharper focus on the economic cycle is a general feature of the current
                               government’s policy that explicitly reflects the “lessons learned” from the
                               past. A recent Treasury report explains the importance of taking the cycle
                               into account:




                               11
                                Fiscal Policy: current and capital spending, HM Treasury (United Kingdom), p. 7,
                               footnote 2.




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“Experience has shown that serious mistakes can occur if purely cyclical improvements in
the public finances are treated as if they represented structural improvements, or if a
structural deterioration is thought to be merely a cyclical effect. The Government therefore
pays particular attention to cyclically-adjusted indicators of the public sector accounts.”12

As a result of the government’s rules, its fiscal policy allows for small
deficits to be used to finance investment spending, provided that overall
debt burden is kept at a stable and prudent level. Despite this allowance for
small deficits, the Treasury estimates that the budget registered a surplus
of 0.1 percent of GDP for public sector net borrowing in fiscal year 1998-99.
Using the government’s “current budget” measure, which excludes
investment, the fiscal year 1999-2000 budget estimated that there would be
a surplus of 4.1 percent of GDP for fiscal year 1998-99 and projected
surpluses on the current budget every fiscal year until 2003-04.




12
 Stability and Investment for the Long Term: The Economic and Fiscal Strategy Report
1998, HM Treasury (United Kingdom), June 1998, p. 45.




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Countries Have Taken Actions to Address
Long-Term Pressures                                                                                       Chapte3
                                                                                                                r




                         Over the past two decades, the case study countries have taken actions that
                         address long-term fiscal pressures expected to arise from aging
                         populations. In Norway’s case, long-term pressures were a major factor
                         leading the government to decide that surpluses were needed to ensure the
                         long-term sustainability of its policies. For other countries, programmatic
                         reforms aimed at addressing long-term pressures enacted prior to the
                         arrival of surpluses resulted in increased fiscal flexibility during a period of
                         surplus. Over the last two decades, four countries--Australia, Canada,
                         Sweden, and the United Kingdom--enacted major pension reforms that
                         have reduced long-term budgetary pressures and put their pension systems
                         on a more sustainable path. Consequently, as these countries have entered
                         a period of surpluses, long-term budgetary pressures due to increasing
                         pension costs have not emerged as a major focus of political debates.

                         By achieving budget surpluses and reducing debt, these countries have
                         taken a step toward improving their long-term fiscal and economic health
                         and enhancing future budget flexibility. Budget surpluses increase national
                         saving, which can lead to increased investment and productivity, thereby
                         increasing potential future economic output and living standards. By
                         reducing debt, budget surpluses also reduce the government’s interest
                         costs, freeing resources to be spent on other priorities. Furthermore, lower
                         levels of debt can improve a nation’s capacity to borrow and meet future
                         budgetary needs.



Most Countries Face      Like the United States, most countries in our study face impending
                         challenges arising from an aging population. While demographic trends
Increasing Costs Due     differ among the countries, all are projecting an increase in the ratio of
to an Aging Population   retirees to working age population. If current spending patterns continue,
                         increased spending on pensions and health care threatens to crowd out
                         spending on other important public goods and services.

                         Each of the case study countries is projecting an increase in the aging
                         population relative to the working age population. (See figure 9.) In about
                         10 years, the baby boom generation will start to retire, and the number of
                         retirees will rise faster than in the past. Increased life expectancy will also
                         contribute to the aging pressure, as the number of years spent in retirement
                         increases. The number of people in the working population will also shrink
                         as a percentage of the population, placing increased pressure on the fiscal
                         system. In Canada for example, the ratio of people aged 65 and over to
                         those in the working age population is expected to more than double
                         between 2000 and 2030.



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Figure 9: Ratio of Population Aged 65 and Over to Population Aged 15-64, 2000 and 2030




                                          Source: Data from World Population Projections 1994, The World Bank, Bos et al.


                                          The aging population is expected to give rise to growing demand for
                                          pension and health care services. The demand for public pensions alone
                                          can be a substantial strain on the budgets, caused by annual public pension
                                          costs that, absent any policy changes, are expected in some countries to
                                          double as a percentage of GDP by 2030. (See table 2.) For example, annual
                                          public pension costs in Norway are projected to increase from about
                                          7 percent in 1996 to about 15 percent in 2030. Similarly, the demand for
                                          health care is expected to increase substantially, not only from an aging
                                          population but also from improved technology and the resulting greater
                                          expectations placed on the health system. Several countries have taken




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                                          steps to address these pressures, either by setting aside budget surpluses
                                          as Norway has done or by enacting pension reforms.



Table 2: Projected Growth in Annual Public Pension Expenditures as a Percentage of GDP, 1995-2030

                          1995     2030 Description of public pension system
Australia                  3.2       4.1 Flat-rate, means-tested benefits financed from general fund revenue. Also includes
                                         service pension for veterans.
Canada                     4.4       7.5 Near-universal, non-contributory benefits financed from general fund revenues and a
                                         compulsory earnings-related public pension.
New Zealand                5.0       9.0 Flat-rate benefits financed from general fund revenues.
Norway                     7.0      15.0 Flat-rate, universal benefits and additional benefits based on annual earnings and years
                                         at work financed by payroll taxes and general fund revenues. Includes disability pensions.
Sweden                    11.8      15.0 Flat-rate, minimum benefits for all residents meeting residency or work requirements and
                                         a supplementary pension based on income. Also includes government housing
                                         supplements and a system of partial pension for those between 61 and 64 years of age.
United Kingdom             4.2       4.7 Flat-rate, basic benefits supplemented by an earnings-related pension. Employees are
                                         provided tax incentives to move from the public earnings-related pension plan into private
                                         plans. Also includes means-tested assistance for low-income retirees.
United States              4.8       5.9 The Old-Age, Survivors and Disability Insurance Program provides monthly payments
                                         based on annual earnings to beneficiaries. The program is financed from payroll taxes.


                                          Note: In Australia, the public pension system is supplemented by a mandatory private pension scheme
                                          funded from employer contributions. In Sweden, in 1998 the Parliament passed legislation to
                                          comprehensively reform the pension system from a pay-as-you-go, defined-benefit system to a pay-as-
                                          you-go, defined contribution system with mandatory individual accounts. Pension expenditure data for
                                          Sweden does not reflect the reform.
                                          Sources: Data from case study countries; David Stanton and Peter Whiteford, Pension Systems and
                                          Policy in the APEC Economies, 1998; Bosworth and Burtless, Aging Societies: The Global Dimension,
                                          1998; Social Security Administration, Retirement Income Security in the United Kingdom, 1998; 1999
                                          Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability
                                          Insurance Trust Funds.




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Countries Have Taken         Case study countries have taken actions in recognition of the fiscal and
                             economic pressures arising from aging populations. As discussed in
Action to Address            chapter 2, Norway has developed a policy goal to save its current budget
Future Demographic           surpluses to address long-term pressures. In 1991, Norway established the
                             Government Petroleum Fund, in which budget surpluses are invested in
Pressures                    stocks and bonds to be used in the future to pay for a projected increase in
                             pension spending.1 Other countries have taken actions to reform their
                             pension systems prior to the arrival of budget surpluses, allowing them to
                             focus on other uses for their surplus.


Norway Has Set Aside         Norway faces the situation of an aging population, a shrinking proportion
Surpluses to Address Long-   of working age population to retirees, and a projected sharp decline in oil
                             revenues in the future. As noted in chapter 2, pension expenditures as a
term Issues
                             share of GDP are projected to more than double by 2050, while petroleum
                             revenues as a share of GDP are projected to fall drastically over the same
                             period. Today, revenues from petroleum activities account for a significant
                             share of government revenues at about 16 percent of total revenue. Norway
                             has responded to this future pressure by establishing the Government
                             Petroleum Fund, in which budget surpluses, which are generated from
                             petroleum revenues, are invested outside the government to pay for future
                             pension costs. The fund constitutes a real asset that can be drawn upon as
                             pension costs increase in the future.

                             The Government Petroleum Fund is also designed to boost Norway’s long-
                             term economic growth potential. The fund is invested in foreign stocks and
                             bonds. By purchasing foreign assets, the fund automatically reduces
                             Norway’s large current account surpluses and reduces upward pressure on
                             Norway’s exchange rate, thereby enhancing the cost competitiveness of
                             non-oil industries with other countries. The government recognizes that in
                             the long run, as petroleum output declines, having competitive non-oil
                             industries will become increasingly important to maintaining economic
                             growth.

                             The fund could also aid long-term growth because it provides a buffer
                             against severe downturns. While the rationale for saving more of the


                             1
                              The Norwegian government receives a significant amount of revenue annually from its
                             petroleum sector. To “save” these excess revenues and prevent them from overheating the
                             economy, Norway established the Government Petroleum Fund in 1991.




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                           surplus has been the long-term pressure caused by an aging population,
                           fund assets are not explicitly reserved for future pension costs.
                           Consequently, fund assets may be used to cover government deficits when
                           necessary, eliminating the need for additional borrowing. In fact, a portion
                           of the fund has been used to cover non-oil budget deficits.


Australia and the United   Australia and the United Kingdom enacted major pension reforms starting
Kingdom Reformed Pension   in the 1980s and continuing through the 1990s. Each country enacted a
                           tiered pension system, with a significant portion of the pension benefits
Systems in the 1980s
                           accruing in private plans and the government providing basic pension
                           benefits that are either limited or have substantially eroded in value. As
                           more workers build up pension benefits in private plans, the government’s
                           pension obligations are projected to decrease.

                           While the budgetary effects are similar, Australia and the United Kingdom
                           undertook their reforms for different reasons. The United Kingdom
                           undertook reform as part of its deficit reduction efforts and to ensure the
                           sustainability of its pension funds. The United Kingdom’s government
                           significantly scaled back its commitment to future retirees by changing the
                           way the basic pension was indexed and by encouraging the movement of
                           workers into individual pensions or employer-provided pensions.2 Australia
                           reformed its pension system as part of a wider effort to reduce real wage
                           increases and thus avert short-term inflationary pressures, to improve the
                           living standards of retirees, and to increase national saving. In 1986, the
                           Australian government created a guaranteed private pension scheme for
                           employees involved in collective bargaining where employers contribute a
                           portion of the employees’ wage into individual accounts invested in the
                           market. In 1992, this scheme was expanded to require mandatory employer
                           contributions to employee retirement benefits.

                           While these countries had different rationales for reforming their pension
                           systems, both approached the challenge of reducing the budgetary
                           pressure of an aging population by switching a portion of the costs away
                           from the public sector. While spending on retirement systems will increase
                           in both countries in the next half-century, retirement spending is projected
                           to take up a relatively small share of GDP. This may explain why, upon



                           2
                            Under the revised pension indexation formula, increases were tied solely to prices rather
                           than the greater of price or wage increases, as was done previously.




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                            entering a period of surpluses, these countries have focused on other
                            issues.


Canada and Sweden Reform    Sweden and Canada both account for their pension systems separately
Public Pensions to Ensure   from the rest of their budgets. Both countries have generally run annual
                            surpluses in their plans and have used the proceeds to build up reserves.3
Sustainability
                            Consequently, discussions regarding the need to address future shortfalls in
                            their pension systems have occurred separately from debates about deficits
                            or surpluses.

                            During the mid-1990s, both countries modified their pension systems to
                            improve their sustainability. These reforms occurred largely as a result of
                            projections showing that they would run out of money early next century.
                            Canada’s reform calls for some benefit reductions coinciding with a gradual
                            buildup of reserves through increased payroll taxes and higher returns on
                            investments by allowing for a portion of fund assets to be invested in
                            stocks and bonds for the first time. Sweden changed its benefit formula to
                            automatically adjust for changing demographics and economic
                            performance and set up individual accounts in which individuals can
                            choose how to invest their fund balances.

                            In Canada, these pension fund surpluses will continue to be excluded from
                            the budget surplus/deficit measure. In Sweden, due to a change in its fiscal
                            measure in 1995, pension fund surpluses are now counted as part of the
                            government’s measure of surplus. However, pension fund surpluses will
                            continue to be accounted for separately from central government revenues,
                            and as a result, annual budget deliberations focus primarily on the
                            non-pension fund portion of the budget.



Reduced Debt Levels         By eliminating budget deficits and reducing debt, case study countries have
                            increased their ability to respond to future fiscal pressures. Lower levels of
Can Help Countries          debt can increase national saving, leading to increased investment and
Better Deal With Long-      productivity, and ultimately increasing potential economic growth. Each
                            case study country lowered its debt burden during the 1990s. If these
term Pressures              countries continue to reduce debt, as is the stated goal for several

                            3
                             Canada has traditionally invested its surpluses in provincial, territorial, and federal
                            government securities. Its current reform allows for investment in stocks and bonds. In
                            Sweden, surpluses are invested in a combination of stocks and bonds.




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countries, they can expect increased budgetary flexibility to address fiscal
pressures in the future. Leaders in several countries have decided to pursue
lower levels of debt to increase their ability to respond to future fiscal
pressures and to improve long-term economic prospects.

As a result of improving budgets and the achievement of surpluses, case
study countries have reduced their debt levels during the 1990s. (See figure
10.) New Zealand achieved the greatest improvement in debt burden during
the 1990s, cutting its debt burden by more than half between 1992 and 1998.
Norway also achieved great success, improving its debt burden by about
17 percent of GDP between 1994 and 1998.




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Figure 10: Improvement in General Government Net Debt as a Percentage of GDP During the 1990s




                                        Note: 1998 data for Canada, Norway, Sweden, and the United Kingdom are OECD estimates. Debt
                                        figures for New Zealand are for central government only.
                                        Sources: OECD Economic Outlook 65, June 1999, and the New Zealand Treasury.


                                        During the 1990s, policymakers have developed fiscal policies with an eye
                                        to the potential long-term benefits associated with lower levels of debt. As
                                        mentioned in chapter 2, several case study countries have pursued
                                        surpluses in an attempt to address long-term pressures, increase budgetary
                                        flexibility, and improve long-term economic growth. Canada, New Zealand,
                                        and Sweden are all attempting to reduce debt levels in order to enhance
                                        future budgetary flexibility. Norway is saving its budget surpluses to
                                        address long-term budgetary pressures. Australia views budget surpluses
                                        as a means of increasing national saving leading to higher long-term
                                        economic growth. The United Kingdom is attempting to increase



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investment spending to enhance long-term economic growth. As these
countries transition to a period of projected surpluses, having a long-term
outlook has played a critical role in the justification of continued fiscal
discipline.




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The Role of Budget Processes and Measures
of Fiscal Position During Periods of Surplus                                                    Chapte4
                                                                                                      r




               The framework for fiscal decision-making, which includes both the budget
               process and the way fiscal position is measured, can play a critical role in
               shaping fiscal policy and maintaining fiscal restraint. The budget
               framework can play an especially important role during a period of budget
               surplus when the goal of fiscal policy is not always clear and maintaining
               fiscal discipline can be difficult. The measure of fiscal position can be used
               to define a goal and to measure “success.” Zero deficit is generally accepted
               as one such measure and a signal of the fiscal health of a country. However,
               during periods of surplus, other measures may play a more prominent role
               because they shed light on long-term fiscal health and/or the fiscal position
               independent of the economy’s impact.

               All of the countries in our study changed their budget process during the
               1990s. In some cases, budget process changes were enacted to support
               deficit reduction efforts, while in other cases, they were enacted to help
               guide fiscal policy decisions. In Norway and Sweden, these changes
               focused on setting top-down spending and revenue targets before policy
               initiatives were considered, making it more difficult to increase spending
               and/or cut taxes. Australia, New Zealand, and the United Kingdom focused
               on increasing transparency by requiring the government to clearly state its
               fiscal goals. Canada’s changes centered on using conservative budget
               estimates to better ensure that it would be able to meet its fiscal goals. As
               these countries moved into a period of budget surpluses, their budget
               processes have continued to play an important role in maintaining fiscal
               discipline and/or in setting fiscal policy.

               The measures that case study countries use to assess fiscal position
               influence and inform decisionmaking not only during periods of deficit, but
               also during periods of surplus. These countries do not always focus on a
               cash balance figure when formulating fiscal policy. For example, some
               countries focus on debt burden or the structural budget position, which
               factors out the economy’s impact on the budget. In periods of surplus,
               these measures can provide a justification for continued fiscal discipline,
               whereas focusing solely on a cash balance may not. Some other countries
               do not include annual surpluses from public pension funds in their primary
               measure of fiscal position, removing these funds from any debate about
               how to use surpluses.




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Budget Process               All the case study countries changed their budget processes during the
                             1990s. In some cases, budget process changes were enacted to support
Changes Play a Critical      deficit reduction efforts, while in other cases, they were enacted to help
Role During Period of        guide fiscal policy decisions. These reforms varied in design, but all strove
                             to make it more difficult to increase spending and/or to cut taxes. In
Surplus                      general, the reforms took an approach where (1) overall expenditure limits
                             were agreed upon before budget details were worked out, (2) transparency
                             increased because governments were required to clearly define their fiscal
                             goals, and (3) conservative budget estimates were used to better ensure
                             that fiscal goals would be met. Decisionmakers and budget experts in each
                             country cited budget process reforms as a critical component of their
                             ability to maintain fiscal discipline and/or to set fiscal policy goals. As the
                             case study countries have transitioned from deficit reduction to surpluses,
                             leaders in these countries have continued to use budget processes to
                             support fiscal constraint.


Expenditure Limits Used to   Expenditure limits as part of a top-down approach to budgeting have
Control Spending             played a key role in attempts to control spending, both during periods of
                             deficit and surplus. Under this approach, decisionmakers agree on overall
                             spending limits prior to making specific decisions on policy initiatives.
                             After reaching an agreement on spending and/or revenue levels, any new
                             policy initiative must fit within these limits.

                             Expenditure ceilings represented a significant change for two countries in
                             particular. Prior to budget process reforms in the 1990s, Norway and
                             Sweden had not previously set expenditure ceilings. In fact, the general
                             trend in each country had been for Parliament to increase spending above
                             the government’s budget proposals, and this was perceived to be a problem
                             in each country.

                             The Norwegian Parliament reformed its budget process in 1997 to show its
                             continued support for fiscal discipline and in reaction to past spending
                             increases. For the first time, the Parliament adopted a top-down approach
                             to budgeting, setting aggregate revenue and expenditure ceilings. Under the
                             old procedure there was no agreement on an overall expenditure and
                             revenue limit at the beginning of the budget process, and the final budget
                             represented the aggregate of individual spending decisions. As a result, the
                             previous budget process often led to Parliament increasing spending above
                             the government’s proposed levels. Under the new budget process,
                             Parliament agrees on an overall fixed budget ceiling and ceilings for



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                             23 spending and 2 income areas at the beginning of the budget process. All
                             spending and revenue proposals must fit within these ceilings.

                             Sweden enacted a comprehensive budget process reform in the mid-1990s
                             in reaction to several studies which found its budget process to be among
                             the weakest in Europe in its ability to control spending and react to large
                             budget deficits. Under this reform, Parliament is required to pass an
                             aggregate expenditure ceiling, and expenditure ceilings covering both
                             discretionary and mandatory programs for a 3-year period. Once enacted,
                             the expenditure ceilings are fixed and generally cannot be changed.
                             Parliament passes a new aggregate expenditure limit every year for the
                             third year only.

                             Sweden’s budget process reform has had a significant impact on fiscal
                             policy during the current period of projected surpluses. As Sweden entered
                             the current period of projected surpluses, the government has remained
                             committed to the previously agreed-to expenditure ceilings. As a result of
                             its commitment, the government has proposed spending cuts totaling
                             nearly 17 billion kronor in fiscal years 1999 and 2000 to remain under the
                             expenditure ceilings. This is much different than in the past when Sweden
                             found it difficult to maintain fiscal discipline. Also, the expenditure ceilings
                             have changed the focus of Sweden’s debate. Because the government
                             remains committed to the expenditure ceilings, the surplus debate has so
                             far focused mainly on the need to reduce debt or cut taxes. As a result the
                             current government has proposed a broad-based income tax cut as part of
                             its fiscal year 2000 budget proposal.


Countries Increased Budget   Several governments in the case study countries have also attempted to
Transparency by Setting      increase the transparency of their budget processes by requiring clearly
                             defined fiscal goals. These reforms require governments to set fiscal goals
Clear Fiscal Goals
                             not only on the bottom-line fiscal position, but also for other important
                             fiscal and economic indicators such as debt burden, national saving, and
                             investment spending.

                             New Zealand was the first country to change its focus when it passed the
                             Fiscal Responsibility Act (FRA) in 1994. Under FRA, New Zealand’s
                             decisionmakers must consider the impact of fiscal policy on such variables
                             as debt burden and national wealth. Likewise, Australia passed the Charter
                             of Budget Honesty Act in 1998, which requires decisionmakers to assess
                             the budget’s impact on national saving and debt burden. In 1998, the United
                             Kingdom passed into law a requirement laying out the parameters within



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                                which fiscal policy must be set. Based on this statute, the current
                                government has developed a Code for Fiscal Stability, in which the
                                government’s fiscal policy stance calls for balanced budgets, on average,
                                while allowing for borrowing only for investment.

New Zealand’s Fiscal            New Zealand’s Fiscal Responsibility Act (FRA) introduced a new
Responsibility Act              framework for fiscal decisionmaking. FRA was designed to lead to better
                                fiscal outcomes by making policymakers consider not only the short-term
                                impacts of decisions, but also the medium- and long-term effects. The act
                                required that policymakers clearly define their fiscal goals and established
                                a set of reporting requirements designed to increase the frequency and
                                transparency of the government’s fiscal reporting.

                                In New Zealand, the requirement that the government establish a “prudent”
                                debt level as a fiscal goal has been critical to their ability to sustain fiscal
                                discipline during a period of surpluses. FRA requires the government to
                                establish a prudent debt goal and to run budget surpluses until the goal is
                                met. This has had a significant impact on fiscal policy in New Zealand since
                                the law was passed. In 1994, the government established a debt goal of
                                between 20 and 30 percent of GDP, and set as its fiscal policy to run
                                surpluses until that goal was achieved. In 1996, once the 30 percent target
                                was achieved, the government established an even lower goal of 20 percent
                                and passed a tax cut package. Subsequently, the government reduced its
                                debt target to 15 percent. In the spring, summer, and fall of 1998 budget
                                forecasts showed that the budget would return to deficit largely as a result
                                of the Asian economic crisis. The government’s reaction was to pass
                                spending cuts to maintain surpluses and to continue to make progress
                                toward its debt goal.

                                To increase public scrutiny and hold the government accountable for its
                                performance, FRA established extensive reporting requirements. In
                                addition to various reports, the government has to disclose all decisions
                                that may have a material effect on the future fiscal and economic outlook.
                                Through these extensive reporting requirements, the act attempts to ensure
                                that departures from responsible fiscal management principles will be
                                temporary because they will be reported to the public. Consequently, the
                                government will be required to explain why it has not met its fiscal goals.

Australia’s Charter of Budget   The Charter of Budget Honesty, which formally was passed into law in
Honesty                         1998, has been the framework guiding fiscal decisionmaking since the
                                current government in Australia came to power in 1996. The Charter was




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                                developed over concerns that the true fiscal position was not always
                                disclosed adequately.

                                The Charter set out principles for the conduct of sound fiscal policy and
                                put in place reporting requirements designed to improve discipline,
                                transparency, and accountability in the formulation of fiscal policy. The
                                Charter’s five principles for sound fiscal management are to (1) maintain
                                prudent levels of debt, (2) ensure that fiscal policy contributes to national
                                saving and moderates economic fluctuations, (3) pursue a policy of stable
                                and predictable tax burdens, (4) maintain integrity of the tax systems, and
                                (5) ensure that policy decisions consider the impacts on future generations.
                                The Charter, however, allows flexibility for the government to define its
                                strategy and goals in such a way as to fulfill these principles.

                                To ensure improved transparency and accountability, the Charter requires
                                extensive reporting on policies that would affect the fiscal position. Prior
                                to or at the same time the budget is released, the government is required to
                                issue fiscal strategy statements. An Economic and Fiscal Outlook is to be
                                published twice each year to provide updated information so that an
                                assessment of performance can be made. The Charter also requires that the
                                government provide cost estimates of proposals made during the election
                                campaign and that it publish ten days after an election is called a
                                pre-election report to provide updated information on economic and fiscal
                                conditions.

                                The Charter has been in place for only a short time, but it has helped to
                                guide fiscal policy decisions during the current period of projected surplus.
                                For example, the Charter requires the government to assess the impact of
                                its fiscal policy decisions on debt level and national saving. In particular,
                                policymakers are concerned about Australia’s low rate of national saving.
                                Consequently, the current government has established a fiscal policy goal
                                calling for balance over the cycle−implying that it will retain surpluses
                                during periods of strong economic growth. Under this policy, the
                                government’s actions would not reduce national saving because the
                                government would not borrow, on average. As a result of this policy, the
                                current government has projected that debt will be eliminated by fiscal
                                year 2002-03, due largely to continued surpluses and proceeds from
                                privatization.

The United Kingdom’s Code for   In 1998, the United Kingdom passed into law a requirement that the
Fiscal Stability                government issue a “Code for Fiscal Stability.” The law’s purpose is to
                                increase transparency and enhance accountability by requiring the



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                                  government to present a fiscal strategy. The statute itself is general,
                                  allowing the government wide discretion in developing a fiscal strategy.
                                  The statute establishes five principles to guide fiscal policy: transparency,
                                  stability, responsibility, fairness, and efficiency. The statute also requires
                                  the issuance of several reports detailing the government’s fiscal plans.

                                  The current government’s fiscal code is guided by two rules: (1) the “golden
                                  rule,” under which borrowing will not be used to finance current spending
                                  (that is, total spending excluding investment), and (2) the “sustainable
                                  investment rule,” which promises to keep net public debt as a share of GDP
                                  at a “stable and prudent” level (which the government currently defines as
                                  below 40 percent). The “golden rule” is intended to ensure “prudent”
                                  control of public finances while allowing for deficit financing of capital
                                  investment. The government has made boosting public investment a major
                                  priority, proposing to double it as a share of the economy. While investment
                                  spending is a priority, the “sustainable investment rule” is intended to
                                  ensure that financing such spending does not result in an imprudent rise in
                                  debt.

                                  Both rules are to be applied over the economic cycle, allowing for fiscal
                                  fluctuations based on current economic conditions. Taking both fiscal rules
                                  into account, the government’s overall fiscal policy allows for running
                                  small budget deficits. Consequently, when it achieved a surplus in fiscal
                                  year 1998-99, the government’s focus was not to sustain surpluses but to
                                  allow increased investment spending and small deficits in future years.

Canada Uses Conservative          In 1994, a newly elected government put in place a series of “prudent”
Budget Estimates to Better        budgeting practices aimed at better ensuring that it could meet its fiscal
Ensure That It Meets Its Fiscal   targets. The new government felt that it had to address Canada’s history of
Goals                             making 5-year budget projections that were never met. To better ensure
                                  that it could meet its projections, the new government put in place three
                                  main budget practices: (1) shortening budget projections from 5 years to
                                  2, (2) using private sector forecasts and lowering them by a “prudence
                                  factor,” and (3) establishing an annual contingency fund to be used for
                                  unanticipated developments and/or debt reduction.

                                  By shortening the budget cycle from 5 years to 2, the new government felt
                                  that it could better ensure that it would meet its fiscal goals. In the past, the
                                  government’s 5-year projections had proved to be overly optimistic, with
                                  the government repeatedly failing to meet its deficit targets. By using
                                  forecasts that are more conservative than private sector forecasts, the new
                                  government felt that it would eliminate criticism that it was basing its fiscal



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                       projections on overly optimistic economic assumptions. The government
                       took the further step of lowering these private sector forecasts by a
                       “prudence factor,” such as raising long-term interest rate projections by
                       ½ of one percent. Finally, the government put in place a contingency
                       reserve that contains CAN$3 billion annually, about 2 percent of total
                       spending, to be used for emergencies and/or debt reduction. By putting in
                       place a contingency reserve, the government felt that it would be able to
                       pay for unforeseen events, better ensuring that it would meet its fiscal
                       goals.

                       As Canada enters a period of small surpluses, the effect of its budgeting
                       practices is that it generally does not spend surpluses until they are about
                       to materialize. The size of surpluses available to be spent appear small
                       because the government’s budget forecasts are for only 2 years and are
                       based on economic forecasts that are more conservative than private
                       sector consensus estimates. To the extent that the economy performs
                       better than expected, then funds become available for new policy
                       initiatives during the fiscal year. This was the case in 1998 when surpluses
                       developed during the year. Toward the end of the fiscal year, the
                       government enacted several initiatives that used up those surpluses. The
                       contingency fund, in practice, has ensured that some moderate debt
                       reduction also occurs during a period of surplus. Under the current
                       government, the contingency reserve is not available to fund new
                       initiatives, thereby ensuring that some debt reduction takes place if budget
                       forecasts are on target.



The Role of Measures   The measures that case study countries use to assess fiscal position
                       influence and inform decisionmaking not only during periods of deficit but
of Fiscal Position     also during periods of surplus. These countries do not always focus on a
During Periods of      year-end cash balance figure when formulating fiscal policy. For example,
                       some countries focus on debt burden, the structural budget position which
Surplus                factors out the economy’s impact on the budget, or operating balance
                       which is an accrual-based measure. In periods of surplus, these measures
                       can provide a justification for continued fiscal discipline, whereas focusing
                       solely on a cash-based measure may not. Finally, some other countries do
                       not include annual surpluses from public pension funds in their primary
                       measure of fiscal position, removing them from any debate about how to
                       use surpluses.




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The Use of Debt Burden as       Several case study countries use debt as an additional indicator of fiscal
an Indicator of Fiscal Health   health and strive to reduce debt as a share of the economy. As they have
                                entered a period of surplus, goals for reduced debt have provided
                                justification for continued attempts to maintain fiscal discipline. New
                                Zealand, Australia, and Sweden in particular have focused on reducing debt
                                burden as a fiscal policy goal and as a justification for attempting to run
                                continued surpluses.


Accounting for the              Several case study countries have set fiscal goals that take into account the
Economy’s Effects on the        economy’s impact on the budget. For example, Norway’s government
                                routinely uses a structural measure of fiscal position when formulating
Budget
                                fiscal policy. Norway’s structural measure, which excludes the cyclical
                                effects of the economy, petroleum revenues, and interest expenditures, is
                                the key measure used to set fiscal policy. Norway’s government uses this
                                measure to assess if its overall fiscal policy is contributing to or detracting
                                from economic growth. The government then attempts to use fiscal policy
                                to stabilize the economy by increasing spending or cutting taxes during
                                slowdowns to increase growth or doing the opposite during periods of
                                inflationary growth.

                                Other governments have also set fiscal goals that take into account the
                                economy’s effects on fiscal position but have chosen not to employ
                                structural measures of fiscal position when setting fiscal policy. For
                                example, Australia’s current fiscal policy calls for balance, on average, over
                                the economic cycle. However, Australia’s government does not forecast its
                                structural budget position. It concedes in its budgets that it is very difficult
                                to project structural position, so it does not make such projections.
                                Likewise, Sweden aims for surpluses of 2 percent of GDP, on average over
                                the economic cycle. However, Sweden currently does not use a structural
                                measure of fiscal position when setting fiscal policy.


Accrual-based Budgeting         New Zealand has adopted an accrual budgeting framework, which uses an
                                accrual-based measure−the operating balance−as a primary measure of
                                deficit/surplus. In general, a cash-based system recognizes a cost when the
                                cash outlay occurs, while an accrual-based system recognizes a cost in the
                                period the resource is consumed. Consequently, the key difference
                                between New Zealand’s operating balance and the traditional cash balance
                                relates to the period in which revenues and expenses are recorded. This
                                difference can vary in magnitude and direction. For example, under the



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                         The Role of Budget Processes and Measures
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                         previous cash system, leave liability would be recognized when a staff
                         member left a government organization and was paid for the cost of the
                         leave balance. Under the accrual system, the government records an
                         expense as the leave is earned, and recognizes a year-end liability for leave
                         earned but not taken. Financing capital projects affects the budget measure
                         in the opposite way. Under a cash measure, capital projects were recorded
                         when cash was disbursed. Under accrual-based measurement, capital items
                         are recorded in the budget over the expected life of the project, thus
                         reducing the initial budgetary impact. Consequently, the net effect of using
                         an accrual-based measure instead of a cash-based measure depends on the
                         specific government activities undertaken in any given year.

                         In addition to the operating balance, decisionmakers focus on the balance
                         sheet−assets, liabilities, and net worth−when making fiscal decisions
                         because they feel it provides an indication of the long-term sustainability of
                         government programs. According to officials we met with, the balance
                         sheet has had an impact on fiscal decisionmaking by making policymakers
                         more aware of some long-term liabilities that were not addressed
                         previously. For example, the recognition of a large unfunded liability in the
                         accident insurance program was cited as a key factor in the decision to
                         increase insurance premiums to fully fund the program. While these
                         decisions may not have had a large immediate impact on the current fiscal
                         balance, they contributed to programmatic changes, which have improved
                         New Zealand’s long-term fiscal health. However, it is important to note that
                         New Zealand does not include the commitments of its social security
                         system in its accrual-based measures.1


Excluding Pension Fund   Two case study countries do not include the annual balances of their public
Surpluses From Budget    pension funds in the central government’s measure of fiscal position. Both
                         Canada and Sweden account for their public pension funds separately from
Debates
                         the general fund. The funds’ assets are invested in stocks and bonds and
                         are not available to the general fund. As a result, pension fund surpluses are
                         not part of budget debates in Canada or Sweden. Debates regarding the
                         need to increase pension fund assets to meet future obligations have
                         generally occurred apart from budget debates. Both countries enacted
                         pension reforms during the 1990s aimed at increasing the sustainability of



                         1
                          The social security commitment is not considered to be a liability under New Zealand’s
                         accounting standards.




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the system as it became clear that their funds would run out of money early
in the next century.




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Implications                                                                                            Chapte5
                                                                                                              r




                       Budget surpluses reflect both the success of past deficit reduction efforts
                       and an opportunity to address pressing needs. As a country transitions
                       from a period of deficit reduction into a period of surpluses, it is a good
                       time to revisit fiscal goals to determine how best to use surpluses. While
                       balancing the budget has been the clear and generally accepted fiscal goal
                       for many years in the United States, the appropriate fiscal policy for an
                       extended period of budget surpluses does not seem so obvious. As
                       discussed in chapter 1, a balanced budget is a fiscal goal that often
                       commands broad support, while running a budget surplus is a goal with
                       less intuitive appeal. While economists generally agree that there are
                       benefits to running a surplus−lower real interest rates, increased national
                       saving, and lower levels of debt−these benefits must compete with other
                       pressing needs. It may seem difficult to justify sustained surpluses since
                       the benefits are diffuse and occur in the future whereas new spending
                       and/or tax cuts have more immediate and politically compelling effects.
                       Accordingly, there may not always be a political constituency to support
                       sustained surpluses.

                       The experiences of other countries suggest it is important to develop a
                       strategy for fiscal policy specifically tailored to a period of surplus in order
                       to guide budgetary decisions. Several countries are seeking to sustain fiscal
                       progress during a period of budget surpluses and have developed fiscal
                       strategies that (1) have specific goals and targets that are justified by
                       compelling rationales, (2) responds to long-term budget pressures, (3) is
                       flexible enough to address pent-up demands, and (4) is supported by a
                       strong budget process. In this chapter, we highlight some of the most
                       promising practices and approaches of the case study countries and
                       suggest how these could assist deliberations in the United States.



Other Countries Have   Surpluses offered the case study countries an opportunity to address fiscal
                       and economic pressures. Surpluses can be used to address any number of
Developed a Surplus    national priorities with long-range benefits, such as reducing debt or
Strategy               reforming rapidly growing entitlement programs. However, these long-
                       range goals must compete with calls for increased spending and/or tax cuts
                       to address more immediate demands, which can be especially strong
                       following a period of deficit reduction.

                       The experiences of the nations in our study suggest that it is possible to
                       develop a strategy to use surpluses to address national priorities. The case
                       study countries developed fiscal strategies for a period of surplus that
                       addressed their own unique and compelling concerns. Fiscal caution was



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the watchword in most of these nations, with three countries setting the
goal of sustained surplus. Others have set a goal for balance, but with the
caveat that surpluses be used to address some specific need, such as
increased investment spending in the United Kingdom.

Continued fiscal restraint was reflected in specific fiscal goals that guided
the use of surpluses and helped crystallize political agreement. Such goals,
however, had to be justified to publics that had already experienced several
years of deficit reduction−a challenge that was met by pointing to the broad
and compelling national economic and fiscal challenges that needed to be
addressed. The fiscal goals articulated by the nations in our study were,
accordingly, justified as ways to improve their long-term fiscal and
economic outlook, reduce debt burdens, maintain investor confidence, and
increase the national saving rate.

While these countries have taken steps to use surpluses to address long-
term national priorities, they have also allowed for a portion of their
surpluses to be used for more immediate needs. As part of their strategy to
maintain continued support for surpluses, the case study countries also
enacted spending increases or tax cuts, which were sometimes used as a
reward for continued fiscal progress. For example, New Zealand promised
tax cuts once debt was reduced to 30 percent of GDP. The government
devoted the entire surplus to debt reduction until it reached this target and
then cut taxes as promised.

A period of surpluses also illustrates the advantages of addressing budget
“drivers,” such as public pension programs, that threaten long-term budget
sustainability. For example, to ensure that surpluses were saved to pay for
future pension commitments, Norway established a Petroleum Fund in
which budget surpluses are invested to be used in the future. The case
study countries that had taken actions to address budget “drivers” years
before the arrival of surplus have been able to use surpluses to address
other national priorities. For example, Australia and the United Kingdom
reformed their pension systems during the 1980s, placing them on a
sustainable long-term path, and Canada and Sweden have taken more
recent actions to reform their pension systems. As each of these countries
entered a period of surplus their budget debate has focused on other
national priorities. The United States has not yet engaged in fundamental
reforms of our public pension and health systems. Such reforms are
necessary to assure the sustainability of these important nationl programs
and to relieve the related longer term budget pressures.




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                       In the case study countries, the budget process has played a critical role in
                       framing budgetary decisions and maintaining fiscal discipline during a
                       period of surplus. For example, three countries−New Zealand, Australia,
                       and the United Kingdom−recently enacted fiscal codes that have played a
                       critical role in shaping fiscal policy decisions during a period of surplus.
                       These codes require policymakers to consider the overall impact of fiscal
                       policy on such factors as debt burden, national saving, the long-term fiscal
                       outlook, and investment spending as part of their budget deliberation
                       policies. In the case of New Zealand, focusing on such broad indicators has
                       allowed it to develop a compelling rationale supporting a period of
                       sustained surplus.

                       Spending targets and other budget constraints have played a critical role in
                       supporting the surplus policies of Canada, Norway, and Sweden. In
                       Norway, the Parliament imposed overall spending caps−something they
                       had not used before−to control spending, which had tended to increase
                       during previous periods of surplus. In Sweden, the government has decided
                       to maintain expenditure limits−including limits for mandatory spending on
                       social safety net and health programs−to show its commitment to
                       maintaining surpluses even though surpluses have materialized sooner
                       than forecast. Finally, Canada has decided to continue using cautious
                       budget assumptions and a short-term forecast horizon to ensure that
                       surpluses materialize before they can be spent.



Implications for the   Like the nations in our study, the United States has turned years of deficits
                       into a surplus, but unlike most of these nations, we have not yet reached
United States          agreement on goals and targets to allocate the use of our surpluses. Over
                       the last 15 years, fiscal policy in the United States has focused on the need
                       to reduce−and eventually eliminate−the deficit. Fiscal constraint reinforced
                       by budget process rules and strong economic growth have been the
                       primary reasons for our budgetary improvement.1 In 1997, the Congress
                       enacted a comprehensive extension and revision of expenditure caps with


                       1
                        The United States has achieved balance using the budgetary control regime established by
                       the Budget Enforcement Act of 1990 (BEA). Under BEA the budget is divided into two parts:
                       (1) discretionary spending, defined as spending that stems from annual appropriations acts,
                       and (2) direct spending, or spending that flows directly from authorizing legislation; often
                       referred to as mandatory spending. Discretionary spending is subject to annual dollar limits,
                       or spending caps. Mandatory spending and receipts legislation are subject to a pay-as-you-
                       go (PAYGO) requirement that legislation enacted during a session of Congress be deficit
                       neutral (i.e., that any mandatory spending increase or tax cut be offset).




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the goal of balancing the budget in 2002. However, the unified budget
reached balance earlier than planned, and the Congress and the President
now face the difficult situation of having to comply with tight spending
caps at the same time that the budget is in surplus.

As with the nations in our study, the years of deficits have led to the
accumulation of pent-up demands for federal policy actions. Although the
United States is still operating under the rules established to achieve
budget balance, the advent of a surplus has led to increased pressure for
spending increases and/or tax cuts. The legitimacy of the restraints
adopted to rescue the nation from deficits is increasingly questioned as
surpluses build up.

The experiences of other nations suggest that it is possible to sustain
support for continued fiscal discipline during a period of surpluses while
also addressing pent-up demands. A fiscal goal anchored by a rationale that
is compelling enough to make continued restraint acceptable is critical. For
each country in our study the goal and the supporting rationale grew out of
a unique economic experience and situation. Many in the United States
have made the case for sustaining at least some portion of surpluses to help
deal with our longer-term pressures. GAO’s long-term model simulations
illustrate the need for continued restraint: saving some of the surplus is
necessary along with structural reform of retirement and health programs.
Our simulations show that saving a good portion of the projected surpluses
would strengthen the nation’s capacity to finance the burgeoning costs of
health and retirement programs prompted by the aging of our population.
For instance, we have estimated that national income would be nearly
$20,000 higher per person in real terms by 2050 if the Social Security
portion of the budget surplus is saved−that is, eliminate the non-Social
Security surplus2−compared to a unified budget balance position. (See
figure 11.) Moreover, in the United States there is widespread recognition
of the need to address long-term budget drivers−Social Security and
Medicare−because even if surpluses are “saved” and used to pay down
debt, growth in these programs threatens to crowd out other discretionary
spending. (See figure 12.)




2
 Assumes that permanent unspecified policy actions (i.e., spending increases and/or tax
cuts) are taken through 2009 that eliminate the on-budget−non-Social Security−surpluses.
Thereafter, these unspecified actions are projected through the end of the simulation period.
On-budget deficits emerge in 2010, followed by unified deficits in 2019.




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Figure 11: GDP per Capita Assuming Non-Social Security Surpluses are Eliminated vs. Unified Budget Balance




                                         Note: The “eliminate non-Social Security surpluses” path assumes that permanent unspecified policy
                                         actions (i.e., spending increases and/or tax cuts) are taken through 2009 that eliminate the on-budget
                                         surpluses. Thereafter, these unspecified actions are projected through the end of the simulation
                                         period. On-budget deficits emerge in 2010, followed by unified deficits in 2019. The “eliminate unified
                                         surpluses” path assumes that surpluses are not retained, but that the unified budget remains in
                                         balance through 2007.
                                         Source: GAO analysis.




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Figure 12: Composition of Spending as a Share of GDP, Assuming On-budget Balance




                                        Note: Revenue as a share of GDP falls from its actual 1998 level to CBO’s 2008 implied level and is
                                        held constant at this level for the remainder of the simulation period.
                                        *In 2030, all other spending includes offsetting interest receipts.
                                        Source: GAO Analysis.


                                        Moreover, there is widespread recognition in the United States of the need
                                        to address long-term budget drivers−Social Security and Medicare−because
                                        even if surpluses are “saved” and used to pay down debt, the U.S.’ fiscal
                                        path is still unsustainable over the long run. Unless policy changes are
                                        made, we could again find ourselves in a “vicious cycle” of increasing
                                        deficits and debt. Growth in Social Security and Medicare spending
                                        threatens to crowd out discretionary spending in the long run, assuming a
                                        constant tax burden. However, our budget process does not incorporate a
                                        long-term perspective, and therefore, it is not designed to address the
                                        increasing pressures in Social Security and Medicare that result from an
                                        aging population and will eventually turn budget surpluses into deficits.




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              Therefore, a challenge for the United States is to find a way to make the
              transition from a budget regime focused on eliminating the unified deficit
              to one that deals with allocating the surplus between long-term pressures
              and short-term demands. Other nations’ experiences suggest that the
              framework for sustaining a portion of the surplus may be different than the
              framework for reaching budget balance. Agreement on appropriate
              long-term fiscal goals is important to both inform the allocation of surplus
              and to promote public acceptance of the choices. Overall fiscal targets
              could guide the more specific debate over the relative merits of different
              priorities−how much of the surplus to devote to reducing debt, increasing
              domestic discretionary or defense spending, securing existing unfunded
              entitlement promises, and cutting taxes. These choices could be
              considered within a broader context that considers tradeoffs between
              current consumption and saving for the future.

              The design and use of fiscal targets requires care, however. U.S. experience
              shows that a target cannot replace agreement on the steps necessary to
              achieve it. In order for any fiscal policy goal to govern actions, it must be
              grounded in a discussion of national needs and the tradeoffs associated
              with reaching such a goal. In addition, selecting the appropriate measures
              in a time of surplus is complicated−indeed a surplus period may call for
              more complex measures. There is no single number like “0” in the surplus
              world. The debate has already begun over what might replace “0” deficit as
              an appropriate fiscal policy measure for the United States−and what
              process might be appropriate to achieve it. Several nations, for instance,
              have selected debt to GDP targets, with a goal of reducing debt burden over
              time by saving a portion of the surpluses. In our nation’s setting, such
              targets could provide a renewed focus for fiscal policy geared to
              monitoring and enhancing our long-term economic and fiscal capacity to
              shoulder the retirement of the baby boom generation. Although it is not
              easy, the countries in our study sought to design a framework strong
              enough to guide action but flexible enough to survive when economic
              conditions or other factors change. In our setting, the current debate over
              saving the Social Security surplus may ultimately yield an agreement on
              both fiscal targets as well as a process for sustaining support for these
              targets over time.



Conclusions   Can the experiences of these nations be translated to the U.S.
              environment? What do their experiences say about the next steps in the
              U.S. debate? First, the failure to define an explicit fiscal path for the future
              has serious downside risks. As we have discussed in this and other reports,



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“doing nothing” is not really an option−long-term pressures associated with
public pension and health programs will overwhelm the budget. While the
debate has begun on how to save a portion of the surplus, until the fiscal
path for a period of budget surpluses is fully and clearly articulated there is
a risk of losing the opportunity to enhance our long-term economic
well-being. A number of the case study countries had already dealt with
reform of their pension or old-age support programs; this made their task
easier. This has not been done yet in the United States and so policymakers
must factor the pressures associated with such programs into any new
fiscal framework.

As the United States considers how to use surpluses to address our own
long-term needs, the other nations’ experiences suggest a framework
which:

• provides transparency through the articulation and defense of fiscal
  policy goals;
• provides accountability for making progress toward those goals; and
• balances the need to meet selected pent-up demands with the need to
  address long-term budget pressures.

As the United States moves from deficit to surplus, it will be important for
policymakers to reach agreement on a clearly defined and transparent
fiscal policy framework that makes sense in light of both the current
pressures and the long-term projections. In order for this framework to
succeed in setting a broad set of principles to guide fiscal policy
decisionmaking, the rationale for it must be explained and defended.

Within this new framework, clear fiscal policy goals should be articulated.
As with the other countries in our study, these goals should not be rigid
fixed targets to be achieved on an annual basis. Rather, they should consist
of broader goals defining a future fiscal policy path for the nation. The
goals can provide an accountability framework strong enough to guide
annual budget targets but flexible enough to survive when economic
conditions and other factors change. Without this balancing of needs, the
strains on the enforcement regime become too great and the discipline to
follow a glide path to achieving national goals may be weakened. In other
countries these goals included reducing the burden of national debt,
maintaining international investor confidence, and increasing the national
saving rate. Although the prospect of a loss in international investor
confidence is not as threatening to the United States as it might be for other
nations, goals and measures relevant to our own long-term fiscal outlook



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need to be explored. Such goals would go beyond “0” budget balance to
focus on such issues as debt burden, questions of intergenerational equity,
and contributions of fiscal policy to net national saving. The use of
structural measures of fiscal position might help keep fiscal policy
focussed on the underlying fiscal position of the federal government,
excluding temporary cyclical economic trends.

The surplus presents an opportunity to address the long-term budget
pressures presented by Social Security and Medicare. If we let the
achievement of a budget surplus lull us into complacency about the budget,
then in the middle of the 21st century, we could face daunting demographic
challenges without having built the economic capacity or program/policy
reforms to handle them. A new fiscal framework for a period of budget
surpluses would be of great value to policymakers and to the U.S. public as
the nation embarks on a period of budget surpluses. Such a framework
could go a long way towards ensuring that future debate on what to do with
surpluses is focussed on issues that are most critical to advancing the
future economic well-being of the nation.

Developing consensus on new fiscal goals and putting in place a framework
to support those goals is not easy. Other nations illustrate, however, that
reaching consensus on using surpluses is possible. Our nation has made
measurable sacrifices of current needs for future goals when those goals
were defined in compelling enough terms. A surplus offers us with a unique
opportunity to revisit the framework under which budgetary decisions are
made and to address selected critical short-term needs and known long-
term obligations.




Page 79                         GAO/AIMD-00-23 Budget Surpluses in Other Nations
Appendix I

Commonwealth of Australia                                                                                  AA
                                                                                                            ppp
                                                                                                              ep
                                                                                                               ned
                                                                                                                 nx
                                                                                                                  idx
                                                                                                                    eIis




              The Commonwealth of Australia has experienced two periods of budget
              surpluses since the mid-1980s, preceded by periods of deficits and deficit
              reduction.1 Beginning in fiscal year 1987-88 Australia entered a 4-year
              period of surpluses that marked its first surpluses in more than three
              decades.2 The surpluses were achieved through a combination of strong
              economic growth and deficit reduction efforts begun in 1984.3 Australia’s
              main fiscal objective during this period of surpluses was to run balanced
              budgets. In accordance with this policy and the additional goal of the
              government to reduce outlays as a percentage of gross domestic product
              (GDP), the government continued to cut aggregate spending while also
              implementing a tax reform, which included tax cuts. Deficits reemerged in
              fiscal year 1991-92 primarily as a result of the 1991 recession.

              In 1996, a newly elected government embarked on a renewed deficit
              reduction effort and achieved a small budget surplus in fiscal year 1997-98.
              This government advanced a new framework for developing fiscal policy
              called the “Charter of Budget Honesty.” The Charter laid out a set of guiding
              principles and reporting requirements aimed at improving fiscal
              performance while increasing transparency and accountability. Under this
              framework, the new government also established a fiscal policy aimed at
              achieving underlying budget balance over the economic cycle so as not to
              reduce national savings. In contrast to the previous surplus period when
              budget balance was the goal, the current government explicitly calls for
              running surpluses during periods of economic strength. The fiscal year
              1998-99 budget forecasted surpluses totaling more than A$23 billion for
              fiscal years 2000-01 and 2001-02, which were used in part to fund a tax
              reform package, passed in June 1999, containing tax cuts totaling
              A$12 billion. Figure 13 shows the Commonwealth budget balance between
              fiscal years 1982-83 and 1997-98.




              1
               Prior to 1996 the term surplus/deficit referred to the cash balance, measured as the
              difference between revenue and outlays. Beginning in 1996, the measurement of the
              surplus/deficit changed from a cash basis to an “underlying” balance basis, which excludes
              the net effects of advances, such as loans, and of equity transactions, such as sales and
              purchases of capital assets. If a cash measurement is used, Australia achieved a small
              surplus of about 0.5 percent of gross domestic product in fiscal year 1996-97.
              2
              Australia’s fiscal year runs from July 1 through June 30.
              3
              Deficit Reduction: Experiences of Other Nations (GAO/AIMD-95-30, December 13, 1994).




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                                         Appendix I
                                         Commonwealth of Australia




Figure 13: Commonwealth of Australia Underlying Budget Balance, 1982-83 to 1997-98




                                         Note: The underlying balance is derived by excluding, from a cash measure of surplus/deficit, the net
                                         effects of advances, such as loans, and of equity transactions, such as sales and purchases of capital
                                         assets. If a cash measurement is used, Australia achieved a small surplus of about 0.5 percent of
                                         gross domestic product in fiscal year 1996-97.
                                         Source: 1998-99 Budget Strategy and Outlook, Budget Paper No. 1.




Background                               The Commonwealth of Australia is a federation composed of the national
                                         government, 6 state governments, a number of territories, and about
                                         900 local government bodies. The legislative power at the national level is
                                         vested in the Commonwealth Parliament, made up of the House of
                                         Representatives (148 members) and the Senate (76 members−12 from each
                                         state and 2 from each of the 2 most populous territories). The party or
                                         coalition of parties with a majority in the House of Representatives forms



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                         Appendix I
                         Commonwealth of Australia




                         the government and provides the Prime Minister. Cabinet Members are
                         generally selected from either the House or the Senate.

                         The two largest political parties in the Commonwealth Parliament are the
                         Australian Labor Party and the Liberal Party of Australia. The Labor Party
                         has traditionally represented worker and union interests while the Liberal
                         Party has represented business and conservative constituencies. The other
                         parties are the Australian Democrats, the National Party of Australia, and
                         independents. The Labor Party was in office from 1983 until 1996, after
                         which it was replaced by a Liberal-National Coalition. In the Senate, no
                         party or coalition of parties currently has a majority.

                         The Commonwealth government collects more than 70 percent of the
                         public sector revenue, but it is responsible for just over half of public
                         sector expenditures−the remainder being transferred to state and local
                         governments to fund additional public sector spending.4 However, this
                         imbalance is being addressed by the tax reform measures to take effect in
                         2000-01. (See section below on tax reform.) Commonwealth budget
                         responsibilities include national defense, immigration, postal and
                         telecommunications services, outpatient services and pharmaceuticals,
                         and social security.5 State responsibilities include most public sector
                         spending on education, hospitals, public safety, and infrastructure. Local
                         responsibilities include local roads and parks, libraries, and land use
                         planning. The Commonwealth raises revenue primarily from income taxes,
                         sales taxes, and custom and excise duties. States receive their revenue
                         mainly from payroll, business franchise, and stamp taxes, as well as
                         Commonwealth transfers in the form of general and specific purpose
                         grants. Local government revenue is derived from property taxes, charges,
                         fines, and a portion of the Commonwealth grants to the states.


The Australian Economy   Australia is a small economy that is relatively dependent on trade−its GDP
                         is about 5 percent the size of the United States economy and exports



                         4
                          States are limited by the Constitution in the type of tax that they can collect. In World War
                         II, states also relinquished the power to tax income to the Commonwealth.
                         5
                          The term “social security” refers to old-age pensions, unemployment benefits, and welfare.
                         Old-age pension payments are funded out of the general fund, and neither employers nor
                         employees make contributory payments. Unemployment benefits are also funded out of the
                         general fund, and there is no separate unemployment insurance fund.




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                          account for 15.6 percent of GDP, compared to about 9 percent for the
                          United States in 1997.

Recent Economic History   Australia’s economy grew quickly in the late 1980s, spurred by strong
                          exports, consumption, and high business investment. However, in 1991
                          Australia entered a short but severe recession. The economy began to
                          recover in late 1992 and since then Australia has experienced a period of
                          sustained growth averaging about 4 percent per year, compared to an
                          average slightly higher than 3 percent in the 1970s and 1980s. In the
                          12 months ending March 1999, GDP growth remained strong at nearly
                          5 percent, despite an economic crisis in much of Asia. See figure 14 for
                          Australia’s GDP growth since 1983.




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Figure 14: GDP Growth in Australia, 1983 to 1998




                                          Source: OECD Economic Outlook 64, January 1999.


                                          Australia’s growth in the 1990s has been accompanied by a lower rate of
                                          inflation than in the 1970s and 1980s. Despite a drop in the unemployment
                                          rate, from a peak of almost 11 percent in 1993 to 7.4 percent in May 1999,
                                          inflation has averaged an annual rate of about 2 percent since 1993. The
                                          low inflation has occurred in part due to an increased focus on sustaining a
                                          low inflation rate, with the Reserve Bank of Australia pursuing an inflation
                                          target of 2 to 3 percent over the economic cycle since fiscal year 1992-93.




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However, the Australian government remains concerned about its low
national saving rate and its high net foreign debt.6 With exports accounting
for about 16 percent of GDP, the Australian economy is highly dependent
on international trade for growth. Also, a large proportion of capital
investment comes from abroad. National saving is crucial to economic
growth because it can be used to finance domestic investment. If national
saving is insufficient to fund investment, borrowing from foreign sources
must finance the shortfall. The drop in national saving from an average rate
of more than 22 percent of GDP the previous three decades to about
17 percent of GDP in the 1990s led to a gap between saving and demand for
investment.7 This gap has been financed by increased borrowing from
foreign sources. The outcome of this reliance on foreign capital is a high
net foreign debt totaling more than 40 percent of GDP in fiscal year
1996-97−more than two-thirds of which is private sector debt.




6
 National saving consists of the private saving of households and businesses and the saving
or dissaving of all levels of government. Net foreign debt measures total indebtedness of the
Australian public and private sectors to foreign investors, less any investment made by the
Australian public and private sectors.
7
 Gross saving is the measure of saving used here and is defined as income minus
consumption. Gross saving does not subtract depreciation−the consumption of capital. Net
saving, which is gross saving minus depreciation, is a better estimate of the amount of
domestic resources available for increasing a nation’s capital stock. However, depreciation
is difficult to measure and is measured differently across countries. To facilitate
cross-country comparisons, the gross saving measure is used. Using the same concept, the
gross saving of the United States has fluctuated between 14 and 17 percent in recent years,
down from around 20 percent in the late 1970s.




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Budget Process              The government is responsible for developing the budget and presenting it
                            to Parliament. The preparation of the budget documents is the
                            responsibility of both the Department of the Treasury and the Department
                            of Finance and Administration. At the beginning of the budget process, the
                            Cabinet formulates and communicates the government’s overall policy
                            goals to the spending ministries. The Cabinet relies heavily on a subgroup
                            known as the Expenditure Review Committee (ERC) to make decisions on
                            which programs to fund. In general, government budgets that fund
                            “ordinary” services are passed largely intact by the Parliament, while
                            requests for capital and new programs are subject to Senate amendments.
                            If the Parliament cannot pass the government’s budget, it is viewed as a
                            vote of no confidence and a new government must be formed.8

                            Under this process the bulk of budget deliberations takes place before the
                            budget is presented publicly. The ERC defines the broad budgetary policy
                            and sets a global budget ceiling, including budgetary savings targets and
                            outlay targets based on a system of forward estimates.9 The ERC also
                            resolves budget conflicts and decides on reductions after consulting with
                            the appropriate Ministers. Cabinet Ministers appear before the ERC to
                            advocate new programs or increased funding. New programs that promise
                            to fulfill priorities set by the Cabinet are recommended to the Cabinet for
                            new funding. Proposed spending outside of priority areas must be funded
                            from savings in other areas.


Measuring Fiscal Position   Prior to fiscal year 1996-97, Australia’s measure of federal surplus/deficit
                            encompassed all receipts and expenditures, including privatization
                            proceeds, other equity transactions, and net advances to other
                            governments as well as private trading enterprises. Basically a cash
                            measure, it captured the impact of government borrowing on credit
                            markets and was similar to the unified budget measure in the United States.




                            8
                             This occurred in 1975 when a refusal by the Senate to pass the funding bills for government
                            operations resulted in a “double dissolution” of the Labor government under Prime Minister
                            Whitlam and the sitting Parliament.
                            9
                             Forward estimates are outlay estimates based on decisions made in the previous budget
                            year with no future policy changes−similar to the “budget baseline” in the United States.
                            Forward estimates are generated by the Department of Finance and Administration rather
                            than by each individual department, as was the practice prior to fiscal year 1983-84.




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                             In 1996, the new Coalition government changed the primary measure of
                             budget position to an “underlying balance” measure. The underlying
                             balance excludes the effects of advances, such as loans, and equity
                             transactions, such as privatization proceeds. The new government felt that
                             by excluding transactions involving the transfer or exchange of a financial
                             asset between the public and private sectors, the measure more accurately
                             reflects the contribution of the Commonwealth budget sector to national
                             saving. Also, the new measure better ensures that privatization proceeds
                             will be used for debt reduction because they do not appear as funds
                             available for spending.



Fiscal Policy of the         The Australian government’s continued efforts−through successive
                             administrations−to reduce its deficits and its subsequent surplus strategy
Mid-1980s to the 1990s       have been developed largely in response to concerns over low national
Driven by the Desire to      saving and high national debt and their impact on Australia’s international
                             competitiveness. While Australia’s fall in national saving was in some part
Increase National            due to a decrease in private saving, it more closely tracked changes in
Saving and Reduce            public saving, i.e., budget balances. As a result of low national saving,
Debt                         investment had to be financed from foreign sources, resulting in an
                             external debt level that was seen as too high. Low national saving and
                             reliance on foreign capital have led to concern over Australia’s ability to
                             compete in the future.

                             These concerns have motivated governments to attempt to search for a
                             solution in the public sector. Government officials felt that their ability to
                             influence declining private saving was limited, so they concentrated on
                             increasing public saving−i.e., reducing budget deficits. Consequently, both
                             Labor and Coalition governments have developed fiscal policies aimed at
                             reducing deficits in the belief that improving the government’s own fiscal
                             performance could contribute to improved national saving.


Mid-1980s: First Period of   The Labor government that came into power in 1983 did not initially focus
Deficit Reduction            on reducing the budget deficit. The government’s goals were to reduce
                             unemployment, control inflation, and stimulate the economy. This changed
                             in late 1984 when the Labor government turned its attention to budget
                             deficits. The government was concerned that borrowing in the public
                             sector was crowding out funds available for investment and detracting
                             from Australia’s international competitiveness. Specifically, Australia’s debt
                             and trade positions were worsening, and in 1986 the Australian dollar
                             suffered a sharp depreciation. These factors combined to create a sense of


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crisis. The government decided to reduce its budget deficits to reassure
foreign capital markets that something was being done to address fiscal
and economic problems.

In 1985, the government first articulated the need for fiscal restraint in
terms of the interest burden, arguing that a public debt interest bill of
nearly 10 percent of total outlays reduces the flexibility of the government
to direct spending in other areas. In 1986, the government argued that
further fiscal consolidation would improve the current account deficit and
reduce external indebtedness.10 As the government championed its fiscal
goal to reduce deficits as a percentage of GDP, expenditure restraint
became the primary means of correcting fiscal imbalances. (See figure 15.)
Deficit reduction efforts were aided initially by larger than anticipated
increases in revenues resulting from a strengthening economy.




10
 The current account balance is the difference between goods and services bought and sold
abroad.




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Figure 15: Receipts and Outlays in Australia, 1982-83 to 1996-97




                                           Source: Budget Statements 1995-96 and 1996-97, Budget Strategy and Outlook, 1998-99.


                                           In fiscal year 1985-86, social security and welfare and transfers to states
                                           accounted for 47 percent of total Commonwealth government outlays, and
                                           were the 2 areas most affected by deficit reduction efforts. In social
                                           programs, the government implemented means-testing and narrowed
                                           eligibility requirements. Also, the Commonwealth government greatly
                                           reduced general-purpose grants to states. While some general-purpose
                                           grants were replaced by specific-purpose grants, the latter only partially
                                           offset the reduction in the former. As a percentage of outlays,
                                           general-purpose grants decreased from almost 20 percent of total outlays in
                                           fiscal year 1985-86 to about 15 percent in fiscal year 1990-91.



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                            In 1985, the Commonwealth government also instituted a major tax reform
                            package. The reform was not aimed at deficit reduction, but it was instead
                            designed to improve the tax structure, broaden the tax base, reduce tax
                            avoidance and evasion, while not increasing the overall tax burden. The
                            reform eliminated several tax expenditures, introduced new taxes on
                            capital gains and employer-paid fringe benefits, and reduced personal tax
                            rates.11


The First Surplus Period:   As a result of strong economic growth and spending restraints, the
Fiscal Years 1987-88        government achieved surpluses for 4 consecutive years from fiscal years
                            1987-88 through 1990-91. These surpluses and proceeds from asset sales
Through 1990-1991
                            were used to substantially reduce the Commonwealth government’s debt
                            both in nominal terms and as a share of GDP. From fiscal year 1987-88 to
                            fiscal year 1990-91, public net debt declined from an estimated A$27.4
                            billion to A$16.9 billion, and the debt to GDP ratio dropped from an
                            estimated 9.1 to 4.4 percent. Figure 16 shows that the public net debt to
                            GDP ratio decreased during the surplus period in the late 1980s, increased
                            after the recession in 1991, and started to decrease again in fiscal year
                            1996-97.




                            11
                             The capital gains tax did not take effect until 1986-87, and therefore was not payable until
                            the 1987-88 budget year. Tax expenditures are reductions in tax liabilities that result from
                            preferential provisions in the tax code, such as exemptions and exclusions from taxation,
                            deductions, credits, deferrals, and preferential tax rates.




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Figure 16: Net Public Sector Debt in Australia, Fiscal Years 1980-81 Through 1998-99




                                           Note: Fiscal years 1997-98 and 1998-99 data are estimated.
                                           Source: Budget Strategy and Outlook, 1998-99.


                                           The government’s primary fiscal objective during its surplus period was to
                                           ensure that fiscal policy made no overall “call” on national saving−i.e., that
                                           the government would, on average, run balanced budgets, and thereby not
                                           absorb resources available for private capital formation through its
                                           borrowing actions. In accordance with this policy, and with the additional
                                           goal of reducing outlays as a percentage of GDP, the government continued
                                           to cut aggregate spending. At the same time, the government cut income
                                           taxes in the 4 years of surpluses. Overall, the government did not pursue an
                                           active policy aimed at maintaining surpluses.




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                            Consistent with a goal of reduced expenditures, the government continued
                            to reduce spending even after surpluses were achieved. Nearly all areas of
                            spending declined as a percentage of GDP, although some received small
                            increases. Overall, outlays dropped from nearly 27 to less than 24 percent
                            of GDP from fiscal years 1987-88 to 1989-90. Transfers to states were the
                            focus of spending cuts. For example, from fiscal years 1987-88 to 1991-92,
                            policy actions reduced outlays to states by a total of A$9.5 billion, an
                            average of 0.5 percent of GDP per year. Consequently, grants to states as a
                            percent of outlays dropped from about 19 to about 13 percent in this 5-year
                            period. These reductions were a major contributor to the government’s
                            ability to sustain the surplus.

                            During the surplus period Australia cut taxes several times.12 As the result
                            of promises made when revenue raising measures were introduced in the
                            1985 tax reform package, the government enacted substantial cuts to
                            personal income taxes, with the first cut occurring in December 1986 and
                            affecting tax receipts in 1987−the first year of surpluses. The drop in the
                            top marginal tax rate from 60 to 49 percent would have decreased tax
                            revenues by 2 percent had it not been offset by new taxes on capital gains
                            and employer benefits and base broadening measures. After a surplus was
                            forecast for fiscal year 1989-90, the government made further cuts to
                            income tax rates, and increased tax rebates for families with dependents
                            and for single parents. The new round of cuts reduced the top marginal rate
                            further to 47 percent, for a total reduction of 13 percentage points from the
                            1986 level. This policy decision reduced revenues by more than 1.5 percent
                            of GDP annually beginning in fiscal year 1989-90. In fiscal year 1990-91, the
                            last year of surpluses, the Labor government made further cuts in personal
                            income taxes for low and middle-income taxpayers. In fiscal year 1990-91,
                            revenues were 25.5 percent of GDP, down from 27.3 percent of GDP in
                            fiscal year 1987-88.


Fiscal Years 1991-92        In 1991, Australia experienced a short but severe recession. The recession
Through 1996-97: A Second   reduced revenue, already at a 12-year low as a result of several rounds of
                            tax cuts, to only 23.5 percent of GDP by fiscal year 1992-93. At the same
Period of Deficits
                            time, the recession led to increased spending in economically sensitive
                            programs such as unemployment and social welfare. In 1992, the


                            12
                              Since the Australian income tax system is not indexed for inflation, some of these cuts
                            were to offset the effects of “bracket creep.” Bracket creep occurs when taxpayers move
                            into higher tax brackets as their incomes grow due to the effects of inflation.




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                         government implemented a major employment initiative and increased
                         assistance to industry in an effort to address the unemployment problem
                         and stimulate the economy. The decrease in revenue−from the recession−
                         and increase in spending resulted in deficits beginning in fiscal year
                         1991-92, which peaked at 3.6 percent of GDP in fiscal year 1992-93. Deficits
                         remained until after the end of the Labor government’s term in 1996.

                         Beginning in fiscal year 1996-97, the newly elected government made
                         numerous cuts in spending in an attempt to eliminate budget deficits. They
                         also made selected tax cuts, but these were mostly offset by cuts to some
                         tax expenditures and new tax surcharges on high-income earners. The
                         combined effects of policy decisions made in fiscal years 1996-97 and
                         1997-98 budgets improved the budget balance by a total of 1.8 percent of
                         GDP. These spending and tax actions and a strong economy led to a surplus
                         at the end of fiscal year 1997-98.

                         In addition, a large privatization effort by the new government helped
                         greatly to reduce Australia’s debt level. Privatization proceeds totaled more
                         than A$23 billion in fiscal year 1996-97 and the first half of fiscal year
                         1997-98. The underlying balance−Australia’s new primary measure of fiscal
                         position−does not include proceeds from asset sales. Consequently, while
                         privatization proceeds did not contribute to Australia’s fiscal improvement
                         as measured, they did directly go to reducing public debt, which decreased
                         from 19.5 percent of GDP in fiscal year 1995-96 to an estimated 15.3 percent
                         in fiscal year 1997-98.


A New Framework for      When the new government came to power in 1996, it introduced a new
Fiscal Decision-Making   framework for fiscal decision-making called the “Charter of Budget
                         Honesty” (the Charter). The Charter set out principles for the conduct of
                         sound fiscal policy and put in place institutional arrangements designed to
                         improve discipline, transparency, and accountability in the formulation of
                         fiscal policy. The Charter was introduced in part to address the perceived
                         lack of transparency in the reporting of a government’s financial position,
                         especially during election time. Specifically, the new government pointed
                         to its discovery upon assuming office that the Commonwealth was in actual
                         deficit of about 2.1 percent of GDP, as compared to a forecast of a balanced
                         budget.

                         The Charter established the following five principles for sound fiscal
                         management: (1) to maintain prudent levels of debt, (2) to ensure that fiscal
                         policy contributes to national saving and moderates economic fluctuations,



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                     (3) to pursue a policy of stable and predictable tax burdens, (4) to maintain
                     the integrity of the tax system, and (5) to ensure that policy decisions
                     consider impacts on future generations. The framework of the Charter
                     allows flexibility for the government to define its medium-term fiscal
                     strategy and short-term fiscal goals in such a way as to fulfill these
                     principles.

                     To improve discipline, accountability, and transparency, the Charter also
                     requires frequent reporting on fiscal policies. The Charter requires the
                     issuance of fiscal strategy statements at or before the time the budget is
                     presented. Subsequent reports, such as the “Budget and Fiscal Outlook”
                     and the “Mid-Year Economic and Fiscal Outlook,” are to contain,
                     respectively, information on how the government intends to implement its
                     strategy and updated information for an assessment of actual fiscal
                     performance compared to the government’s plans. The Charter also
                     requires that during an election, cost estimates be prepared by the
                     Department of Finance and Administration and the Department of Treasury
                     for election commitments made by both the government and, if requested,
                     the opposition. The Charter also calls for intergenerational reports every
                     5 years and for the publication of updated information on the status of
                     economic and fiscal policies 10 days after an election is called.


A Second Period of   In fiscal year 1997-98, Australia achieved a budget surplus, and with the
Surpluses            fiscal year 1999-2000 budget, the government forecasts surpluses for the
                     next 4 years. The government’s medium-term fiscal strategy, developed as
                     required by the Charter, is to balance the budget over the cycle. As a result,
                     the Government’s current fiscal policy has a short-term goal of running
                     surpluses during the current period of expansion that is forecast. Also, the
                     government is projecting that debt will be eliminated by 2002-03.13

                     Within this goal of surpluses for the short-term, the government has made
                     room for new spending increases and selective tax cuts. The fiscal year
                     1998-99 budget proposed spending initiatives totaling nearly A$10 billion
                     through fiscal year 2001-02, with a large portion dedicated to health care.



                     13
                      In mid-1998, the government proposed reducing debt to about 1½ percent of GDP by fiscal
                     year 2001-2002 by selling its remaining equity in Telstra−the government’s telephone
                     monopoly. While the Senate has rejected the government’s proposal, it recently approved
                     the sale of an additional 16 percent of Telstra.




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             The government also proposed to cut personal income tax rates and
             introduced a taxation rebate for savings.

             The main difference between the first and the second surplus period is that
             the new government’s policy explicitly calls for surpluses over the
             short-term, concurrent with economic expansion. This is due in part to the
             new requirements under the Charter of Budget Honesty that governments
             spell out the medium-term fiscal policy and assess its impact on national
             saving. The fiscal year 1996-97 budget set out to achieve balance within
             3 years, before the end of the government’s first term in Parliament. The
             medium-term strategy was that the underlying budget should be in balance
             on average over the course of the economic cycle. After it became apparent
             that the surplus would materialize before the end of the 3-year cycle, the
             government reaffirmed its commitment to balance over the cycle. For this
             government, achieving balance over the cycle meant that it had to achieve
             surpluses during the remaining years of the present economic expansion.

             Such cyclical balance has not always been achieved. As far back as fiscal
             year 1996-97, the government warned that the deterioration in fiscal
             position that occurred during economic slowdowns in the previous
             20 years was only partly, and sometimes not at all, offset by surpluses
             during periods of strong growth. Consequently, the government is now
             aiming for surpluses while the economy is growing, reducing debt, and
             providing extra capacity for the government to use fiscal policy to run
             deficits when the economy is weak. According to current projections, and
             due to continued expansion in the Australian economy, the government
             appears poised to eliminate net debt by fiscal year 2002-03.


Tax Reform   Fiscal arrangements in Australia are characterized by a significant
             difference between the relative revenue and expenditure responsibility of
             the Commonwealth and the states−referred to as vertical fiscal imbalance.
             States are unable to raise revenues sufficient to cover their obligations and
             must rely on the federal government to make up the difference. For
             example, the federal government in fiscal year 1997-98 raised 72 percent of
             total government revenue but was responsible for only about 57 percent of
             total government spending, the states accounting for most of the
             remainder. As a result, states are heavily reliant on the Commonwealth for
             a significant share of their revenue.

             The states’ ability to raise revenues is limited by several factors. First, the
             Australian Constitution denies states the power to levy certain taxes,



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                      including retail and wholesale taxes on goods and services. Also, the states
                      relinquished the power to tax income to the Commonwealth in World War
                      II. As a result, states rely on many land, payroll, and miscellaneous taxes
                      for their revenue. Recently, the states’ ability to raise revenues was further
                      limited by a Supreme Court decision in 1997 that ruled that state tobacco
                      franchise fees were unconstitutional.

                      Against this backdrop, and with a forecast of budget surpluses, the
                      Coalition government campaigned in the 1998 election on a tax reform
                      platform to introduce the Goods and Services Tax (GST). As conceived, the
                      GST would be a broad-based sales tax levied on all goods and services. The
                      GST revenues would go to state governments, thereby greatly reducing the
                      reliance of states on the Commonwealth. To offset this, general-purpose
                      assistance to state governments would no longer be available while the
                      wholesale sales tax and nine other state taxes would be eliminated. The
                      GST proposal is mostly revenue neutral. However, due to concerns that a
                      GST would be regressive−i.e., that it would fall most heavily on low-wage
                      earners−the government also proposed to use budget surpluses to finance a
                      reduction in personal income tax rates and an increased threshold for
                      family benefits.

                      The Coalition government was reelected in 1998. After extensive
                      negotiation and compromises−including major new anti-tax avoidance
                      measures, reduced income tax cuts, and the elimination of food from the
                      GST−the Parliament finally passed a tax package in June 1999, with the
                      GST expected to go into effect starting July 1, 2000. The new compromise
                      tax package includes tax cut provisions totaling A$12 billion, funded in part
                      from the underlying surpluses forecasted in the 1998-99 budget.
                      Nevertheless, the government projects continued underlying surpluses
                      through at least fiscal year 2002-03.



Long-term Pressures   Australia has a relatively younger age profile than most developed
                      countries. However, the proportion of the population aged 65 and over is
and Reforms           projected to grow from about 11 to over 19 percent between 1991 and 2030.
                      During the same period, the ratio of working age population to retirees is
                      projected to decrease from 6 to 3.3. However, many officials we talked with
                      remained optimistic that the budget impact of an aging population would
                      not be too severe.

                      Australia’s pension system is made up of a flat rate, means-tested public
                      pension program, and a mandatory superannuation program funded from



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employers’ contributions. Public pensions are financed from general
government revenue and account for less than 3 percent of GDP. Pension
benefits are not related to an individual’s prior earnings, but they are
subject to means testing based on income and assets. Benefits are
legislated so as not to fall below 25 percent of annualized male total
average weekly earnings.

The superannuation portion of the pension system is a mandatory,
employer-funded program. This program started in 1986 when, in an effort
to rein in inflation pressures, the Labor government put in place a program
whereby employers contributed to individual pension accounts−
superannuation−in exchange for real wage reductions. While
superannuation benefits had always been available to selected employees
in professional occupations, the 1986 program extended coverage so that
by 1991 more than 72 percent of employees were covered, up from
42 percent in 1982. In 1992, the Commonwealth passed the Superannuation
Guarantee Act to extend employer-based retirement benefits to almost all
employees.14 The act required the employers to make pension
contributions to individual pension accounts of the employees’ choosing.
By 1996, approximately 89 percent of both public and private sector
employees were covered by superannuation, with the remaining 11 percent
of the work force falling below the income threshold where
superannuation started to apply.

According to officials we interviewed, the 1992 reform was not undertaken
to reduce pressure on the budget. Estimates show that in the absence of
superannuation, public pensions would only have grown to 5 percent of
GDP in 2050, compared to 4.7 percent with superannuation. Rather, the
reforms were undertaken primarily to ensure that the elderly population
could retire comfortably by extending superannuation to the entire
workforce.

While a growth in the elderly population is predicted to have little effect on
pension spending, officials we interviewed cited concerns about the
pressure of an elderly population on health care cost and quality. Officials
in the Department of Health and Family Services further added that the
pressure would not come from aging per se, but from improved technology
and public expectations. For example, officials informed us that health


14
 The Superannuation Guarantee Act established an income threshold−less than A$450 per
month−under which employers do not have to pay superannuation benefits.




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             care costs had increased recently by more than 3.5 percent annually. Of
             this, only about 0.6 percent was due to the aging of the population, with the
             remainder attributable to increased expectations and technological
             development. However, long-term fiscal pressures have generally not been
             a part of any debate about what to do with budget surpluses.



Conclusion   Australia experienced a period of budget surpluses in the late 1980s and
             early 1990s that was largely the result of its deficit reduction efforts of the
             early 1980s and a strong economy. During this period, Australia’s main
             fiscal policy goal was to balance the budget. However, governments
             continued to cut spending throughout this period while giving fairly large
             tax cuts. As the economy slipped into a short but severe recession in the
             early 1990s, Australia again ran deficits. In 1996, a newly elected
             government initiated a deficit reduction program and put in place a new
             framework for setting fiscal policy, which called for the government in
             power to consider certain factors, such as national saving and the public
             debt level, when setting fiscal policy. As a result of the deficit reduction
             program and increased economic growth, budget surpluses reoccurred in
             fiscal year 1997-98. Under the new framework, the government is calling for
             surpluses over the immediate period of economic expansion. In 1999, the
             government passed a tax reform package containing tax cut provisions
             totaling about A$12 billion. Nevertheless, the government continues to
             project underlying budget surpluses for fiscal year 1999-2000 and the
             following 3 fiscal years.




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Canada                                                                                              Appendx
                                                                                                          iI




              After struggling with large deficits for over two decades, Canada achieved
              federal budget surpluses in fiscal years 1997-98 and 1998-99.1 (See figure
              17.) These results reflect several years of significant fiscal restraint,
              particularly on the spending side of the budget, as well as a large surplus in
              the Employment Insurance Account. Fiscal restraint was prompted by
              concerns that a high and rising debt burden was a major obstacle to the
              nation’s economic future. In response, the federal government’s strategy
              since 1994 has been to reduce the deficit and achieve a balanced budget. To
              support this strategy the government put in place a cautious approach to
              budget planning designed to increase the government’s chances of
              exceeding its fiscal goals. The government has set as its official fiscal
              policy a goal of “balance or better,” which implies a policy of at least
              modest surpluses given its cautious approach to budget planning.




              1
              Canada’s fiscal year runs from April 1 to March 31.




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Figure 17: Federal Budgetary Surpluses/Deficits in Canada, 1980-81 to 1998-99




                                          Source: Fiscal Reference Tables, Department of Finance of Canada, September 1999.


                                          The government’s cautious planning strategy is based on three elements:
                                          (1) economic assumptions that are more conservative than those of private
                                          forecasters, (2) a CAN$3 billion contingency reserve that applies to debt
                                          reduction if it is not needed to cover unexpected shortfalls, and (3) a 2-year
                                          short forecast horizon that focuses attention on achieving goals in the
                                          near-term. As the federal budget has come into surplus, the central
                                          government has adopted a similarly cautious approach to allocating
                                          additional resources. This allocation strategy is based on an approach
                                          where the government waits until surpluses are apparent before
                                          introducing new spending and tax cut initiatives.



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             During the period of deficit reduction, the government’s fiscal policy
             received widespread support. Since Canada has achieved budget surpluses,
             consensus for the government’s fiscal strategy has eroded. Critics have
             argued that the government’s careful planning approach amounts to a
             policy of “stealth surpluses” that makes it difficult to conduct a full-scale
             public debate over how to use current and future surpluses.

             There has been much debate over how to allocate budget surpluses. This
             debate has been heavily influenced by pent-up demand following years of
             fiscal restraint. For example, since the mid-1990s, the federal government
             has substantially cut aid to the provinces for health care and other social
             programs. Given the current fiscal climate, the provinces have pushed for
             additional grants for health spending to address public concerns that the
             system has been deteriorating. In another example, the business
             community and others have used the improved fiscal situation to argue for
             substantial tax cuts. They point out that Canada has one of the highest
             personal income tax burdens among major industrial countries. Finally,
             some fiscal analysts continue to express concern that Canada’s high debt
             burden warrants a more aggressive approach to debt reduction.



Background   Canada is a federal system composed of a central government, 10
             provincial governments, and 3 territories.2 It has a parliamentary form of
             government, which is composed of a Senate and a House of Commons.
             Members of the House of Commons are elected by popular vote, at least
             every 5 years, while Senators are chosen by the Prime Minister. The House
             of Commons is the main law-making body. In general, the political party
             with the majority of seats in the House of Commons forms the government
             and the leader of this party becomes the Prime Minister.3

             Prime Minister Jean Chretien is leader of the current Liberal government.
             He became Prime Minister in 1993 when the Liberals regained a majority in
             the House after 9 years of Progressive Conservative Party rule. In June
             1997, the Liberal government was reelected, winning 155 seats in the
             House. Throughout most of this century, the left-of-center Liberal Party and
             the right-of-center Progressive Conservative Party have dominated


             2
              In addition, provincial legislatures may set up municipal governments, giving municipal
             governments powers as the legislatures see fit.
             3
             Each provincial legislature is composed of a single house that is elected by popular vote.




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Canadian federal politics. As of September 1999, however, the Reform
Party had the second largest number of seats in the House at 58. The
remaining seats are divided among the Bloc Quebecois (44), the New
Democratic Party (20), the Progressive Conservatives (18), and
independent members (3).

Executive authority at the federal level resides in the Prime Minister’s
Cabinet. The Prime Minister chooses Cabinet ministers from members of
Parliament in the governing party. The Cabinet is responsible for most
legislation; it develops government policy and is responsible to the House
of Commons. The Cabinet has the sole power to prepare and introduce
budget-related bills. In general, neither the House nor the Senate may
increase taxes or expenditures.4

The federal government has explicit responsibility over national defense,
interprovincial and international trade and commerce, immigration, the
banking and monetary system, criminal law, and fisheries. Provincial
governments are responsible for education, property and civil rights, the
administration of justice, the hospital system, natural resources within
their borders, social security, health, and municipal institutions. All powers
not specifically conferred upon the provinces are assigned to the federal
government.

The majority of provincial spending is directed toward health, education,
and social service programs. For many years, the federal government has
contributed to the funding of these and other provincial and territorial
programs and services through a system of transfer payments. Overall, in
fiscal year 1997-98, federal cash transfers to provinces accounted for nearly
15 percent of total provincial revenues.

The three main transfer programs are the Canada Health and Social
Transfer (CHST), the Equalization Program, and Territorial Formula
Financing (TFF). These three programs account for more than 90 percent
of all federal transfers to the provinces and territories, with CHST
representing the largest portion. CHST is a block grant that helps finance
health care, post-secondary education, social assistance, and social


4
 Members are allowed to propose a decrease in a tax or expenditure, but such actions are
rare. If a budget, or any other legislation, is not passed−meaning the government does not
have the support of a majority in the House−a new election must be held or the opposition
party forms a new government.




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                          services provided by the provinces. The Equalization Program ensures that
                          provincial governments can provide similar levels of public services at
                          reasonably comparable levels of taxation. The program subsidizes
                          provinces whose revenue-raising capacities are below a national standard.
                          TTF, the main source of revenue for territorial governments, was designed
                          to reflect the higher costs of providing services in the territories and to
                          compensate for their lower revenue-generating capacity, which results
                          from a less developed economic base. Territories also receive funds via
                          CHST.


The Canadian Economy      The Canadian economy is about one-tenth the size of the United States’
                          economy and heavily dependent on trade. In 1997, exports accounted for
                          about 40 percent of gross domestic product (GDP). Exports to the United
                          States are particularly important to Canada’s economy as they constitute
                          nearly 30 percent of Canada’s GDP. Therefore, the United States’ economy
                          has a large effect on overall economic activity in Canada.

Recent Economic History   During the last two decades, Canada experienced two short but severe
                          recessions and two lengthy periods of growth. As a result of the first
                          recession in 1981 and 1982, unemployment soared from less than 8 percent
                          in 1981 to nearly 12 percent in 1983. The economy rebounded strongly from
                          the recession, with real economic growth above 5 percent in both 1984 and
                          1985. The strong recovery, however, eventually led to inflationary pressures
                          and the Bank of Canada responded by tightening monetary policy in late
                          1987. When economic activity slowed in late 1990, the Bank began to
                          gradually lower interest rates.

                          By 1991, the Canadian economy was again in recession. The unemployment
                          rate rose from about 8 percent in 1990 to over 10 percent in 1991, and
                          remained above 10 percent until 1995. The recovery from this recession
                          was unusually slow. Growth finally began picking up in mid-1993,
                          increasing from 0.9 percent in 1992 to 2.3 percent in 1994. Growth was even
                          stronger in 1994 at 4.7 percent, but began to slow again in 1995. During the
                          last 2 years, however, growth has again picked up. (See figure 18.)




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Figure 18: Real GDP Growth in Canada, 1981 to 1998




                                         Source: Canadian Embassy, Washington, D.C.




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                 Since 1993, inflation has remained relatively low and stable, allowing for an
                 overall easing of monetary policy and historically low interest rates.
                 Although the Bank of Canada controls monetary policy, the government
                 does influence the direction of monetary policy, at least in part, because the
                 Bank of Canada Act stipulates that “[t]he Minister and the Governor shall
                 consult regularly on monetary policy and on its relation to general
                 economic policy.”5 Since 1991, the Bank of Canada and the government
                 have jointly set specific inflation-reduction targets.6 Inflation has remained
                 in or below the target range since the targets were established. In 1990, the
                 last full year before the targets were introduced, the inflation rate was
                 4.8 percent. The first targets were established for a 5-year period with the
                 goal of reducing inflation to 3 percent by the end of 1992 and to 2 percent
                 by 1995. By 1993, inflation was down to 2 percent and the Bank and the
                 government extended the targets until 1998 with a new target range of 1 to
                 3 percent. In 1998, the existing target range was extended through 2001.


Budget Process   The Canadian federal budget process is relatively closed to the public as
                 well as to Members of Parliament. The government, led by the Finance
                 Department, prepares the budget, and until the budget is presented to
                 Parliament only the Prime Minister and the Finance Minister know the
                 exact details. Having received some criticism for the closed nature of the
                 budget process, the government began to open up the process somewhat in
                 1994. In the fall of 1994, the government began releasing mid-year fiscal
                 updates that include any deficit/surplus targets and an economic update. At
                 the same time, the Finance Minister presents to Parliament plans for the
                 upcoming budget. Subsequently, the House of Commons Standing
                 Committee on Finance holds a series of prebudget consultations with the
                 public and presents its recommendations to the Minister of Finance. It is
                 important to note, however, that the budget is still formulated by the
                 Finance Department and it is almost never changed in Parliament.




                 5
                 Consolidated Statutes, Chapter B-2, Bank of Canada Act, Department of Justice of Canada.
                 6
                  The target rate is actually the midpoint of a target range that extends 1 percentage point on
                 either side.




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Measuring Fiscal Position   Canada’s main measure of the federal surplus/deficit−called the budgetary
                            balance−is calculated on a modified accrual basis.7 Canada also reports a
                            cash-based measure called “financial requirements/surplus.” The main
                            difference between these two measures is the treatment of federal
                            employee pensions.8 Under the “budgetary” measure, employee pension
                            costs are accrued as they are earned by current workers, not when cash
                            payments are made to retirees. In contrast, the “financial” measure reflects
                            only the cash paid to cover current retiree benefits less employee
                            premiums paid. In recent years, the financial measure has recorded
                            significantly lower deficits or higher surpluses than the budgetary measure.
                            For example, in fiscal year 1997-98, the budgetary surplus was nearly
                            CAN$3.5 billion−about 0.4 percent of GDP−while the financial surplus
                            came in at about CAN$12.7 billion. Given this pattern, Canada achieved a
                            financial surplus in fiscal year 1996-97−1 year earlier than it reached a
                            budgetary surplus, its primary measure of fiscal position.

                            Canada’s main budget measure−the budgetary balance−does not include
                            the finances of the Canadian Pension Plan (CPP).9 The CPP is an earnings-
                            related pension program that is broadly similar to the United States’ Social
                            Security system. The CPP was established in 1965 as a joint federal-
                            provincial program, and it has been separate from both federal and
                            provincial budgets since its origin. Until recently, any surpluses generated
                            by the CPP were, by law, invested in provincial, territorial, and federal
                            government securities.10 In addition to the CPP, Canada does provide some
                            retirement income support through the federal budget, which is financed
                            by general revenues. This support includes an Old Age Security (OAS)
                            pension received by all retirees and a Guaranteed Income Supplement
                            (GIS) benefit for low-income retirees.


                            7
                             Unless otherwise noted, any reference to Canada’s surplus/deficit throughout this appendix
                            refers to the budgetary balance measure.
                            8
                             In addition to the treatment of employee retirement costs, the budgetary measure includes
                            other obligations incurred during a year, while “financial requirements” reflects only actual
                            cash outlays.
                            9
                            Quebec has a separate, but similar, plan called the Quebec Pension Plan.
                            10
                             In the United States, analysts have expressed concern that Social Security’s finances--
                            which are invested in United States Treasury securities and included in the unified budget--
                            mask the actual fiscal position of the government. However, this concern is not an issue for
                            Canada’s provinces because CPP is a separate entity--not an account within provincial
                            government budgets.




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While Canada’s budget excludes the CPP’s finances, it includes a fund for
unemployment benefits−the Employment Insurance (EI) fund−that has
been running large surpluses in recent years. This fund, similar to trust
funds in the United States’ federal budget, is a budget account with an
earmarked revenue source.11 Fiscal analysts we interviewed noted that
without the surpluses in the EI fund, Canada’s budget would still be in
deficit.

In addition to its measures of annual fiscal position, Canada also
emphasizes the debt to GDP ratio as a useful indicator of the government’s
fiscal health. Net debt, which is total debt minus financial assets, such as
assets held in the employee retirement system, is the debt measure most
frequently used for computing this ratio−and this measure corresponds to
the budgetary balance indicator.12 The debt to GDP ratio is particularly
important given Canada’s high debt burden and its implications for the
budget and the economy. To underscore how a high debt level restricts
budgetary flexibility, the government also reports an interest burden
measure in which interest spending is expressed as a share of budgetary
revenues.13

Due to the prominence of the provincial governments in Canada’s federal
system, it is important to consider their fiscal situation in any assessment
of Canadian government finances. Provincial-territorial program spending
accounts for a greater percentage of GDP than federal program spending.
For this reason, Canada’s federal budget documents regularly include fiscal
data on provinces. For example, a combined federal-provincial debt
measure is used show the total burden of government debt on the economy.




11
  Trust funds in the United States’ federal budget are budget accounts that are designated as
“trust funds” by law. The largest trust fund accounts, like Social Security, typically have
earmarked sources of revenue. Trust fund expenditures and receipts are included in the
unified budget surplus/deficit.
12
 Market debt is the measure that corresponds to the financial requirements indicator.
Throughout this report the term debt refers to the net debt measure.
13
     Interest spending on net debt includes the interest paid to employee retirement accounts.




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Canadian Fiscal Policy     Before the substantial fiscal progress of the mid- to late 1990s, Canada had
                           struggled with large federal deficits for two decades.14 (See figure 17.)
in the 1980s and 1990s     These sizable and persistent deficits emerged in the mid-1970s in response
                           to several factors, including a slowdown in economic growth, increased
                           program spending, and the indexation of both social programs and the tax
                           system to inflation. In the 1980s, the Canadian government began
                           attempting to eliminate budget deficits. While these efforts did reduce the
                           size of deficits, they did not eliminate them. In the early 1990s an economic
                           slowdown hampered the government’s deficit reduction efforts. Beginning
                           in 1994, a newly elected government initiated a new deficit reduction
                           program and put in place a set of cautious budgeting practices to better
                           ensure that deficit targets would be met. Canada achieved a budget surplus
                           in fiscal year 1997-98 as a result of these efforts and an improving economy.


Deficit Reduction in the   In 1984, a Progressive Conservative government came into power with a
1980s                      fiscal strategy that emphasized deficit reduction. Their objective was to
                           reduce the growing debt burden and to bolster both domestic and
                           international investor confidence in the economy. Maintaining investor
                           confidence has been an important concern during recent decades. While
                           Canada has never experienced an economic crisis in which the government
                           was unable to sell its bonds, it has experienced currency depreciations,
                           high interest rates, and lowered credit ratings by external bond rating
                           agencies at both the federal and provincial levels.




                           14
                            For a detailed discussion of this period, see Deficit Reduction: Experiences of Other
                           Nations (GAO/AIMD-95-30, December 13, 1994), pp. 95-117.




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                                The government’s deficit reduction efforts in the mid-1980s produced
                                noticeable progress. Between fiscal years 1984-85 and 1989-90, the deficit
                                fell by nearly half as a percentage of GDP due to robust economic growth
                                and a combination of tax increases and spending cuts. Among these policy
                                actions were the introduction of a tax on OAS pension benefits and the
                                partial de-indexation of the tax system. The OAS change, referred to as a
                                “claw-back” tax, requires higher income seniors to repay part or all of their
                                benefits depending on their income level. Under the indexation change,
                                Canada’s taxes are only adjusted for annual inflation that exceeds 3
                                percent.15 Both of these actions, which are still in force, have continued to
                                contribute to fiscal improvement in the 1990s. For example, an analysis by
                                a public policy research group found that for 1998 alone, the tax indexation
                                change resulted in more than CAN$10 billion in additional revenue−over
                                1 percent of GDP.16 And this amount grows every year due to the
                                cumulative effect of partial indexation on the tax base.

                                Despite the successful initiatives of the mid-1980s, the government had
                                some difficulty in sustaining these efforts and the deficit remained
                                relatively high at over 4 percent of GDP in fiscal year 1989-90. One reason
                                for the intractable nature of these large deficits was the debt burden that
                                had accumulated since the mid-1970s. Between the mid-1970s and the late
                                1980s, the federal debt nearly tripled as a share of the economy−rising from
                                less than 20 percent of GDP to over 50 percent. Rising debt was
                                accompanied by growing interest costs. From fiscal years 1974-75 through
                                1987-88, interest spending increased from just over 11 percent of total
                                federal revenues to nearly 30 percent, significantly reducing the
                                government’s budgetary flexibility. Excluding these interest costs, the
                                government’s finances actually reached a surplus in the late 1980s.

Deteriorating Economy Prompts   The strong economic growth in the mid- to late 1980s eventually created
Rising Deficits                 upward pressure on inflation. In response, the Bank of Canada significantly
                                tightened monetary policy beginning in 1987. In the early 1990s, Canada
                                experienced a recession that was influenced by high interest rates and the
                                economic difficulties of its trading partners−particularly the United States.
                                As a result of the recession, the deficit began rising again despite renewed


                                15
                                 Since 1992, Canada’s inflation rate has not exceeded 3 percent, meaning that there has
                                been no automatic inflation adjustment.
                                16
                                 Finn Poschmann. “How Do I Tax Thee? Choices Made on Federal Income Taxes,” C.D.
                                Howe Institute, February 25, 1998, p. 4.




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                           efforts by the government to restrain spending. By fiscal year 1992-93, the
                           deficit had risen to nearly 6 percent of GDP. Consequently, the debt burden,
                           which had stabilized in the late 1980s, began rising rapidly again, going
                           from 57.6 percent of GDP in fiscal year 1990-91 to 71.1 percent of GDP in
                           1994-95.


New Government Confronts   A newly elected Liberal government came to power in 1993 pledging to
Growing Fiscal Crisis      reduce the deficit to 3 percent of GDP over 3 years.17 Both this target and
                           the government’s initial budget were criticized by some as too modest.
                           However, a fiscal crisis beginning in 1994 led the government to take more
                           radical steps to reduce the deficit.

                           During 1994 and early 1995, Canada’s fiscal outlook deteriorated quickly.
                           The situation worsened due to a sharp rise in interest rates, which rose in
                           response to interest rate hikes in the United States and partly due to
                           concerns in the international investment community about Canada’s large
                           debt burden. Long-term interest rates in 1994 turned out to be 2 percentage
                           points higher than the Finance Department’s original projections, even
                           though these projections had been intended to reflect conservative
                           assumptions. Canada’s large federal debt burden and its associated interest
                           payments made federal finances particularly vulnerable to higher interest
                           rates. For example, in 1994, the Finance Department estimated that a
                           1 percentage point increase in interest rates would raise interest
                           expenditures by CAN$1.7 billion in the first year−0.23 percent of GDP.
                           Growing interest expenses threatened the government’s ability to achieve
                           its 3 percent deficit to GDP target in fiscal year 1996-97.

                           Adding to the sense of fiscal crisis in 1994 was the decline in provincial
                           finances that occurred in the early 1990s. The aggregate provincial deficit
                           rose from 0.7 percent of GDP in fiscal year 1989-90 to 3.6 percent of GDP in
                           1992-93. As at the federal level, these deficits resulted in a rapidly rising
                           debt burden. Together, the federal and provincial debt approached
                           100 percent of GDP during the mid-1990s. (See figure 19.) According to an
                           analyst we interviewed, the 100 percent level had an unsettling
                           psychological effect.




                           17
                            This target consciously echoed the deficit ceiling set for countries participating in the
                           European Monetary Union.




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Figure 19: Federal and Provincial-Territorial Net Debt in Canada, 1980-81 to 1998-99




                                           Note: 1998-99 data for provincial-territorial net debt is an estimate.
                                           Sources: Fiscal Reference Tables, Department of Finance of Canada, September 1999, and The
                                           Budget Plan 1999, Department of Finance of Canada, February 1999.

                                           Canada’s declining fiscal fortunes and its vulnerability to future economic
                                           shocks convinced the federal government of the need for comprehensive
                                           structural changes in the fiscal year 1995-96 budget. These changes were
                                           considered necessary to ensure that the 3 percent deficit to GDP target
                                           would be met. In the fall of 1994, the government laid the groundwork for
                                           its 1995-96 budget with the publication of two reports. The first report−
                                           known as the Purple book after the color of its cover−outlined in detail the
                                           origins and implications of the nation’s current economic and fiscal
                                           difficulties. The second report−called the Grey book−was a fiscal update
                                           that was intended to encourage a public dialogue by discussing the scope
                                           of the budget challenge.

                                           The Purple book emphasized Canada’s spiraling debt burden and how it
                                           posed a major threat to the government’s economic agenda:



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“Returning Canada to fiscal health is a prerequisite to achieving all of the other elements of
the [government’s] economic strategy.…Increasing productivity and sustained job growth
are the results of investment, of entrepreneurial vigour, and of consumer confidence. All are
being undermined by a growing public debt that has led to higher taxes, higher real interest
rates, and a diminished capacity of the Government of Canada to address the other vital
issues of an economic strategy for the future.”18

Since the fundamental problem outlined in the government’s analysis was
the debt burden, the solution was to break the vicious circle of high
deficits, a growing debt burden, and rising interest costs. The government
concluded that achieving this goal would require a major effort to reduce,
and eventually eliminate, the deficit and to set the debt to GDP ratio on a
declining path. The deficit reduction efforts were to be based heavily on
spending restraint because the government concluded that the revenue
burden was already very high and, over the long term, should be reduced.
The government reinforced its commitment to solving the fiscal problem
with a promise by Finance Minister Paul Martin to reach the 3 percent
deficit to GDP target “come hell or high water.”

In assembling the fiscal year 1995-96 budget, the government relied on
comprehensive reviews of government programs to generate the savings
needed for the deficit reduction package. An assessment called “Program
Review” covered most components of direct program spending (which
excludes major transfer payments to individuals and other levels of
government). Under this review, the Finance Department determined
spending cut targets for each ministry, and the ministries were responsible
for assembling a detailed plan to meet these targets. A governmentwide
Committee of Ministers was charged with overseeing the budget plans
proposed by the ministries under the Program Review process. In addition
to the Program Review, the government conducted assessments of major
transfer programs to the provinces and territories and employment
insurance benefits.

As the budget was prepared, the fiscal outlook continued to deteriorate.
The economic crisis experienced by Mexico in late 1994 raised concerns in
the international investment community about the potential for similar
problems in Canada. Investors responded by shifting some of their assets
out of Canada. This asset shift further pushed up Canadian interest rates,
pushed down the Canadian dollar, and added a clear element of crisis to


18
 A New Framework for Economic Policy, Government of Canada, Department of Finance,
1994, p. 71.




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federal budget preparations. The government was very concerned about
Canada’s vulnerability to foreign investors. The Grey book emphasized that
Canada’s deficits and debt were among the highest of major industrial
countries. Likewise, the nation’s foreign debt−public and private
combined−was also high, reaching 44 percent of GDP by the end of 1993.
The result was that foreign investors demanded higher interest rates on
Canadian debt to compensate for its perceived riskiness compared to the
debt risk posed by other major industrial countries.

According to an account of the period, to help ensure that the budget
would be well received by financial markets, the Finance Department
increased the amount of deficit reduction planned for the fiscal year
1995-96 budget. Finance Minister Martin was concerned that if the financial
markets judged the fiscal restraint in Canada’s budget to be insufficient, the
government might be forced into revising its plans. A negative reaction
from the financial community could result in a downgrade to Canada’s
bond rating, and further declines in the currency, which had already
reached an 8½-year low against the U.S. dollar. This posed a significant risk
as a decline in the value of the Canadian dollar would make
foreign-denominated debt more expensive to repay.

The final fiscal year 1995-96 budget included CAN$5 billion in deficit
reduction measures in the first year, and CAN$29 billion over 3 years. In the
budget, these measures were described as “by far the largest set of actions
in any Canadian budget since post-war demobilization.” For every dollar of
revenue increases there were nearly 7 dollars of spending cuts. The
reductions affected nearly every government department. Major cuts
included the extension of a pay freeze on public employee salaries, the
elimination of 15 percent of the federal workforce, and a large reduction in
subsidies to businesses, such as railways, agricultural industries, and
cultural industries. In addition, a major restructuring of provincial aid was
announced that would take effect in the following fiscal year. The two
major social services grants to the provinces covering health care,
education, and welfare were combined into one block grant and funding
was cut substantially. (See figure 20.) For more information on this change
in provincial aid, see figure 21 on The Canada Health and Social Transfer.




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Figure 20: Major Federal Transfers to Other Levels of Government in Canada, 1980-81 to 1998-99




                                          Note: Includes the Canada Health and Social Transfer, fiscal transfers, insurance and medical care,
                                          Canada Assistance Plan, and education support.
                                          Source: Fiscal Reference Tables, Department of Finance of Canada, September 1999.




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Figure 21: The Canada Health and Social Transfer




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Canada Achieves Rapid        The deficit reduction packages in the 1994-95 and 1995-96 budgets, along
Fiscal Progress In Mid- to   with an improving economy, provided the main impetus for Canada’s rapid
                             fiscal progress in the late 1990s. Subsequent budgets have held to the
Late 1990s
                             course of fiscal restraint without introducing any major new deficit
                             reduction initiatives.19 The current government has consistently bettered its
                             fiscal targets, often by a wide margin. For example, the government had
                             promised a deficit of no more than 3 percent of GDP in 1996-97, and the
                             actual result was a deficit of about 1 percent of GDP. (See figure 22.)




                             19
                              The 1996 budget did include a proposal for reforming the basic pension and income
                             support benefits provided to Canada’s seniors. The proposed Seniors’ Benefit was expected
                             to provide cost savings over the long term. However, the government later decided to drop
                             this proposal. In 1997, the federal government and the provinces agreed to a major reform in
                             the earnings-related Canadian Pension Plan. But, since CPP is a separate financial entity,
                             these changes had no impact on the budget.




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Figure 22: Deficit Targets Compared to Actual Results in Canada, 1994-95 to 1997-98




                                          Note: Negative number indicates a surplus.
                                          Source: Various Canadian budgets, fiscal years 1994-95 through 1998-99.


                                          To ensure that its targets are met, the government has relied on cautious
                                          planning techniques that have become a defining characteristic of its
                                          approach to budgeting. These techniques provide a buffer against
                                          forecasting errors and unpredictable events. The government’s cautious
                                          strategy is composed of three main elements: (1) conservative economic
                                          assumptions and forecasting methods, (2) a sizable contingency reserve
                                          that cannot be tapped for new initiatives, and (3) a 2-year planning period.


Canada’s Cautious                         The federal government relies on a cautious approach to budget planning
Budgeting Techniques                      that is based on conservative economic and technical assumptions, a
                                          contingency reserve, and a short forecast horizon.



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The Finance Department uses assumptions for interest rates, and
sometimes economic growth, that are intentionally more conservative than
private sector forecasts. In developing these assumptions, the department
first surveys private forecasters. Then, using the average of these forecasts
as a base, it adjusts interest rate projections upward. For example, the
adjustment factor for long-term interest rates is typically ½ of 1 percent
(50 basis points). This cautious forecasting policy was based on a
recommendation from a panel of economists convened in late 1993 to
advise the government on fiscal and economic issues. The panel’s
recommendation was underscored by a private sector analysis that found
that the government’s economic assumptions in the 1980s and early 1990s
tended to be overly optimistic. Under the current government’s cautious
approach, the Finance Department’s economic assumptions have often
been more pessimistic than actual outcomes.

The contingency reserve is an annual amount that is built into projected
spending, but it is not allocated to any specific program. It is an accounting
mechanism used to supplement the government’s cautious forecasting
policy, rather than an actual cash fund. Under the current government, this
reserve is not available to fund new initiatives. Instead, it serves solely as a
buffer against unanticipated developments, such as an adverse change in
the economy. If the government’s budget projections are on target (or
overly pessimistic), the reserve acts to reduce the deficit or increase the
surplus. For example, in fiscal year 1998-99, the government projected a
balanced budget. This balanced budget estimate assumed that the
CAN$3 billion contingency reserve would need to be spent to compensate
for shortfalls in the projections. If the budget forecast is exactly on target,
the government will actually realize a CAN$3 billion surplus that will be
used to reduce debt.20

The final element in the government’s cautious approach is a short forecast
horizon; it publishes detailed projections for only 2 years. A short forecast
period is not necessarily a more prudent approach to budgeting, but the
government explains that its short horizon is a response to the inherent
sensitivity of longer-term forecasts to future economic developments.
Another important reason for the shorter forecasts is that during a period
of deficit reduction they focus attention on making cuts today rather than
delaying action until tomorrow. For example, prior to the current


20
 The realized surplus was actually CAN$2.9 billion in fiscal year 1998-99, which was used to
reduce debt.




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government, the Finance Department used a 5-year budgeting time frame
for setting fiscal policy and repeatedly failed to meet its deficit targets. In
contrast, since fiscal year 1994-95, the current government has consistently
bettered its 2-year fiscal targets. The effect of this policy during a time of
surplus is to reduce the ability to spend projected surpluses. On the other
hand, a short-term budgeting time frame does not disclose the full
long-term impact of policy decisions.

Aided by these cautious planning techniques, the government progressively
lowered its deficit target to zero−i.e., a balanced budget. In fiscal year
1997-98, the federal budget registered a small surplus, its first in nearly
30 years. The elimination of the deficit has begun to ease Canada’s high
federal debt burden. After peaking in fiscal year 1995-96 at just over
70 percent of the economy, it has fallen modestly. The interest burden
declined more dramatically, from 36 percent of revenues to just under
27 percent, between fiscal years 1995-96 and 1997-98.21 By running balanced
budgets and not using the contingency reserve, the government intends to
reduce debt as a share of GDP.

The government and the Organization for Economic Cooperation and
Development (OECD) attribute the majority of this substantial fiscal
improvement to spending restraint rather than increased revenue. (See
figure 23.) The 1999-2000 budget estimated that program spending (which
excludes interest) will have fallen from 16.6 percent of GDP in 1993-94 to
12.6 percent of GDP in 1998-99. In comparison, the budget estimates that
revenues will have risen from 16 to 17.6 percent of GDP over the same
period.22




21
 These figures include interest on internally held government debt, for instance interest on
the federal government’s employee pension plan.
22
 A portion of this revenue increase is due to the partial deindexation of the tax system that
was enacted in the 1980s.




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Figure 23: Federal Government Revenues and Expenditures in Canada, 1993-94 to 1998-99




                                        Sources: Fiscal Reference Tables, Department of Finance of Canada, September 1999.




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The Debate Over Fiscal       As it has entered a period of budget surpluses, the government has
Choices During a Period of   continued to rely on a cautious approach. Excluding the contingency
                             reserve, the Finance Department does not publicly project budget
Surplus
                             surpluses. The government’s current fiscal goal is, at a minimum, a
                             balanced budget−a strategy that it refers to as “balance or better.” However,
                             the contingency reserve implies that the actual target is a surplus of at least
                             CAN$3 billion, about 0.3 percent of GDP. The government has
                             acknowledged that it anticipates budget surpluses by introducing the Debt
                             Repayment Plan. The plan is an explicit statement that the government’s
                             cautious approach could result in budget surpluses and that the
                             contingency reserve would be used to reduce debt. The 1999 Budget Plan
                             states that “the level of debt in relation to the ability to service the debt (the
                             debt-to-GDP ratio) is still too high−both by historical Canadian and
                             international standards. . . Reducing the debt-to-GDP ratio must remain a
                             key objective of the government’s fiscal policy.”23

                             While the government is committed to using a modest amount of budget
                             surpluses for debt reduction through the contingency reserve, it also uses
                             surplus revenues for new spending and tax cut initiatives. (See figure 24.)
                             This strategy of dividing surpluses between debt reduction, tax cuts, and
                             new spending was articulated during the government’s 1997 reelection
                             campaign. At that time, the government stated that it would devote
                             50 percent of budget surpluses to new spending and the other 50 percent to
                             a combination of tax cuts and debt reduction. Analysts we interviewed
                             stated that this allocation framework applies to surpluses over the full
                             Parliamentary term and will not necessarily be followed on a year-by-year
                             basis.




                             23
                              The Budget Plan 1999, Government of Canada, Department of Finance, February 16, 1999,
                             p. 52.




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Figure 24: Summary of Spending and Tax Actions in the 1997-98, 1998-99, and 1999-2000 Canadian Federal Budgets




                                         Source: The Budget Plan 1999, Department of Finance of Canada, February 1999.


                                         In both the fiscal year 1998-99 and 1999-2000 budgets, the government
                                         introduced a number of new spending and tax initiatives. The Finance
                                         Department estimates that these initiatives will cost the government about
                                         CAN$50 billion cumulatively from fiscal years 1997-98 through 2001-02. On
                                         the spending side, these initiatives have focused on health care and
                                         education. The tax changes include an increase in the amount of income
                                         that low-income earners can receive tax-free, the elimination of a 3 percent
                                         surtax, an increase in the Child Tax Benefit, and a reduction in employment
                                         insurance rates for both employers and employees.




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                               In launching new policy initiatives, the government has adopted a
                               philosophy that generally avoids committing resources before they
                               materialize. Typically, the government does not introduce new spending or
                               tax cuts until late in the fiscal year when a surplus becomes apparent. The
                               1999-2000 budget explained this approach and its rationale as follows:

                               “Central to [the government’s] planning approach is the notion that spending initiatives and
                               tax cuts will be introduced only when the government is reasonably certain that it has the
                               necessary resources to do so. This protects against the risk of having to make hasty, and
                               potentially damaging, corrections to the budget plan, such as announcing tax relief one year
                               and then having to raise taxes the following year.”

                               In line with this cautious approach, the government has generally shied
                               away from both large-scale spending commitments and major tax cuts. In
                               addition, the government has enacted nonpermanent spending initiatives,
                               showing its preference for limiting future commitments. An example is the
                               Canada Millennium Scholarship Fund. The full cost of the fund−a
                               nonrecurring CAN$2.5 billion−was booked in fiscal year 1997-98, though
                               scholarships will not be awarded until 2000. The government has also made
                               many nonpermanent investments for health care, research, and education.
                               This careful strategy for allocating extra resources is supported by the
                               Finance Department’s use of conservative economic assumptions, which
                               tend to understate the resources available for spending.

Recent Critiques of Cautious   While the government’s deficit reduction strategy received widespread
Budgeting During a Period of   support, as Canada entered a period of surplus many fiscal analysts have
Surplus                        criticized some of the government’s techniques. Although many of these
                               critics support the general notion of cautious planning, they suggest that
                               the degree of caution used by the government is excessive. A pervasive
                               concern is that, while the government officially targets a balanced budget,
                               its cautious techniques result in “stealth surpluses.” According to a number
                               of analysts and social advocates from both sides of the political spectrum
                               we interviewed, understating the size and duration of expected surpluses
                               precludes a full-scale public debate over how to allocate these additional
                               resources.

                               Several different techniques may contribute to understating budget
                               surpluses. These techniques fall in two distinct groups: (1) the planning
                               assumptions that were developed during the period of deficit reduction and
                               (2) the practices adopted by the government for allocating surplus
                               revenues.




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Planning Assumptions    Some analysts have criticized the government’s continued use of a 2-year
                        time frame for budget planning. They assert that this short horizon makes it
                        harder to argue either for permanent spending or tax changes or for
                        initiatives with benefits realized over a longer period, such as substantial
                        debt reduction. A 1998 report from a public policy research group argued
                        that the government’s 2-year horizon “may have helped rein in the federal
                        deficit, but it is not so well suited to the task of framing priorities for the
                        post-deficit era, since it by definition neglects the longer-term implications
                        of decisions made today.”

                        Another practice that has received some criticism is the use of conservative
                        economic assumptions. Analysts told us that they routinely discount the
                        Finance Department’s forecasts as overly pessimistic. Due to this tendency,
                        some groups have argued that the government should adopt more realistic
                        assumptions for its budget projections. However, other analysts continue
                        to support the use of conservative assumptions as an acceptable way of
                        ensuring that Canada’s finances remain under control. In addition, a recent
                        Finance Committee report suggested that recent economic developments,
                        such as declining commodity prices and a projected slowing of economic
                        growth, have validated the government’s cautious approach. The
                        government has recently responded to these criticisms and plans to
                        explicitly show the impact of its “prudent” economic assumptions on its
                        budget totals. By fully disclosing the impact of its assumptions, the
                        government feels that there will be less debate surrounding the likely size
                        of the surplus.

Allocation Techniques   Several analysts have criticized the way in which the government allocates
                        surplus resources, charging that its methods obscure how much money is
                        really available. Some cite the government’s recent pattern of introducing
                        new initiatives near the end of a fiscal year that have the effect of reducing
                        the surplus realized in that year. For example, the government estimated
                        that new spending and tax cuts introduced in the fiscal year 1999-2000
                        budget would cost CAN$5.7 billion in fiscal year 1998-99. Along with
                        economic and technical adjustments, these new initiatives reduced a
                        potential fiscal year 1998-99 surplus from an estimated CAN$11.7 billion to
                        zero, excluding the contingency reserve. (See table 3.)




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                                  Table 3: Fiscal Outlook for Fiscal Year 1998-99

                                  Billions of Canadian dollars
                                  Budgetary surplus from April 1, 1998 through December                                       $11.7
                                  1998
                                  Economic and technical adjustments                                                           -3.2
                                  Impact of new initiatives announced during fiscal year 1998-                                 -5.5
                                  99
                                  Remaining surplus                                                                             3.0
                                  Less contingency reserve                                                                     -3.0
                                  Planning outcome                                                                                0


                                  Source: The Budget Plan 1999, Department of Finance of Canada, February 1999.


                                  Several analysts are also critical of the accounting methods that the
                                  government uses for some of its new initiatives. They argue that the
                                  methods overstate deficits or understate surpluses. For example, during
                                  fiscal year 1997-98, the government announced the Millennium Scholarship
                                  Fund and booked the cost of the fund in the current year even though the
                                  fund and the expenditure were not yet authorized. This action was
                                  criticized by Canada’s Auditor General,24 among others. The government
                                  responded that the disputed amounts were authorized before the financial
                                  statements for the fiscal year in question were finalized.25

Alternative Views on Allocating   The debate over the size and duration of budget surpluses is closely tied to
Budget Surpluses                  the debate over how to allocate them. For example, the government’s
                                  position is that since the size of the surplus is uncertain, it is safer to
                                  assume that it will be small. And, since the government’s budgeting horizon
                                  is limited to 2 years, it tends to avoid allocation decisions that would have a
                                  major impact on the long term. Therefore, the government prefers modest
                                  tax cuts and nonpermanent spending initiatives over more costly and
                                  longer-term commitments. In contrast, various analysts and advocates
                                  prefer spending cuts or tax increases that are both more substantial and
                                  more permanent.




                                  24
                                       1998 Public Accounts of Canada, Office of the Auditor General.
                                  25
                                       The books on each fiscal year are not closed until 6 to 7 months after the fiscal year ends.




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In addition to differences over the size of surpluses, the allocation debate is
about differing preferences for debt reduction, spending increases, and tax
cuts. The government emphasizes a balanced approach, dividing money
between the three priorities with more emphasis on spending. (See figure
24.) Others have argued for a greater focus on one or more of these
priorities. To some extent, public and interest group opinion on the surplus
reflects pent-up demands from the years of budgetary restraint.

Advocates of greater spending point to the large cutbacks in health care,
unemployment benefits, and other social assistance programs enacted
earlier in the decade. Boosting health care spending, in particular, has
commanded widespread public support and has been a top priority for
provincial governments and interest groups. Many have expressed concern
that the cuts in federal aid to the provinces have caused substantial erosion
in Canada’s national health insurance program. Health Canada (the federal
department of health) estimates that from 1992 through 1996 public sector
spending on health dropped from 7.5 percent to 6.6 percent of GDP. In
response to these concerns, the government announced in the fiscal year
1999-2000 budget that it was increasing provincial aid for health care by
CAN$11.5 billion over the next 5 years. However, critics have stated that
this amount is still insufficient to cover the system’s growing funding
needs.

Similarly, tax cut supporters, including the business community and a
number of economic analysts, have characterized the government’s tax
relief initiatives as inadequate. They point out that Canada has a high tax
burden, which makes it difficult for its businesses to compete. More
specifically, they note that Canada’s taxes are significantly higher than
taxes in the United States, which poses a potential problem for Canada’s
economic competitiveness.

Several of those who support tax cuts also favor a more aggressive
approach to debt reduction. According to the Finance Department, the
government’s current fiscal plans would reduce the debt to GDP ratio from
about 68 percent at the end of fiscal year 1997-98 to about 55.5 percent in
fiscal year 2002-03, assuming nominal economic growth averages 3.5
percent annually and the contingency reserve is available to pay down the
debt. Several analysts and organizations that we spoke with would like
debt reduction to occur at a faster pace. Some cited the lack of budgetary
flexibility caused by the federal government’s large interest burden and
vulnerability to higher interest rates.




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                     To help support a policy of debt reduction, several analysts suggest that the
                     government adopt debt to GDP targets to replace or complement the fiscal
                     targets that have been used successfully since the mid-1990s. Suggested
                     targets vary from 40 to 60 percent of GDP. Five provinces and one territory
                     have fiscal rules concerning debt. While some of these fiscal rules are more
                     stringent than others, they reveal a focus on debt and the need to reduce or
                     at least stabilize it.



Canada Faces Long-   Like many other industrial nations, Canada faces an aging population due
                     to a baby boom generation and increasing longevity. According to Statistics
term Demographic     Canada, the agency that collects statistics on Canada’s society and
Pressures            economy, the ratio of the population that is 65 and over to those aged
                     20 through 64 will nearly double from 20 percent in 1998 to over 38 percent
                     by 2031.

                     Long-term fiscal analysis does not have any formal role in Canada’s budget
                     process as the Finance Department does not publish detailed budget
                     projections beyond 2 years. However, federal officials and analysts are
                     concerned about longer-term issues. For example, regular long-term
                     projections are prepared for the Canadian Pension Plan (CPP), and these
                     projections were used to help support a recent reform of the system.26




                     26
                      The Canada Pension Plan law requires that an actuarial report be prepared every 3 years to
                     allow for a review of CPP’s contribution rates. The most recent report was issued in
                     December 1998 and includes projections of CPP revenue and spending up to the year 2100.




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                        Going beyond an analysis of particular programs, Canada’s Office of the
                        Auditor General (OAG) has looked at the broader fiscal implications of
                        long-term spending trends. As part of its annual report to Parliament in
                        1998, OAG looked out three decades into the future to assess the fiscal
                        implications of demographic pressures using illustrative simulations for
                        spending and revenues.27 OAG found that, absent any policy changes,
                        spending on retirement income programs and health care is expected to
                        grow much faster than the economy in coming decades−rising from around
                        12 percent of GDP in 1996 to about 17 percent of GDP in 2031 using the
                        mid-range assumption for growth in health spending.28 Such dramatic
                        growth would cause significant pressure to reduce all other spending,
                        assuming that the government chose to keep the debt burden stable. OAG’s
                        simulations showed that devoting at least a portion of budget surpluses to
                        debt reduction over the next decade could help alleviate some of this
                        pressure by shrinking the burden of interest spending.


Reforming Canada’s      In 1997, Canada announced a major reform of CPP that is designed to build
Retirement Income and   up a substantial reserve in what had been a largely pay-as-you-go system.
                        The changes include a substantial increase in payroll tax rates, benefit
Health Care Programs
                        reductions, and a plan for investing some of CPP’s reserves in higher
                        yielding assets, such as equities. Several analysts we interviewed were
                        largely supportive of the CPP reform and some noted that the government
                        effectively built support for this reform through a period of public
                        consultations and education. Since CPP is separate from the rest of the
                        federal budget, debates over reforming the program generally do not
                        become entangled in other budgetary issues as they often do in the United
                        States.

                        While the CPP reform has been successful, a recent government proposal
                        for reforming the government’s existing retirement income programs, the
                        OAS and GIS programs, was dropped last year in response to opposition
                        from fiscal analysts and interest groups. Analysts we interviewed said that
                        critics of the proposal expressed concern that it would have created
                        significant disincentives for middle income people to save for retirement by


                        27
                         Report of the Auditor General of Canada, (April 1998), Chapter 6, “Population Aging and
                        Information for Parliament: Understanding the Choices.”
                        28
                         Health care spending in the OAG study includes all levels of government in Canada. The
                        OAG produced three different simulations for growth in health care spending: low cost,
                        medium cost, and high cost.




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             requiring beneficiaries to give back a substantial portion of future benefits
             as their income levels increased.

             In the OAG’s 1998 report, two of three health cost projections showed
             health spending rising considerably faster than GDP in the coming decades.
             The third projection−a cost-containment scenario−shows health spending
             rising in absolute terms and growing at about the same rate as projected
             GDP. However, recent debate about healthcare has focused on restoring
             health care funding following the years of spending cuts that were part of
             the government’s deficit reduction efforts.



Conclusion   To support a successful policy of fiscal restraint begun in the mid-1990s, the
             Canadian government has relied on cautious budgeting practices that have
             allowed it to regularly exceed its fiscal goals. Having succeeded in
             eliminating the deficit, the government’s current goal is “balance or better.”
             As the budget has come into surplus, the government has maintained its
             cautious planning practices and has adopted a similarly cautious approach
             to allocating budget surpluses. This allocation strategy, which reserves a
             portion of surpluses for debt reduction, is based on a philosophy under
             which the government waits until surpluses are apparent before
             introducing new initiatives. Critics have argued that the government’s
             careful planning approach amounts to a policy of “stealth surpluses” that
             makes it difficult to conduct a full-scale public debate over how to use
             surpluses. Despite the criticisms, the federal government’s cautious
             approach has been adopted by many of the provinces, whose combined
             deficits decreased from 2.8 percent of GDP in 1993-94 to only 0.4 percent of
             GDP in 1997-98.




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Appendix III

New Zealand                                                                                                 Appendx
                                                                                                                  Ii




               After almost two decades of deficits, New Zealand has experienced 6 years
               of surpluses since fiscal year 1993-94.1 The initial drive toward surplus
               began in 1984 when the newly elected Labor government faced, upon
               election, an impending economic crisis marked by heavy capital outflows,
               which precipitated a large exchange rate devaluation, a credit downgrade,
               high inflation, and high debt. In response, the government implemented a
               series of sweeping economic reforms. In addition, the government
               undertook comprehensive public sector reforms that reduced the role of
               the government in the economy. During this period, fiscal restraint played
               an important role and was supported across the political spectrum. The
               Labor government attempted to address a deficit of 6.5 percent of gross
               domestic product (GDP) by increasing taxes and cutting expenditures in
               some areas, such as assistance to industries, while increasing expenditures
               in social programs, such as housing and education assistance to
               low-income earners. However, in 1990, when Labor left office, the budget
               was still in deficit, and net debt had grown to 50 percent of GDP.2

               In 1990, a newly elected National government embarked on a program of
               increased fiscal restraint, targeting mainly social expenditures. However, a
               recession in the early 1990s led to large budget deficits that increased net
               debt to 52 percent of GDP in 1992. The continuation of the government’s
               deficit reduction program, combined with a strengthening economy, led to
               surpluses beginning in fiscal year 1993-94. (See figure 25.)




               1
               New Zealand’s fiscal year runs from July 1 through June 30.
               2
               Net debt is defined as gross debt owed to the public offset by similar financial assets of the
               New Zealand government.




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                                         New Zealand




Figure 25: Budgetary Balance in New Zealand, 1974-75 to 1997-98




                                         Note: In 1994, the New Zealand government changed its definition of surpluses/deficits from a
                                         adjusted financial balance (cash) basis to an operating balance basis, and no longer reported its
                                         operations on an adjusted financial balance basis. The budgetary balances from fiscal years 1994-95
                                         through 1997-98 are derived by making adjustments to cash flows from operations to approximate the
                                         cash basis.
                                         Source: New Zealand Treasury.


                                         As surpluses materialized, the government introduced a new framework
                                         for developing fiscal policy called the Fiscal Responsibility Act (FRA) of
                                         1994. FRA has played a critical role in guiding fiscal policy in times of
                                         surplus. Specifically, FRA laid out a set of guiding principles for fiscal
                                         decision-making. FRA also set out reporting requirements aimed at
                                         improving fiscal performance while increasing transparency and
                                         accountability. Using this framework, the National government established
                                         a fiscal policy aimed at reducing debt by running surpluses. Specifically, the



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             New Zealand




             government promised to defer tax cuts until net debt was reduced to
             between 20 and 30 percent of GDP. In 1996, once the 30 percent target was
             achieved, the government reduced the debt target to 20 percent of GDP,
             while still allowing for some spending increases and tax cuts. Setting a debt
             target played a critical role in the government’s ability to maintain fiscal
             discipline. In May 1998, the government articulated a new fiscal goal of
             running surpluses to reduce net debt below 15 percent of GDP.



Background   New Zealand has a unicameral parliamentary system with 120 members
             elected for 3-year terms through general elections. The executive
             government of New Zealand is composed of the Governor General and the
             Cabinet.3 The Cabinet consists of the Prime Minister, the Deputy Prime
             Minister, and other Ministers chosen from elected members of Parliament.
             The Cabinet has the power to make administrative or regulatory changes
             without further public input or legislative approval where this power has
             been delegated by Parliament. These changes are simply announced before
             implementation.

             During the 1990s, New Zealand’s electoral system underwent significant
             reform. Prior to the 1996 election, New Zealand had a “first-past-the-post”
             system, in which the political party that won the most votes in an electoral
             region won the electoral seat. Parties that gained a majority of the electoral
             seats formed the government and provided the Prime Minister. Under a
             “first-past-the-post” system two major parties controlled the government
             while smaller parties found it difficult to obtain representation. From 1984
             through 1990, the Labor Party was in power. From late 1990 through 1996,
             the New Zealand National Party, representing more conservative
             constituencies, controlled the government.




             3
              The Governor General is the Queen’s representative. He/she does not actively participate in
             government, but acts on the recommendation of the government.




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                          New Zealand




                          The electoral system changed significantly in 1993 when New Zealand
                          voted for a “mixed member proportional” (MMP) system of representation.
                          The MMP system was put in place in part to address concerns that minority
                          views were underrepresented in a “first-past-the-post” system. Under MMP,
                          voters cast two ballots: one for members of Parliament and one for the
                          party. Around half of the 120 members of Parliament are elected directly as
                          representatives of their district, while the remaining members are chosen
                          by the parties in proportion to the percentage of the overall party vote
                          received in the election. The outcome of the new system is that smaller
                          parties are now able to gain more seats. In 1996, the first year under the
                          new MMP system, the National Party won 44 out of 120 seats and entered
                          into an agreement with the New Zealand First Party (17 seats) to form a
                          coalition government. In August 1998, the coalition dissolved and was
                          replaced by a minority government led by the National Party.4


The New Zealand Economy   New Zealand is a small economy that is dependent on trade−its GDP is less
                          than 1 percent the size of the U.S. economy and exports account for nearly
                          22 percent of GDP, compared to about 9 percent for the U.S. in 1997.

Recent Economic History   Until the early 1980s, New Zealand was one of the most regulated of the
                          developed economies. New Zealand heavily subsidized its industries, with
                          the agricultural sector receiving price supports and tax concessions, and
                          the manufacturing sector benefiting from import licensing and tariffs. The
                          government provided a fairly comprehensive and generous package of
                          social programs, including pensions for the elderly, benefits for single
                          parents and mothers, universal health care, and policies that ensured full
                          employment. The government also played a large, direct role in the
                          economy, with a major presence in industries such as telecommunications,
                          banking, energy, forestry, transport, and broadcasting services that
                          together produced more than 12 percent of GDP.

                          New Zealand has traditionally been heavily dependent on trade for
                          economic growth. In 1997, exports of goods and services totaled 22 percent
                          of GDP. Until the mid-1980s, New Zealand relied heavily on the United
                          Kingdom as a market for its exports, which were mostly agricultural


                          4
                           A minority government can remain in power so long as it can survive a vote of no
                          confidence, or until another coalition with more votes is formed. If a majority of the
                          members of Parliament vote no confidence in the government, then an election must be
                          held.




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products. The United Kindgom’s entrance into the European Common
Market in 1973 opened the British market up to goods from European
Union countries but denied New Zealand easy access to its traditional
major export market.

In addition to losing the United Kingdom as a protected market for
agricultural exports, New Zealand was also affected by two world oil price
shocks in the 1970s. The government responded by increasing taxes,
devaluing the currency, and implementing programs such as state-funded
investments aimed at cushioning the economy from these international
shocks. One such response was “Think Big,” a program designed to
improve New Zealand’s production of energy, thereby reducing its reliance
on external energy sources. Contrary to the government’s expectations,
these initiatives led to increased debt, fiscal constraints, and higher interest
rates. Economic growth remained low: from 1975 through 1982 there was
virtually no growth, while inflation averaged about 15 percent per year.
During this period, unemployment emerged as a serious problem, rising
from less than 1 percent to more than 5 percent in 1983. Furthermore, large
fiscal deficits emerged in the late 1970s, and foreign debt rose rapidly as a
result of large external deficits. By the early 1980s, economic performance
as measured by a wide range of indicators−growth, unemployment,
inflation, and the external deficit−had deteriorated substantially.

In response to the deteriorating economic and fiscal conditions, the new
Labor government in July 1984 began to institute a series of sweeping
reforms that by the end of its term in 1990 had transformed the country
from one of the most to one of the least regulated economies. However,
economic benefits did not materialize until the 1990s. In 1991, after 7 years
of reform, real GDP was only 2.8 percent higher than in 1984 compared to
an average of 24 percent for Organization for Economic Cooperation and
Development (OECD) member countries in the same period.
Unemployment also grew during this period, peaking at almost 11 percent
in September 1991, up from less than 5 percent in the early 1980s.

Strong export-driven growth began in 1991, and the economy grew at an
annual average rate of 3.5 percent from 1991 through 1997. From June 1995
through December 1996, unemployment dropped to a low of around
6 percent. Since 1996, growth has slowed, as shown in figure 26, and
unemployment increased to 7.7 percent in December 1998. More recently,
the Asian economic downturn and drought conditions have negatively
affected the country’s growth rate.




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Figure 26: GDP Growth in New Zealand, 1983 to 1998




                                        Source: OECD Economic Outlook 63, June 1998.


                                        Economic changes in the 1990s can be linked, in part, to a change in
                                        monetary policy. In 1989, New Zealand passed the Reserve Bank of New
                                        Zealand Act that assigns a single role for monetary policy: to achieve and
                                        maintain price stability. Prior to the act, monetary policy focused on
                                        ensuring the stability of the economy, maintaining full employment, and
                                        increasing economic growth. The act requires a written agreement between
                                        the Treasurer and the Governor of the Reserve Bank that defines and
                                        makes public the specific targets for price stability.

                                        The Governor of the Reserve Bank believes that the stable inflation policy
                                        has contributed to the strong fiscal performance by offsetting, or



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                            threatening to offset, expansionary fiscal policies. For example, in
                            response to an expansionary budget introduced during the 1990 election
                            year, the bank tightened monetary policy. In 1996, the government reduced
                            income tax rates only after it was satisfied that such tax cuts would not
                            result in a significant tightening of monetary policy.


Budget Process              The government, through the Treasury, is responsible for developing the
                            budget and presenting it to Parliament. The process starts with the
                            government releasing its policy statement setting forth its vision and the
                            strategic objectives for the fiscal year and the coming 3 years. After the
                            release of the policy statement, departments submit bids for new program
                            initiatives. Bids are reviewed by the Cabinet on advice from Treasury, and
                            those that fit with strategic objectives can receive new funding. In May or
                            June, the government submits a budget that has to fulfill the strategic
                            objectives announced in the policy statement or provides explanations or
                            justifications for inconsistencies. By that time, the government has decided
                            which new programs and policy actions to fund.

                            Under this process, most budget deliberations and the approval of new
                            policy actions take place prior to the public presentation of the budget.
                            After the budget is presented to Parliament, select committees examine the
                            budget, question ministers and departments about their budget requests,
                            and may propose changes to appropriations. However, in general,
                            government budgets are passed without many changes. Failure to pass a
                            budget would result in the dissolution of the government and probably a
                            new election.


Measuring Fiscal Position   Prior to 1994, New Zealand’s surplus/deficit was a cash number, similar to
                            the unified budget figure used in the United States. Revenue and
                            expenditures, including capital expenditures, were recorded when cash
                            was actually received or spent. Consequently, the surplus/deficit measure
                            encompassed all receipts and expenditures.




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In 1994, New Zealand became the first OECD country to use an accrual-
based measure of fiscal position.5 The measure, called the operating
balance, is designed to match more closely the cost of resources consumed
in the production of goods and services with the revenues. As part of this
change, departments no longer record an expenditure when an asset is
purchased. Rather, a depreciation expense is recorded when the asset is
used. Another important change is that the government records the cost of
liabilities when the events that give rise to these liabilities occur. For
example, the cost of providing public employee pensions is recorded at the
time the employee works, rather than when the employee has claim on the
cash. This method of recognizing liabilities differs from the approach taken
under the cash basis, under which the cost is recognized only when a cash
outlay occurs. The net effect of the differences between the operating
balance−the primary measure of fiscal position−and the cash balance is
shown in figure 27.




5
 The Public Finance Act of 1989 first required the use of accrual budgeting at the
department level. In 1994, the government enacted FRA, which reaffirmed its commitment
to greater accountability and transparency in government through improved financial
management and devolution of responsibilities. FRA endorses the move to accrual as
necessary to the new fiscal environment and requires that the government as a whole
budget on an accrual basis.




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Figure 27: Comparison Between Adjusted Cash and Operating Balances in New Zealand, 1994-95 to 1997-98




                                        Note: In 1994, the New Zealand government changed its definition of surpluses/deficits from an
                                        adjusted financial balance (cash) basis to an operating balance basis and no longer reported its
                                        deficit/surplus on a cash basis. The adjusted cash balances from fiscal years 1994-95 through
                                        1997-98 are GAO calculations. They reflect adjustments made to the cash flows from operations,
                                        which approximate the adjusted financial balance used to measure surpluses/deficits prior to 1994.
                                        However, some additional adjustments are necessary to arrive at an exact measure of the adjusted
                                        financial balance as reported prior to 1994.
                                        Source: New Zealand Treasury.


                                        Government officials and experts we met with felt that accrual measures of
                                        deficits/surpluses better reflect the ongoing health of the government than
                                        pure cash measures. They stated that by recognizing employee pension
                                        costs, accrual data give a better picture of the cost and obligations of
                                        government policies. Also, by excluding privatization proceeds that are



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                        one-time-only transactions that cannot be expected to occur again in the
                        future, the new measure better reflects the ongoing performance of
                        government. Finally, by requiring recognition of the long-term cost of
                        decisions, accrual measures make clear the full cost of spending decisions
                        that have minimal effects today but greatly affect future budgets. For
                        example, in the 1970s, the government did not recognize the cost of
                        establishing guarantee programs for energy projects. In the late 1980s, the
                        guarantee costs totaled more than NZ$6 billion, or more than 10 percent of
                        GDP. According to an ex-finance official, under accrual such costs would
                        have been recognized over the years and such a large delayed charge to the
                        budget would not have occurred. Had the full cost of such decisions been
                        made available, commitments with large deferred costs may not have been
                        made. However, New Zealand does not include the commitment of its
                        social security system in its accrual-based measures because these
                        commitments (1) can be changed by acts of Parliament, and (2) cannot be
                        reliably estimated and, therefore, do not meet the criteria, as defined by
                        generally accepted accounting practice, for recognition as a liability.

                        In addition to the operating balance, New Zealand also emphasizes the debt
                        to GDP ratio as a key indicator to track the government’s performance in
                        the economy. The government articulated the need for New Zealand, as a
                        nation with a small and open economy, to maintain a low debt to GDP ratio
                        in order to be better able to respond to economic shocks. Officials and
                        experts we interviewed explained that setting debt targets was a necessary
                        first step in determining the operating balance and articulating the
                        necessity for operating surpluses. These officials felt that the use of the
                        debt to GDP ratio was a critical factor in keeping the government on track
                        towards surpluses in order to pay down debt.



Fiscal Policy of the    As shown earlier in figure 25, New Zealand had large deficits extending
                        back to the late 1970s. The deficits were large, exceeding 2 percent of GDP
Mid-1980s Driven by     in all years before 1984. The deficits were caused in part by government
the Desire to Reduce    actions taken to implement fiscal policies that sought to counter the effects
                        of a weak economy through expansionary policies. These policies, which
the Government’s Role   were financed largely through additional borrowing from abroad, led to a
in the Economy          sharp deterioration in the fiscal position. By 1984, the ratio of government
                        expenditure to GDP was more than 38 percent, and the deficit was
                        6.5 percent of GDP. Thus, deficit reduction efforts in New Zealand
                        beginning in 1984 were aimed at reforming the economy and reducing the
                        size of the public sector.




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Economic and Public Sector   The New Zealand economy in the late 1970s and early 1980s was marked by
Reform                       a major government presence in many sectors of the economy and
                             extensive government intervention in the economy. However, from 1975
                             through 1982, the New Zealand economy experienced virtually no growth,
                             while inflation averaged about 15 percent per year and unemployment,
                             which had never risen beyond 1 percent, reached a peak of over
                             5 percent in 1983. A loss of investor confidence led to heavy capital
                             outflows, which precipitated a large currency crisis. Thus, in the early
                             1980s, the New Zealand economy was marked by serious problems.

                             The impending economic crisis prompted the Labor government that came
                             to power in 1984 to take decisive actions. The primary goal of the new
                             government was to introduce more openness and competition−which the
                             reformers saw as the primary engines for economic growth−into the highly
                             controlled economy. From 1984 through 1990, the government focused its
                             efforts primarily on reforming the economy to improve its performance and
                             restore investor confidence, while deficit reduction played a supporting
                             role. Specifically, in 1984 the new government devalued the currency by
                             20 percent and then allowed its value to float on the open market, opened
                             up the financial markets to international competition and investment, and
                             deregulated major sectors of the economy. The government also removed
                             wage and price controls and reduced or eliminated subsidies for many
                             industries.

                             Along with economic reforms, the government implemented many reforms
                             that resulted in a smaller public sector. It began by corporatizing
                             government departments engaged in commercial activities into state-
                             owned enterprises and putting them on a commercial basis. In many
                             instances, these enterprises had to adopt business practices and compete
                             with private sector enterprises. From 1986 through 1990, many of these
                             state-owned enterprises were privatized. By 1994, privatization and other
                             initiatives aimed at improving economic and government performance had
                             reduced the number of public sector employees to less than half the 1984
                             level.

                             In addition, the government passed several laws changing the focus of
                             government management and budgeting. The Public Finance Act of 1989
                             required the use of accrual budgeting while the State Sector Act of 1988
                             shifted responsibility for managing inputs, such as the number of
                             employees, from central control to department managers. The acts gave
                             these managers more latitude in purchasing and hiring decisions in




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                            exchange for the delivery of outputs such as serving a specific number of
                            welfare recipients.


Deficit Reduction Efforts   From 1984 through 1990, deficit reduction was achieved mainly through
                            increases in revenues. In October 1986, the government introduced a
                            broad-based 10 percent Goods and Services Tax (GST), part of a general
                            effort to move the tax burden from direct taxes such as income taxes to
                            indirect taxes such as GST.6 Although there were significant cuts in the
                            marginal personal income tax rates, these were offset somewhat by the
                            elimination of tax loopholes and a general broadening of the tax base. As
                            the tax brackets were not indexed for inflation and the economy grew, tax
                            revenues increased as a share of GDP. In addition, government-owned
                            enterprises were generating healthy surpluses, which were counted as
                            government revenue. Taken together, the result was an increase in revenue
                            from about 32 percent of GDP in fiscal year 1984-85 to almost 40 percent of
                            GDP in fiscal year 1989-90.

                            Despite efforts to cut government spending, government expenditures as a
                            percentage of GDP increased from less than 37 to more than 41 percent
                            from fiscal year 1984-85 to fiscal year 1989-90. Although the government
                            moved initially to reduce or abolish subsidies and restrain spending in most
                            program areas, these cuts were more than offset by growth in expenditures
                            in social welfare, health, and education that together made up more than
                            55 percent of the budget in 1984. Increases in social expenditures were
                            driven by increased demand for education and health programs. In
                            addition, the turbulence in the economy and slow economic growth led to
                            large increases in cyclically-sensitive claims such as unemployment. By
                            fiscal year 1990-91, social programs had grown to about 62 percent of the
                            budget, representing more than 25 percent of GDP and a level that was
                            5 percentage points higher than in fiscal year 1984-85.

                            Although privatization was undertaken mainly to improve economic
                            performance, proceeds from these efforts led to a decrease in debt during
                            the 1980s. From 1988 through the end of 1990, 15 of the largest state-owned
                            enterprises were privatized. Privatization proceeds totaled more than
                            NZ$9.4 billion as of December 1990. Proceeds contributed to reduction of
                            the gross public debt from almost 78 percent of GDP in 1987 to about
                            62 percent of GDP in 1990.

                            6
                            The GST rate was subsequently increased to 12.5 percent in March 1989.




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Fiscal Policy of the   Beginning in late 1990, the newly elected government focused on deficit
                       reduction. The government was unaware that it would face, upon election,
Early 1990s Focused    a large deficit instead of a balanced budget. Furthermore, upon taking
on Eliminating the     office, it became apparent that deficits would persist due to an economy
                       that was entering a deep recession, unless policy actions were taken. In
Deficit and Then       addition, New Zealand was faced with the prospect of a credit downgrade
Reducing the Debt      due to concerns about the state of the economy, which would cause its
                       borrowing costs to increase. Decisionmakers became keenly aware of the
                       need to sustain foreign investor confidence in their economic and fiscal
                       policies.

                       Shortly after the election, the government presented an economic package
                       that focused primarily on spending cuts to restore fiscal health. The
                       package reflected the keen awareness among decisionmakers of the need
                       to sustain foreign investor confidence in their economic and fiscal policies.
                       Among other things, the budget retained the surcharge on superannuation
                       (New Zealand’s public pension program) that the new government had
                       promised to abolish during the 1990 campaign. The fiscal year 1990-91
                       budget enacted severe cuts to social welfare benefits totaling
                       NZ$245 million while the fiscal year 1991-92 budget cut another
                       NZ$1.25 billion. The government also held spending increases to a
                       minimum on other expenditure categories. Officials believed that such
                       difficult decisions were necessary to turn the economy and the fiscal
                       position around.

                       The deficit reduction program, along with an improving economy led by
                       growth in exports, provided the impetus for New Zealand’s improving fiscal
                       position. By fiscal year 1993-94, the first year of surplus, the government
                       had succeeded in reducing expenditures from more than 42 percent of GDP
                       in fiscal year 1990-91 to less than 35 percent.7 Strong progress on
                       constraining expenditure, together with proceeds from privatization
                       totaling nearly NZ$3.2 billion from 1991 through 1993, allowed the
                       government to reduce debt.

                       In 1994, when it became apparent that surpluses would continue, the
                       government articulated the need for continued surpluses in order to reduce
                       debt. New Zealand is a small, open economy that is highly susceptible to
                       international shocks. The government believed that a lower debt level


                       7
                       In 1993-94, New Zealand achieved surplus in both cash and operating bases.




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                                          would improve fiscal flexibility and better prepare New Zealand for the
                                          next economic shock. Furthermore, policymakers thought that reducing
                                          debt would serve to increase the confidence of international investors in
                                          the New Zealand economy. The government’s efforts have largely been
                                          successful, with public sector debt falling from over 50 percent of GDP in
                                          1990 to a 1998 level of under 25 percent. (See figure 28.) While this is
                                          generally viewed as a significant achievement, some believe that further
                                          debt reduction will be necessary if the country is to successfully address
                                          long-term fiscal and economic issues. Currently, the government has a
                                          public sector debt goal of less than 15 percent of GDP.



Figure 28: Net Public Sector Debt in New Zealand, 1980 to 1998




                                          Source: New Zealand Treasury.




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                         New Zealand finance officials we interviewed credited at least part of the
                         ability to maintain fiscal discipline to budget and accounting reforms. They
                         stated that the government maintained departmental budgets at the same
                         level from 1991 through 1998 unless departments could present a
                         compelling case for increased spending. As a result, it became difficult to
                         introduce new programs or undertake additional activities under this new
                         approach, and most departments experienced a budget reduction in real
                         terms, which they were expected to absorb through increased efficiency.
                         Officials we spoke with felt that the budget and accounting reforms
                         improved their ability to price governmental goods and services (outputs)
                         and have helped New Zealand to make efficiency gains without a drop in
                         the level and quality of service. For example, by requiring that departments
                         absorb a capital charge, the government reduced the desire to acquire new
                         capital assets and provided an incentive for selling non-performing assets.


A New Framework for      As noted earlier, in 1994 the government passed the FRA, which established
Fiscal Decision-making   a new framework for fiscal decision-making. FRA was developed to lead to
                         better fiscal outcomes by making policymakers consider not only the
                         short-term impacts of decisions but also the medium- and long-term
                         impacts. FRA was also put in place, in part, in anticipation of the new MMP
                         electoral system. The change to MMP was likely to lead to coalition
                         governments. Officials feared that the compromises resulting from
                         coalition governments would result in a deterioration of fiscal discipline.
                         FRA was designed to make this more difficult.

                         FRA established five main principles for sound fiscal management. The
                         government is required to (1) establish a prudent level for debt necessary
                         to provide a buffer against future adverse events, then work to reduce debt
                         to that level by achieving operating surpluses every year that the debt is
                         above a targeted level, (2) maintain this prudent debt level once achieved
                         by running a balanced budget on average over the economic cycle,
                         (3) achieve a level of national net worth that would provide a buffer against
                         adverse economic shocks, (4) pursue a policy of stable and predictable tax
                         rates, and (5) manage the risks facing the government. The framework does
                         not dictate specific targets for debt, surpluses, or risks, but allows the
                         government to define its own medium-term strategies and short-term fiscal
                         goals in such a way as to fulfill these principles.

                         FRA also put in place institutional arrangements designed to improve
                         transparency in the formulation of and accountability in the performance
                         of fiscal policies by requiring extensive reporting on these policies. Before



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                       the budget is presented, a Budget Policy Statement must be presented that
                       sets forth the broad strategic goals of the government. The Fiscal Strategy
                       Report that accompanies the budget has to specify that the budget is
                       consistent with the Budget Policy Statement or justify any departure. This
                       report must provide fiscal scenarios covering at least the next 10 years.
                       Other reporting requirements include the Economic and Fiscal Update at
                       the time of the budget, a half-year Economic and Fiscal Update in
                       December, an update with supplementary appropriations, as well as a
                       pre-election economic and fiscal update at least 14 days before a general
                       election. FRA also requires the government to use accrual concepts for
                       budgeting and reporting. Finally, FRA requires the government to disclose
                       all decisions that may have a material effect on the future fiscal and
                       economic outlook. The government hoped that these extensive reporting
                       requirements would ensure that departures from what are deemed the
                       principles of responsible fiscal management would only be temporary since
                       they would have to be reported and justified to the public.



New Zealand Aims for   Since 1994, New Zealand’s fiscal policy has been to run sustained surpluses
                       until a desired debt level is achieved.8 The government cites three main
Sustained Surpluses    reasons for running sustained surpluses and reducing debt: (1) to provide a
                       buffer against economic shocks, (2) to deal with the significant pressures
                       that demographic trends will place on the fiscal position in the future, and
                       (3) to allow for lower taxes in order to increase international
                       competitiveness and economic growth.

                       Most officials and experts we talked with agreed that the New Zealand
                       economy is extremely susceptible to external economic shocks. A fallback
                       into budget deficit is seen as undesirable because it would likely result in
                       an adverse response by international markets. The resulting increase in
                       interest rates would be harmful to the business sector and, ultimately,
                       would be detrimental to the health of the economy as a whole. A budget
                       deficit is not acceptable because concern still exists over the debt level and
                       because future demographic pressures are becoming more apparent.

                       Interviewees added that the New Zealand political landscape has
                       undergone substantial changes, to the point that running sustained


                       8
                        The targeted net debt level was originally set at between 20 and 30 percent of GDP in the
                       1994 budget. The target was decreased to 20 percent of GDP in the 1995 budget and further
                       decreased to less than 15 percent of GDP in May 1998.




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surpluses is now the accepted norm of most political parties. While some
interviewees, concerned about the deterioration in the national
infrastructure, argued that New Zealand could assume additional debt for
investment purposes, most agreed on a policy of continued surpluses. An
ex-finance official argued that some consensus existed for maintaining
surpluses in time of economic growth so the government could better
address long-term pressure such as the aging population. According to this
ex-official, the relevant question in New Zealand is not whether to maintain
surpluses but rather how rigidly the policy needs to be carried out. Some
opposition parties are committed to achieving surpluses over the business
cycle, allowing for deficits during periods of economic weakness. However,
the current government has said it is imperative to maintain surpluses until
the desirable level of debt is achieved.

The fiscal year 1994-95 budget was the first in a series of budgets to
operationalize the principles of FRA. A main objective of the budget was to
reduce net debt to between 20 and 30 percent of GDP and achieve a debt to
GDP ratio of 20 percent by 2003-04. In fiscal years 1994-95 and 1995-96−2
years after the first budget surplus was achieved−the government
continued to maintain fiscally conservative policies. In 1995, the
government reaffirmed its commitment to running short-term surpluses
and promised to consider tax cuts only after net debt fell below 30 percent
of GDP. Pointing to experience that showed that the fiscal balance could
shift up or down by more than 3 percent of GDP over the cycle, the
government committed itself to running surpluses of at least 3 percent of
GDP in an environment of strong economic growth. In addition, the
government continued its privatization programs. Proceeds from
privatization, as well as cash made available from operating surpluses,
were dedicated to debt reduction, resulting in substantial progress towards
achieving the 30 percent debt goal.9

As a result of the increasing revenues and decreasing expenditures, New
Zealand ran operating surpluses averaging almost 3 percent of GDP from
fiscal years 1994-95 through 1997-98. Despite the fact that the government
did not actively increase taxes during the mid-1990s, revenues increased as
a percent of GDP during this period for several non-policy related reasons.

9
 The full cash value of privatization proceeds is not included in the operating balance. Under
an accrual basis, only gains or losses are recorded in the operating balance. A gain would
occur if the sale price was above the net asset value, and a loss would occur if the sale price
was below the net asset value. However, all of the cash from the asset sale is available for
debt reduction.




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Tax receipts increased because New Zealand’s taxes are not indexed to
inflation and corporate profits grew with the improving economy. In fiscal
year 1995-96, taxes and other revenues accounted for more than 38 percent
of GDP, an increase from 36.6 percent in fiscal year 1993-94. On the
expenditure side, the government held the line on nominal increases, so
that by fiscal year 1995-96, expenditures as a share of GDP decreased to
approximately 34.5 percent, from 36 percent in fiscal year 1993-94.

Once the government’s debt level goals were reached, the government both
lowered the targets and passed budgets with tax cuts and increased
expenditures. In 1996, as the debt level was estimated to reach the initial
target of 30 percent of GDP, the government enacted a new budget that
aimed to reduce debt to below 20 percent of GDP while making room for
reduction in taxes. The 1996 tax cut package consisted of a two-stage
reduction in the income tax rate planned for 1996 and 1997. The package,
which went into effect July 1, 1996, totaled more than NZ$7 billion over
3 years and, along with smaller measures, reduced revenues from more
than 38 percent of GDP in fiscal year 1995-96 to a fiscal year 1998-99
estimated level of less than 35 percent. While the budget also targeted
specific areas such as health and education for spending increases, the
growth in expenditures was relatively small.

As mentioned previously, the 1996 election resulted in the formation of a
coalition government in New Zealand. The coalition government supported
spending initiatives that were not included in the fiscal year 1996-97
budget. In response to these pressures, the government passed a
NZ$5 billion spending package to be phased in over 3 fiscal years starting
with fiscal year 1997-98. The spending package allocated additional funding
to health and education and abolished the superannuation surcharge to
fulfill a 1990 campaign promise. To mitigate the fiscal pressure and reaffirm
its commitment towards surpluses, the government postponed the second
round of tax cuts until July 1, 1998, citing as reasons slowing economic
conditions and reduced projected surpluses.

Despite actions taken to reduce taxes and increase expenditures, reducing
net debt is still the overriding objective of fiscal policy. In 1998, the
government once again changed its target for debt to less than 15 percent
of GDP and planned to run surpluses until this level of debt was achieved.
In response to the Asian downturn and a forecasted fallback into deficit,
the government agreed in May 1998 to set aside NZ$300 million of the
NZ$5 billion spending package to bolster operating surpluses, thus
effectively reducing spending by NZ$150 million in fiscal years 1998-99 and



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                      1999-2000. In July 1998, the government once again reduced NZ$300 million
                      from the spending package, thus lowering funding for policy initiatives to
                      NZ$4.4 billion over the next 3 years. In September 1998, the government
                      launched yet another program to cut NZ$150 million in expenditure that
                      contained, among other provisions, a continuation of government policy to
                      index old-age pension benefits to prices instead of wages until benefits
                      reach 60 percent of average wage. According to an ex-official we
                      interviewed, this was a difficult and controversial decision because it
                      reduced the potential increases in benefits, but it was necessary if the
                      government wanted to adhere to its debt reduction policy. Most recently,
                      the government forecast that its budget would be in balance for fiscal year
                      1999-2000, before achieving surpluses again starting with fiscal year
                      2000-01.



Long-term Pressures   Like many other industrial nations, New Zealand faces the fiscal pressures
                      associated with an aging population. The proportion of the population aged
and Reforms           65 and over is projected to increase by more than 75 percent between 1996
                      and 2031, from about 12 percent to 21 percent of the population. About the
                      same time, the ratio of workers to retirees is projected to decrease from
                      5.8 to 3.4 workers per retiree. The growth in the elderly population is
                      forecast to impose extensive pressure on New Zealand’s fiscal position.
                      Because the benefits are fairly generous and because beneficiaries are not
                      subject to either asset or explicit income tests to qualify for benefits,
                      old-age pensions are forecast to almost double as a share of GDP from a
                      current level of more than 5 percent of GDP.

                      The government has made temporary changes to pension provisions, such
                      as imposing a surcharge on high-income earners (subsequently repealed)
                      and indexing old-age pension to prices rather than wages. In 1991, the
                      government raised the eligibility age for pensions from 60 to 65 over a
                      10-year period from 1991 through 2001. However, these changes have not
                      fully addressed the large projected increases in pension expenditures. In an
                      attempt to improve the long-term fiscal balance, the government in 1997
                      designed a compulsory savings scheme that was submitted to a public
                      referendum, but it was overwhelmingly rejected. Officials that we spoke
                      with said they thought this outcome had deferred pension reform
                      discussions for the time being.

                      According to officials, the health system also presents numerous
                      challenges to reformers. The system is primarily a public system,
                      supplemented by private insurance and out-of-pocket copayments for



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             New Zealand




             general practitioners and pharmaceuticals and for surgical procedures that
             would otherwise not be available immediately. Since the 1980s, health care
             expenditures have shifted to the private sector, with their share of total
             health expenditures increasing from 12 percent in fiscal year 1979-80 to
             almost 23 percent in fiscal year 1996-97. Despite the expenditure shift and
             other government actions to reform this area, government health
             expenditure continued to average around 5 to 6 percent of GDP, below the
             average of other developed nations. The growth in the elderly population is
             forecast to almost double health care costs from fiscal year 1997-98
             through the year 2050.



Conclusion   New Zealand began on the road to surpluses and lower debt by first
             addressing economic fundamentals and undertaking reforms of the public
             sector that included substantial privatization of government enterprises. In
             the 1980s, proceeds from privatization and increased tax revenues allowed
             the government to pay down debt and support large increases in social
             expenditures. In the 1990s, the government began a deficit reduction period
             that was marked by a focus on holding the line on expenditures. The
             government further enforced fiscal discipline by putting in place a new
             framework that focused fiscal policies on achieving prudent debt levels. By
             focusing on the debt to GDP ratio, the government was able to justify the
             need to run surpluses for several years. Upon achieving its initial goal of a
             net debt level from 20 to 30 percent of GDP, the government enacted a
             package of tax cuts. Subsequently, the government has set even lower
             levels of debt and confirmed surpluses as its primary goal, while allowing
             for increased spending in priority areas.




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Norway                                                                                                   Appendx
                                                                                                               i
                                                                                                               IV




              Norway has achieved budget surpluses on a general government basis in all
              but two−1992 and 1993−of the last 50 years.1 Generally throughout the
              post-war period, running budget surpluses was the aim of the government
              in power. Since the early 1970s, surpluses have increasingly been the result
              of a rapid increase in revenues from the oil industry. A large and growing
              oil industry has had a dramatic impact not only on the budget but also on
              the Norwegian economy. Norway has generally enjoyed strong economic
              growth during the past 25 years as a result of its petroleum industry.
              However, beginning with an oil price collapse in late 1985, Norway
              experienced a prolonged economic slowdown, which by the early 1990s
              resulted in record high unemployment and a return of budget deficits for
              the first time in nearly 50 years.

              Decisionmakers responded with a series of reforms aimed to improve the
              long-term fiscal and economic health of the country. In 1993, the
              government entered into an agreement with labor and business leaders
              with the stated goal of achieving long-term economic growth, high
              employment, low inflation, and a stable exchange rate. The government
              agreed to focus fiscal policy on stabilizing the economy, while monetary
              policy would focus on stabilizing the currency. Labor and business leaders
              agreed to hold down wage increases, reducing inflationary pressures in the
              economy. Officials we spoke with felt that these reforms have played a
              critical role in the turnaround of the economy and the return to surpluses.
              Figure 29 shows Norway’s general government financial balance as a
              percentage of GDP from 1970 to 1998.




              1
               A general government basis includes the fiscal position of subnational levels of government
              and public pension funds.




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Figure 29: General Government Financial Balance as a Percent of GDP in Norway, 1970 to 1998




                                         Source: OECD Economic Outlook 65, June 1999.


                                         Upon achieving surpluses, the government has adopted a long-term focus
                                         for fiscal policy−attempting to save surpluses to deal with future budget
                                         pressures. Specifically, Norway projects a sharp rise in public pension
                                         expenditures and a corresponding decrease in petroleum revenues. The
                                         government has decided that it needs to accumulate financial wealth to
                                         help pay for these pressures, and since 1996 has deposited budget
                                         surpluses in the Government Petroleum Fund. To further support
                                         continued fiscal discipline, the Parliament reformed its budget process in
                                         1997, putting in place expenditure and revenue ceilings for the first time.
                                         However, the ability of the government to maintain fiscal discipline during
                                         a period of surplus came under increasing pressure. A minority coalition



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             government was formed in 1997, and it increased spending above the
             previous government’s proposals. A tight labor market, a sharp drop in oil
             prices, and turbulence in currency markets have, together, placed
             increasing strain on the government’s ability to maintain fiscal discipline.



Background   Norway is a constitutional monarchy with a parliamentary system of
             government.2 The Parliament, called the Storting, is composed of two
             chambers with a total of 165 members. The government is headed by the
             Prime Minister and a Cabinet of 19 ministers. The governing party or
             coalition of parties must be backed by a majority of Parliament but need
             not constitute a majority of Parliament. The government is responsible for
             most legislation, but individual members of Parliament may introduce bills.
             Each year, the government prepares and introduces the budget to
             Parliament. Parliament has final authority over all budget matters and in
             practice often changes the government’s proposals.

             Elections are held every 4 years, and a new election may not be called
             outside this cycle. If the government receives a no confidence vote or
             resigns, then a new government must form from the current Parliament.
             Norway has a system of proportional representation with the number of
             representatives of each party determined roughly in proportion to the votes
             the party receives in the election.3

             Since 1945, the left-of-center Labor party has dominated Norwegian
             politics, holding government for all but 16 years. From 1945 until 1961, the
             Labor party held a majority of seats. Since 1961, power has alternated
             between coalition governments and minority Labor governments, with the
             Conservative party holding power from 1981 to 1983.




             2
              In practice, the King accepts the will of Parliament and functions in a largely ceremonial
             role.
             3
              There is some discrepancy between the popular vote and the makeup of Parliament.
             Norway’s electoral system is weighted to give more sparsely populated areas more
             representation. Also, seats for Parliament are allocated by electoral district, and as a result
             some smaller parties may not get enough votes to receive a seat. To compensate for this,
             Norway added eight nationwide seats to Parliament in 1989, to be awarded to parties so that
             the makeup of Parliament more closely approximates the election results.




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                          Currently, Prime Minister Kjell Magne Bondevik is leader of a minority
                          coalition government. He became Prime Minister following the 1997
                          election when a centrist coalition made up of the Christian Democrats
                          (Mr. Bondevik’s party), the Centre party, and the Liberal party formed the
                          government. The coalition government took over after the Labor party
                          stepped down following a poorer than expected showing in the 1997
                          election, despite the fact that Labor holds a higher percentage of seats with
                          35 percent than the coalition with 26 percent.4


Economy                   The Norwegian economy is about 2 percent the size of the U.S. economy
                          and heavily dependent on foreign trade. In 1997, exports accounted for
                          about 41 percent of GDP. Norwegian industry has traditionally been raw-
                          material based. The discovery of oil in the late 1960s has had a profound
                          effect on the Norwegian economy, and the petroleum sector has grown
                          rapidly to account for about 20 percent of the economy and about one half
                          of total merchandise exports.

Recent Economic History   Since the 1970s, Norway’s economic performance has been heavily
                          influenced by its rapidly growing oil industry. However, as a result, the
                          Norwegian economy has become subject to increasingly volatile swings in
                          oil prices and production. For example, Norway experienced a period of
                          strong economic growth in the mid-1970s as a result of high oil prices and
                          increased oil production, which was followed by a period of slow growth in
                          the early 1980s. Then, in the mid-1980s, Norway experienced a short but
                          strong economic boom, which was brought on by expansionary fiscal and
                          monetary policies and a sharp increase in the availability of consumer
                          credit. From 1986 to 1992, Norway experienced its longest economic
                          downturn since World War II, which was precipitated by a sharp drop in
                          world oil prices. The slowdown continued through the late 1980s as the
                          government maintained its tight fiscal policy stance in an attempt to reduce
                          inflationary pressures and because consumer spending slowed in reaction
                          to the sharp run-up in borrowing during the mid-1980s and the increased
                          cost of borrowing.

                          In reaction to rising unemployment, the government adopted an
                          expansionary fiscal stance beginning in 1989, but the economy did not
                          begin its turnaround until 1992. The expansion has been broadly based,

                          4
                           The Labor government stepped down because it failed to receive a larger percentage of the
                          vote in the 1997 elections than in the 1993 elections.




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                                         with strong growth in investments, exports, and private consumption. See
                                         figure 30 for Norway’s annual GDP growth since 1981.



Figure 30: Real GDP Growth in Norway, 1981 to 1998




                                         Sources: OECD Economic Outlook 65, June 1999 and OECD Economic Outlook 63, June 1998.


Key Structural Factors of the            As a small, trade dependent nation, Norway is sensitive to external factors
Norwegian Economy That Affect            that affect its economy. Particularly important to Norway’s economic
Fiscal Policy                            performance is its currency exchange rate and inflation rate. Appreciation
                                         in the value of its currency makes Norway’s exports relatively more
                                         expensive, reducing the competitiveness of its export industries. It is also
                                         important for Norway that inflation remains at or below the rate of key
                                         trading partners. If inflation is higher, then Norwegian goods become more



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                 expensive relative to competitors. The period from the late 1970s to the late
                 1980s was marked by high inflation and deteriorating cost competitiveness,
                 and on occasion the government devalued the currency to maintain cost
                 competitiveness.

                 The ability to maintain competitiveness is particularly critical in Norway
                 because a strong petroleum sector could lead to a weaker economy in the
                 long run. Strong petroleum exports put upward pressure on exchange
                 rates, can lead to increased public and private spending, and high inflation.
                 This effect, known as “Dutch Disease,” results in a loss of competitiveness
                 to traditional industries exposed to international competition.5 Over the
                 long run, as petroleum revenues decline, this could have a negative impact
                 on economic growth when Norway becomes more dependent on other
                 sectors to generate economic growth.


Budget Process   The Norwegian budget process occurs in two distinct steps. First, the
                 government prepares its budget proposal with the Finance Ministry taking
                 the lead. At the beginning of this phase, the Minister of Finance proposes
                 expenditure and revenue ceilings based on economic projections from the
                 Ministry of Finance. Then, the entire cabinet meets to decide spending
                 limits and debate how to allocate the budget. Most of this debate takes
                 place away from public view.

                 During the second phase of the budget process, the Parliament debates the
                 government’s proposal and passes a budget bill. The Finance Committee
                 sets an aggregate ceiling and ceilings for 23 expenditure areas and
                 2 revenue areas, which must be approved by Parliament.6 Parliamentary
                 committees then must develop their budget proposals within the

                 5
                  Dutch Disease refers to the experience of the Netherlands in the 1970s. During this period
                 the Netherlands received large revenues from gas exploration which led to strong economic
                 growth and growth in public expenditures. However, there were unwanted side effects. The
                 exchange rate appreciated resulting in reduced competitiveness. Also, there was a strong
                 rise in real wages, an expansion in services−both public and private−and a contraction in
                 manufacturing. The economy slowed, unemployment increased significantly, and large
                 budget deficits developed in the early 1980s. The government reacted with a large deficit
                 reduction effort. The restructuring of the Dutch economy has taken a long time and the
                 country still suffers from the after-effects of the strong expansion of the 1970s.
                 6
                  This new process was adopted in 1997. Prior to the implementation of expenditure ceilings,
                 spending increases and tax cuts could be passed without any offsets. This was often the
                 case with the budget passed by Parliament usually exceeding the spending proposed by the
                 government.




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                            expenditure limits. It is not unusual for Parliament to change the
                            government’s budget proposal.


Measuring Fiscal Position   Norway’s main measure of fiscal position is the fiscal budget
                            surplus/deficit, which includes all the activities of the central government
                            and is similar to the United States’ unified budget measure. Because of the
                            significance of petroleum revenues in Norway’s budget, it also reports a
                            non-oil budget figure, which separates the oil-related revenues and
                            expenditures from the fiscal budget. The difference can be quite large. For
                            example, in 1998 the government recorded a fiscal budget surplus of more
                            than 27 billion krone, while the non-oil budget deficit was about 17 billion
                            krone.

                            Also, Norway’s government uses the non-oil cyclically adjusted balance net
                            of interest payments as a key measure for setting fiscal policy. The
                            government uses fiscal policy in an active manner in an attempt to smooth
                            economic fluctuations and stabilize inflation. Consequently, this measure is
                            important because it shows the impact of the government’s core fiscal
                            actions on the economy by removing the effects of oil activities, the
                            economy, and fixed interest expenses. Officials we met with pointed out,
                            however, that it can be difficult to correctly forecast economic
                            performance, and in the past their estimates have varied significantly from
                            actual outcomes.



Norway Adopts Fiscal        Over the last 30 years Norway’s economy has undergone truly profound
                            changes due to a rapid increase in the size of its petroleum industry. The
Policy to Address           petroleum industry has grown to account for a large share of both the
Long-term Fiscal and        economy and government revenues. Prior to the arrival of petroleum
                            revenues, Norwegian governments had a history of achieving budget
Economic Pressures          surpluses. While Norway has generally continued to achieve surpluses,
                            they have become increasingly due to petroleum revenues.

                            Following a prolonged period of slow growth in the late 1980s and early
                            1990s, Norway developed a new framework to support sustained economic
                            growth. This framework, the so called “Solidarity Alternative,” was adopted
                            in 1993 and called for low nominal price inflation, sound public finances,
                            and a stable exchange rate in order to maintain stable economic growth
                            and high levels of employment. This framework was viewed as playing a
                            key role in the fiscal and economic improvement that occurred during the
                            mid-1990s. As a result of fiscal tightening measures and strong growth in


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                            petroleum revenues the budget has improved significantly, with surpluses
                            growing to over 7 percent of GDP in 1997.

                            As surpluses have developed, the government has adopted a long-term
                            budgetary focus and has called for setting aside budget surpluses to help
                            pay for future expenses. Norway faces the prospect of increasing public
                            pension expenditures at the same time that petroleum revenues are
                            forecast to decline. In order to help pay for these future expenses, the
                            government began depositing budget surpluses in the Government
                            Petroleum Fund in 1996.7 Also, the Parliament reformed its budget process,
                            adopting top-down spending and revenue targets in order to help maintain
                            fiscal discipline. However, as called for by the Solidarity Alternative, it
                            became increasingly difficult to maintain fiscal discipline during the
                            current period of strong economic growth. A minority coalition
                            government was elected in 1997 and increased spending above the previous
                            government’s proposals. A tight labor market, a sharp drop in oil prices,
                            and turbulence in currency markets have, together, placed increasing strain
                            on the government’s ability to maintain fiscal discipline.


1970s and 1980s: A          The Norwegian economy underwent truly profound changes with the
Transition to a Petroleum   discovery of oil in the late 1960s. Oil production began in 1971 and
                            increased rapidly after 1975. From 1975 to 1985, the petroleum sector grew
Based Economy
                            from about 2.5 percent of GDP to nearly 20 percent, oil and gas exports
                            grew from 9 percent to nearly one half of all exports, and oil tax revenues
                            increased from 2 percent to about 19 percent of total government income.

                            The impact on the broader economy was no less dramatic. During a period
                            of generally slow worldwide growth, Norway’s average annual real GDP
                            growth was 3.8 percent from 1975 to 1983, compared to 1.8 percent for
                            other OECD countries. From 1975 to 1983, unemployment averaged about
                            2 percent, nearly 5 percent below the OECD average. The government ran
                            budget surpluses from 1975 to 1983 averaging about 3 percent of GDP,
                            compared to an average deficit of 3.5 percent for other European OECD
                            countries. However, budget surpluses were increasingly due to petroleum
                            revenues−the non-oil budget showed a deficit of about 7 percent of GDP in
                            1983 compared to a surplus of about 4 percent 10 years earlier.



                            7
                            Petroleum fund assets are not specifically earmarked to cover public pension obligations.
                            Therefore, the Fund’s assets could be used to cover any government expense.




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                        Almost from the beginning, there was debate about how to manage the
                        petroleum wealth. There were concerns that a strong petroleum sector
                        could crowd out investment in the rest of the economy, leading to a weaker
                        economy in the long run when petroleum revenues declined. Initially,
                        during the early 1970s, it was decided to develop and spend oil revenues
                        cautiously to minimize the impacts on other sectors of the economy.
                        However, attempts to limit the impact of oil on Norway’s economy proved
                        unsuccessful as Norway’s oil revenues increased more rapidly than planned
                        as a result of a rise in the price of oil and the dollar exchange rate.

                        Concerns over a dominant petroleum sector crowding out other sectors of
                        the economy proved well founded. Growth in the manufacturing sector
                        stagnated from 1975 to 1985 and employment in that sector dropped by
                        over 13 percent. In response, the government increased subsidies to
                        domestic industries, including shipbuilding, farming, and fisheries. By the
                        mid-1980s, Norway’s corporate subsidies were among the highest of OECD
                        nations. The strong petroleum sector and the strong overall economy also
                        had other costs. A tight labor market contributed to persistently high
                        inflation and a decrease in the cost competitiveness of exports, which
                        Norway compensated for by devaluing its currency several times.


1983 Through 1986: An   Beginning in 1983 and lasting until 1986, Norway experienced a period of
Overheating Economy     strong economic growth. Although, initially the upturn was led by an
                        increase in exports, it was sustained by increasing domestic demand led by
                        expansionary fiscal and monetary policies. Also, the expansion was aided
                        by a steep rise in private consumption caused, in part, by the increased
                        availability of private credit following financial market deregulation.8

                        By 1985, the Norwegian economy had become overheated, led by a surge in
                        private consumption of more than 8 percent, and unemployment fell to
                        about 2 percent. Also, inflation rates remained high and above those of
                        other industrial countries, resulting in a loss of competitiveness, a drop in
                        exports, and a widening trade gap. Largely as a result of the strong
                        economy and strong petroleum revenues, budget surpluses grew to a peak
                        of about 10 percent of GDP in 1985.


                        8
                         Traditionally, Norway had maintained extensive controls over its financial markets, which
                        included controls over the supply of credit available to the private sector. Starting in the late
                        1970s, Norway began to deregulate its controls over financial markets which had the effect
                        of making credit more available.




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1986 Through 1992: Norway   From 1986 to 1992, Norway experienced the longest economic downturn in
Experiences the Longest     its post-war history. A sharp drop in oil prices, from about $30 a barrel in
                            late 1985 to about $10 a barrel in 1986, precipitated the downturn. The
Economic Downturn in Its
                            economic and fiscal effects were severe. Norway experienced a 1-year
Post-war History            10 percent decline in real national income, a 15 percent decline in total
                            export earnings, and a decline in the budget surplus of about 4 percent of
                            GDP. In 1986, the Norwegian currency came under increasing pressure, as
                            investors became concerned over the impact of a fall in oil prices on
                            Norway’s economy, and the central bank intervened to defend the currency.

                            Against this backdrop, a newly elected minority government came to
                            power in 1986 and implemented a strategy to restore economic stability
                            and international competitiveness. The new government devalued the
                            currency by 10 percent, improving the cost competitiveness of its export
                            sector. The government also tightened monetary and fiscal policy to slow
                            down the economy and reduce inflationary pressures. Finally, the new
                            government took several steps to improve Norway’s centralized wage
                            negotiation process and to reform its system of industrial subsidies. These
                            measures were intended to improve international competitiveness by
                            reducing wage inflation pressures and improving economic efficiency.

                            The economic slowdown was also prolonged due to a drop in consumption
                            as consumers attempted to reduce the indebtedness they had built up
                            during the mid-1980s borrowing surge. This retraction was exacerbated by
                            a tax reform package enacted in 1987, which reduced marginal tax rates
                            and the tax deductibility of interest payments, increasing the cost of debt.

                            The government continued to maintain a tight fiscal policy until 1989 when
                            it changed to a stimulative fiscal policy in reaction to rising unemployment
                            rates. Specifically, the government increased spending on labor market
                            programs, housing loans, and public construction while reducing employer
                            social security contributions in an attempt to stimulate the economy and
                            increase employment. However, just as the economy showed signs of
                            picking up due to increased private consumption in 1990, a general
                            worldwide economic slowdown acted to prolong Norway’s slowdown.


Prolonged Economic          The prolonged economic downturn led Norwegian policymakers to take
Downturn Leads to           actions to improve economic performance. As a result, the budget had
                            moved into deficit in 1992 and 1993 for the first time in many years.
Consensus on the Need for
                            Unemployment peaked at about 6 percent in 1992−a very high level by
Fiscal Discipline


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                                  Norwegian standards. Following turmoil in European exchange markets in
                                  1992, Norway was forced to give up its fixed exchange rate policy.

                                  Against this backdrop, the government appointed a commission in 1991 to
                                  study the causes of the rapid rise in unemployment. The Commission
                                  consisted of representatives from all political parties in Parliament, labor
                                  and business groups, economic experts, and government officials. In the
                                  summer of 1992, the Commission, with broad support from the major
                                  political parties, issued its report recommending a new approach for
                                  economic policy−a so called “Solidarity Alternative.”

                                  The Solidarity Alternative established clear roles for fiscal and monetary
                                  policy. The government was to use fiscal policy in a counter-cyclical
                                  fashion−increasing demand during economic slowdowns and decreasing
                                  demand during periods of overly strong economic growth. Monetary policy
                                  was to be used primarily to maintain stable exchange rates. In addition, as
                                  part of the Solidarity Alternative labor and business leaders agreed to
                                  cooperate to mitigate wage inflation pressures. Officials and experts we
                                  spoke with felt that the Solidarity Alternative played a key role in the
                                  turnaround of the economy.

Norway Sets Goal for Surpluses    Once the fiscal budget was projected to return to surplus in 1996, the
to Address Long-term Fiscal and   government added a long-term focus to its fiscal policy goals. A major
Economic Concerns                 reason for the return to surplus was a surge in petroleum revenues, which
                                  more than doubled between 1994 and 1996, and an overall improvement in
                                  the economy and in non-oil exports. Also, the government’s attempt to limit
                                  the growth of “underlying” expenditures (excluding unemployment
                                  benefits and one-time items) contributed to fiscal improvement.

                                  With the advent of surpluses, Norway established a goal of sustained
                                  surpluses in order to build up savings to address long-term fiscal and
                                  economic concerns resulting primarily from an aging population and
                                  declining petroleum revenues. (See figure 31.) The goal to save surpluses
                                  was based, in large part, on a study of the long-term outlook for
                                  government finances.9 Specifically, the study projected that petroleum
                                  revenues would peak in 2001 at about 8 percent of GDP and decline
                                  thereafter to about 1 percent of GDP in 2030. At the same time, public
                                  pension expenditures were projected to grow from about 7 percent of GDP
                                  to nearly 15 percent. Figure 31 shows the most recent long-term forecast

                                  9
                                  Long-term Program for 1994-1997, Norwegian Ministry of Finance.




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extended out to 2050. This long-term problem has been presented as the
primary rationale for the current fiscal policy of sustained surpluses.



Figure 31: Long-term Projections for Pension Expenditures and Petroleum
Revenues as a Percentage of GDP in Norway, 1973 to 2050




Source: Statistics Norway and Norwegian Ministry of Finance.


The government’s projections showed that it was necessary to accumulate
financial reserves to help pay for increasing public expenditures. As a
vehicle for accumulating assets, the government created the Government
Petroleum Fund in 1991 to help manage Norway’s petroleum wealth over
the long term. The Government Petroleum Fund serves several important
fiscal and economic functions. By investing surpluses, the Fund is an
instrument for saving part of Norway’s petroleum revenues for the next
generation. Also, the Fund’s assets are invested in foreign stocks and bonds
to help reduce inflation and upward pressure on the exchange rate. Low
inflation and a stable exchange rate help to keep Norway’s exports
competitive with other countries. If Norway allowed excess petroleum
revenues to remain in the domestic economy it could result in higher levels
of inflation and a real appreciation of its currency. As a result, non-oil
industries would become less competitive over time as the price of their
goods and services would rise relative to foreign competitors. This is a
major concern to policymakers because petroleum output is projected to
decline early in the 21st century, and Norway will have to rely more on its



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                               non-oil industries to generate economic growth. If those industries lose
                               their competitiveness now, it could have a negative impact on long-term
                               economic growth when the petroleum industry declines. Consequently,
                               policymakers in Norway have come to view surpluses as critical to the
                               long-term fiscal and economic health of the country, and the Fund has
                               become a symbol of the importance of saving for future needs.


Budget Process Reformed        The Norwegian Parliament reformed its budget process in 1997 to show its
to Sustain Fiscal Discipline   continued support for fiscal discipline and in reaction to past spending
                               increases. For the first time, the Parliament adopted a top-down approach
                               to budgeting, setting aggregate revenue and expenditure ceilings. Under the
                               old procedure there was no agreement on an overall expenditure and
                               revenue limit at the beginning of the budget process, and the final budget
                               represented the aggregate of individual spending decisions. As a result, the
                               previous budget process often led to Parliament increasing spending above
                               the government’s proposed levels. Under the new budget process,
                               Parliament agrees on an overall fixed budget ceiling and ceilings for
                               23 spending and 2 income areas at the beginning of the budget process. All
                               spending and revenue proposals must fit within these ceilings.


Surplus Policy Comes           During the 1997 elections, the then governing Labor party promoted
Under Pressure                 continued austerity in order to avoid making the mistakes that occurred
                               during the 1980s, while several smaller opposition parties called for
                               increased spending on various social programs. In order to ensure support
                               for continued fiscal discipline, the Labor party vowed to step down unless
                               it received an equal percentage of the popular vote in the election as in the
                               previous election. The Labor party failed to garner an equal percentage of
                               votes and stepped down as promised, despite holding the largest number of
                               seats in Parliament. A minority coalition took over, and its first budget
                               proposed to increase spending on pensions and family allowances.

                               In 1998, a sharp decline in oil revenues led to a sharp decline in the budget
                               surplus, including oil revenues, from about 7 percent of GDP to about
                               4 percent of GDP. Financial markets became concerned over the relatively
                               easy stance of fiscal policy, resulting in strong downward pressure on
                               Norway’s currency. In late 1998, the Central Bank was forced to step in and
                               defend the currency. Furthermore, a tight labor market has led to increased
                               inflationary pressures. Consequently, it may be difficult for a weak minority
                               coalition government to maintain fiscal discipline in light of the pressures
                               that have emerged since 1997. Nonetheless, the government remains



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             committed to the Solidarity Alternative and maintaining surpluses to be
             invested for the future.



Conclusion   Norway has had a long history of budget surpluses and fiscal discipline.
             With the discovery of oil in the late 1960s, the Norwegian economy and
             fiscal position have come to be increasingly influenced by oil activities.
             Following a prolonged period of slow economic growth in the late 1980s
             and early 1990s, the government reached a broad consensus on the need to
             take actions to sustain economic growth and maintain full employment
             over the long term. Part of this agreement called for fiscal policy to be used
             in a counter-cyclical fashion and has been a major reason why Norway has
             been able to maintain fiscal discipline throughout the latter half of the
             1990s. With the arrival surpluses in 1996, the government has added a
             long-term focus to its fiscal goals and now calls for surpluses to be saved to
             help pay for future budgetary pressures. However, this framework has
             come under increasing pressure due to a weak minority government, a
             strong domestic economy, and turbulence in international currency
             markets. Nevertheless, the current government remains committed to the
             Solidarity Alternative and maintaining surpluses to be invested for the
             future.




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Appendix V

Sweden                                                                                                    Appendx
                                                                                                                i
                                                                                                                V




             Since the early 1980s, Sweden has experienced 2 periods of budget
             surpluses: 1987 through 1990 and again beginning in 1998.1 Surpluses
             achieved in the late 1980s were largely the result of the deficit reduction
             program begun in 1982 and a strong economy. During this period, the
             government did not have an explicit policy to sustain surpluses and
             generally attempted to use fiscal policy to stabilize the economy and
             control inflation. Deficits reemerged in 1991 as the economy slipped into its
             worst recession since the 1930s. The budget swung from a surplus of about
             4 percent of GDP on a general government basis in 1990 to a deficit of more
             than 12 percent of GDP 3 years later. Unemployment increased sharply,
             several large banks nearly failed, and the currency was devalued.

             In response to the economic crisis of the early 1990s the government
             undertook a series of major reforms. In 1992, Sweden ended its policy of
             maintaining a fixed exchange rate by changing the focus of monetary policy
             to controlling inflation. As a result, the use of fiscal policy to stabilize the
             economy and control inflation was reduced. The government focused its
             fiscal policies on deficit reduction and, in 1994, introduced a package that
             attempted to reduce the deficit by about 7 percent of GDP over 4 years. To
             support the deficit reduction program, the government reformed its budget
             process to include, for the first time, the use of spending caps. Finally,
             Sweden overhauled its pension system with the goal of making it
             permanently sustainable. By 1998, Sweden returned to a budget surplus
             and had set as its fiscal objective running surpluses averaging 2 percent of
             GDP. Figure 32 shows Sweden’s general government financial balance as a
             percentage of GDP from 1981 to 1998.2




             1
              In 1995, Sweden changed its measure of fiscal position to a general government measure,
             which includes not only the central government’s fiscal position, but also the fiscal position
             of local governments and its public pension funds. Prior to 1995, budget figures refer
             primarily to the central government budget. The fiscal surplus was positive for both the
             central and general government in 1987-1990. Sweden has also changed its fiscal year from
             July 1 to January 1; 1997 was the first budget year to coincide with the calendar year.
             2
              General government financial balance includes the financial balance of the federal
             government, the public pension system, and local government.




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Figure 32: General Government Financial Balance in Sweden, 1981 to 1998




                                         Sources: OECD Economic Outlook 63, June 1998 and OECD Economic Outlook 65, June 1999.




Background                               Sweden is a constitutional monarchy with a parliamentary form of
                                         government. The Swedish Parliament, the Riksdag, is unicameral with
                                         349 members. Sweden has a proportional electoral system, with
                                         310 members elected from districts, while the remainder are nominated by
                                         their parties in order to achieve a nationally proportional result.3



                                         3
                                         A party must gain at least 4 percent of the national vote to qualify for representation.




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General elections for Parliament are held in Sweden every 4 years.4 A
government forms from the political party, or coalition of parties, that can
garner the majority support of Parliament. However, the governing party or
parties do not need a majority of seats in Parliament. Governments have no
specific term limit and can remain in office for as long as they maintain
majority support of Parliament. A change in government can occur after an
election when a governing party or coalition loses its majority or when a
sitting government resigns. If at least half the members of Parliament
support a vote of no confidence, the government is forced to resign. No
government has actually been overthrown by a formal vote of no
confidence. Occasionally, however, governments have resigned after losing
important votes in Parliament, in effect an informal vote of no confidence.
Governments have also resigned as a result of internal disagreements; this
occurs most often with coalition governments.

For most of the last 60 years, Sweden has had minority or coalition
governments. The Social Democratic Party, a left-of-center party generally
representing the interests of labor, has held power for approximately 58 of
the last 67 years. After losing the 1991 election, the Social Democrats
returned to power in 1994 with 46 percent of the vote. After the election in
1994, the Social Democratic minority government was first supported by
the Left Party, then by the Center Party. In the September 1998 elections,
the Social Democrats’ share of the vote dipped to 36.4 percent. However,
they were able to remain in power with the support of the more politically
left-of-center Green and Left parties. Göran Persson is the current Prime
Minister.5

The cabinet, headed by the Prime Minister, is the decision-making body for
the government. It is composed of the Prime Minister, a Deputy Prime
Minister, 13 Heads of Ministry, and 7 Ministers without portfolio. Cabinet
Ministers are appointed by the Prime Minister and are generally
representatives of the political party or parties in power. They are often,
but not always, members of the Parliament. The government is responsible
for preparing the budget, which is submitted to Parliament in September.




4
 Governments may call for an election between regularly scheduled elections, with the
results of a mid-term election remaining in effect only until the next scheduled election.
5
Göran Persson was appointed Prime Minister in March 1996 after Prime Minister Ingvar
Carlsson resigned as leader of the Social Democrats.




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The Swedish Economy       Sweden has a small economy that is dependent on trade−its GDP is less
                          than 3 percent the size of the U.S. economy and exports accounted for over
                          35 percent of GDP in 1997, compared to about 9 percent for the United
                          States.

Recent Economic History   During the 1970s, Sweden’s economy experienced an extended period of
                          slow growth similar to that of other developed economies. Between 1974
                          and 1984, average annual growth was 1.3 percent, about 2 percentage
                          points lower than the previous 10 years. During this period of slow growth,
                          Sweden continued to pursue a policy of full employment, financed largely
                          by increased public sector borrowing. As a result, Sweden’s public
                          expenditures grew at a fast rate during the 1970s, reaching a peak of nearly
                          two-thirds of GDP in 1982. Under this fiscal policy, Sweden maintained a
                          low unemployment rate−but at the cost of high inflation and large budget
                          deficits.

                          By the early 1980s, Sweden was experiencing slow economic growth, high
                          inflation, and growing budget deficits. Beginning in 1982, Sweden enacted
                          an economic and fiscal reform package designed to help revive the
                          economy and reduce budget deficits. During the early and mid-1980s,
                          Sweden’s government also deregulated its financial markets, which
                          included the removal of governmentally-imposed limits on the amount of
                          credit that banks could issue in a given year.6 The increased availability of
                          credit led to a surge in borrowing and a large increase in consumer
                          spending and real estate investment.7 These reforms contributed to a
                          sustained period of growth beginning in 1982 and ending in 1990.

                          In 1990, the Swedish economy entered its worst recession since the 1930s,
                          due largely to a slowdown in consumer spending and a slowing world
                          economy. Consumer spending slowed as borrowing costs increased due in
                          part to a government tax reform package which decreased marginal tax
                          rates on capital income and reduced the deductibility of interest costs. A
                          loss in confidence by investors in the underlying strength of the economy
                          led to strong downward pressure on the value of Sweden’s currency. The


                          6
                           Sweden’s government set borrowing and lending ceilings in an attempt to control credit
                          growth.
                          7
                           Interest payments were deductible from income taxes, which, combined with high marginal
                          tax rates and a relatively high inflation rate, led to a negative real rate of interest for many
                          borrowers.




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government’s attempts to maintain the fixed exchange rate exacerbated the
economic slowdown; interest rates for loans in the central bank were
increased to 500 percent in the fall of 1992 in an attempt to defend the
currency. Economic growth was negative from 1991 to 1993, and registered
unemployment increased dramatically from about 2 percent in 1990 to over
8 percent in 1993. The slowing economy also precipitated a banking crisis
requiring the government to bail out several banks. The economic
slowdown and banking bailout had dramatic fiscal effects leading to a
sharp increase in budget deficits, which peaked at over 12 percent of GDP
in 1993.

In reaction to the economic and fiscal crisis, the government took a
number of steps to revive the economy and bring the fiscal situation under
control. First, Sweden ended its fixed exchange rate policy in 1992 and
reoriented monetary policy toward a focus on controlling inflation. In late
1994, a newly elected Social Democratic government put in place a deficit
reduction package totaling over 7 percent of GDP over 4 years. Sweden
also reformed its budget process to include expenditure caps and reformed
its pension system. By 1994, the economy had begun to turn around.
(See figure 33.) In the later half of the 1990s, inflation has remained low and
stable, unemployment rates have begun to come down, and the budget
moved into surplus in 1998.




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Figure 33: Real GDP Growth in Sweden, 1982 to 1998




                                        Source: OECD Economic Outlook 65, June 1999.


Key Structural Factors of the           As a country with a small, open economy, Sweden is sensitive to external
Swedish Economy That Affect             factors that affect its economy. Particularly important to Sweden’s
Fiscal Policy                           economic performance is its exchange rate, as appreciation in its currency
                                        makes Sweden’s exports more expensive and reduces its competitiveness.
                                        Prior to 1992, Sweden generally pursued a fixed exchange rate policy. Since
                                        1992, it has allowed its currency to float on the open market.

                                        Prior to 1992, Sweden’s primary tool to regulate exchange rates was
                                        monetary policy. However, as a result, monetary policy was limited in its
                                        ability to control inflation. Containing inflation at the rate that prevails
                                        abroad is important to maintaining a fixed exchange rate. Through the



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                 early 1990s, Sweden attempted to control inflation primarily through the
                 use of fiscal policy. However, fiscal policy was often expansionary, even
                 during economic booms, generally adding pressure to an overheating
                 economy and higher rates of inflation. Consequently, Sweden’s fixed
                 exchange rate policy was ultimately unsuccessful, and the central bank
                 was unable to defend the value of the currency.


Budget Process   Sweden began its budget process reforms in 1994 based, in large part, on
                 several studies showing its process was weak in its ability to control overall
                 spending. The reforms put in place a top-down budget process intended to
                 facilitate spending constraint and lead to better budget outcomes. The new
                 budget process was fully implemented in 1997. These reforms are now
                 viewed as a major factor contributing to Sweden’s recent fiscal
                 improvement.

                 Sweden’s budget reforms focused on achieving better fiscal outcomes,
                 mainly by placing controls on spending. For example, the new process
                 requires the adoption of fiscal policy targets for a 3-year period, including
                 expenditure ceilings. Operating under a 3-year time horizon, each year the
                 government adds the overall expenditure ceiling for the third year, keeping
                 in place previously agreed to expenditure ceilings. Expenditure ceilings
                 may be changed in exceptional cases, but since they were introduced, there
                 have been no increases of previously agreed to ceilings.8

                 The adoption of a top-down approach to budgeting represents a significant
                 change for Sweden. Prior to the reforms, top-down targets were generally
                 not used by the government or by Parliament. In fact, the general trend was
                 that Parliament would increase spending above the government’s budget
                 proposal. Under the new process Parliament passes a bill establishing the
                 aggregate spending level 3 months prior to the government’s final budget
                 proposal. The government’s budget proposal must conform with these
                 limits established by Parliament. Parliament, upon receiving the
                 government’s budget proposal, then prepares its own budget bill allocating
                 expenditures among 27 expenditure areas. By passing expenditure ceilings
                 at the beginning of the parliamentary budget process, the new process


                 8
                  However, the ceilings have been adjusted for technical reasons. For example, with the
                 introduction of the new pension system, ceilings were adjusted since pension fees were to
                 be paid on transfers. The fiscal balance for the general government was not affected by this
                 change. The ceilings have not been changed due to inability to contain spending.




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                            limits the ability of Parliament to increase spending once overall targets are
                            agreed upon.


Measuring Fiscal Position   Sweden’s main measure of fiscal position is the general government
                            financial balance, which includes the central government budget, the local
                            government sector, and Sweden’s public pension system. Prior to 1995, the
                            government focused primarily on the central government budget, also
                            known as the state budget. After joining the European Union (EU) in 1995,
                            Sweden’s primary measure of fiscal position became the general
                            government financial balance. EU member countries must comply with the
                            Growth and Stability Pact. Under the Pact, countries agree to support the
                            economic growth and stability of the Union, by, among other things,
                            keeping government budgets close to balance and maintaining low levels of
                            debt. The EU assesses compliance with the balanced budget requirement
                            using a general government financial balance measure because it includes
                            all levels of government activity allowing for better comparisons across
                            countries. Consequently, Sweden chose this measure as its primary
                            measure of fiscal position.

                            However, when planning the budget the government also focuses on the
                            expenditure ceiling. The overall expenditure ceiling includes central
                            government spending as well as the public pension system. Until the recent
                            focus on the general government financial balance, Sweden’s pension
                            system was considered separately from the rest of the central government
                            budget. The pension system funds are still accounted for separately from
                            central government revenues, and surpluses accumulating in the pension
                            system are invested in marketable securities, i.e., they are not used to
                            reduce the government’s public borrowing needs.



Sweden’s Fiscal Policy      Sweden’s public expenditures, taxes, and deficits all increased at a
                            significant rate throughout the 1970s as the government reacted to an
in the 1970s, 1980s, and    economic slowdown by attempting to use fiscal policy to stimulate the
1990s                       economy and reduce unemployment. By 1982, public expenditures totaled
                            about two-thirds of the economy, up dramatically from less than 45 percent
                            in 1970. Revenues also grew at a rapid rate during this period−increasing
                            from about 48 percent of GDP in 1970 to about 58 percent of GDP in 1982.
                            (See figure 34 for expenditures and revenues as a percent of GDP from
                            1970 to 1998.) As rapidly as revenues grew, they did not grow fast enough to
                            offset rapidly increasing expenditures, and very large deficits emerged by




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                                        the early 1980s. In 1982, the central government’s deficit stood at nearly
                                        10 percent of GDP.



Figure 34: Expenditures and Revenues as a Percentage of GDP in Sweden, 1970 to 1998




                                        Sources: OECD Economic Outlook 42, December 1987 and OECD Economic Outlook 65, June 1999.


                                        Beginning in 1982, a newly elected government enacted an economic and
                                        fiscal reform package aimed at improving economic performance and
                                        reducing the budget deficit. The government’s efforts were largely
                                        successful leading to an economic recovery, which lasted until 1990. As a
                                        result, the budget reached surplus from 1987 until 1990. During this surplus
                                        period, the government’s fiscal policy was generally neutral as attempts to



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                              tighten fiscal policy to slowdown an overheating economy failed to garner
                              support in Parliament. Beginning in 1990, the Swedish economy entered its
                              worst economic slowdown since the 1930s, with economic growth falling
                              by about 5 percentage points from 1991 to 1993 and the unemployment rate
                              reaching record levels. The economic slowdown was a major factor
                              contributing to a substantial deterioration in public finances during this
                              period. From 1990 to 1993, Sweden’s budget went from a surplus of about
                              4 percent of GDP to a deficit of more than 12 percent. The large deficits
                              resulted in an explosion of government debt, with general government
                              gross debt nearly doubling as a percentage of GDP from 1990 to 1994.

                              In reaction to the crisis, Sweden’s main fiscal objective changed during the
                              mid-1990s from a focus on maintaining full employment to a focus on
                              reducing budget deficits and stabilizing debt as a share of GDP. Sweden put
                              in place an austere deficit reduction program in fiscal year 1994-95 with
                              spending reductions and revenue increases totaling about 7 percent of GDP
                              through 1998. Sweden also overhauled its budget process with the aim of
                              constraining spending. These efforts played a critical role in Sweden’s
                              ability to eliminate budget deficits. In 1998, Sweden ran a small surplus and
                              now projects surpluses for the next 3 years. Sweden’s current stated fiscal
                              goal is to run surpluses of 2 percent of GDP, on average, over the economic
                              cycle.

                              The government has also made reforms aimed at improving its long-term
                              fiscal health. During the mid-1990s, Sweden overhauled its public pension
                              system when it became apparent that the system was unsustainable and
                              would run out of money early next century. Sweden’s pension system is run
                              separately from central government finances−tax revenues go directly to
                              the pension system and excess monies are invested in stocks and bonds
                              through one of several government-managed funds. Consequently, the
                              pension reform debate occurred separately from the general budget
                              debate, and prior to any debate about the need for surpluses.


1982 Through 1987: A Period   Sweden began the early 1980s in the midst of fiscal and economic crisis.
of Deficit Reduction          Sweden’s public sector had grown throughout the 1970s to account for
                              about two-thirds of the economy in 1982, the largest proportion among
                              developed economies at that time. However, the increase in expenditures
                              throughout the late 1970s was not matched by an increase in revenues, and
                              large budget deficits developed, peaking at about 7 percent of GDP in 1982.
                              Government debt also grew rapidly during the late 1970s and early 1980s,
                              reaching its peak of about 67 percent of GDP in 1984. By the early 1980s,



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Sweden was experiencing slow growth, high inflation, and rising
unemployment.

Against this backdrop, a newly elected Social Democratic government
came to power in 1982 and enacted a comprehensive economic
stabilization program in an attempt to address concerns over economic
underperformance and persistent budget deficits. The first step in the
stabilization program was a devaluation of the currency to make Swedish
exports more cost competitive and boost economic growth by increasing
exports. Secondly, the government attempted to reduce the budget deficit
by reducing expenditures gradually as the economy recovered. The
economy did pick up beginning in 1982, but the deficit initially worsened as
the devaluation increased the interest costs of the government because a
large portion of its debt was denominated in foreign currencies.9 Also, the
government initially increased spending in an attempt to limit the negative
economic effects of the devaluation and to fulfill campaign promises.
Finally in 1983, the government proposed a deficit reduction program
containing both spending cuts and tax increases.

Over the next 3 years, the government continued to focus fiscal policy on
reducing the size of public expenditure and debt. From 1982 to 1986, the
general government financial deficit was reduced from 7 percent of GDP to
about 1 percent of GDP, primarily due to spending restraint and aided by an
improving economy. For example, interest payments were reduced in 1985
due to a depreciation in the U.S. dollar−nearly one half of Swedish public
debt at that time was denominated in U.S. dollars.




9
Interest payments on foreign denominated debt must be made in that currency.
Consequently, a devaluation in the Swedish krona made these payments more expensive.




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                              The government’s economic stabilization package led to a rapidly
                              improving economy, which also contributed to improving budget figures.
                              For example, the 1982 currency devaluation increased the price
                              competitiveness of Swedish exports and led to a temporary increase in
                              exports. Also, the government’s deregulation of the credit markets made
                              credit more readily available to consumers and businesses. As a result,
                              consumers increased their borrowing leading to increased growth as
                              borrowed money was used for consumption and investment spending,
                              especially in real estate.10 The growing economy, coupled with the cuts in
                              spending, greatly improved Sweden’s fiscal position, and it achieved a
                              budget surplus in 1987 and in the next 3 years.


1987 Through 1990: A Period   Sweden achieved budget surpluses for 4 years beginning in 1987 largely as
of Surpluses                  a result of the booming economy and deficit reduction efforts. During this
                              period, Sweden did not have an explicit policy for sustaining surpluses, as
                              fiscal policy was focused on maintaining full employment and controlling
                              inflation. Under such a regime, fiscal policy would be tightened−i.e., taxes
                              raised or spending cut−during periods of inflationary growth.

                              However, during the surplus period, the government’s fiscal policy varied
                              from year to year as a lack of political consensus halted most attempts to
                              tighten fiscal policy. With the arrival of surpluses in 1987, the government
                              continued with its attempts to tighten fiscal policy, and in 1988 the
                              government’s fiscal policy was broadly neutral. In an attempt to tighten
                              fiscal policy in its fiscal year 1989-90 budget, the government proposed an
                              increase of 2 percent in the value-added tax (VAT). However, the minority
                              government was unable to develop enough support for its passage. Instead,
                              Parliament passed a temporary compulsory savings scheme as part of a
                              more limited attempt to tighten fiscal policy. By 1990, the economy was
                              beginning to weaken, and in 1991 the budget went back into deficit where it
                              remained for 7 years.


1991 Through 1998: A New      In the early 1990s, Sweden experienced its worst recession since the 1930s.
Focus for Fiscal Policy       In 1991, the government enacted a tax reform package that lowered
                              marginal rates and eliminated certain deductions, including the consumer


                              10
                                Interest on consumer loans was tax deductible in Sweden at the time. With high marginal
                              tax rates and a high rate of inflation, many borrowers were able to borrow at a negative real
                              interest rate.




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interest deduction. As a result, consumer spending slowed dramatically as
the cost of borrowing became more expensive despite the income tax cuts.
Also, a loss of confidence in the Swedish currency led to downward
pressure on its value, which the government initially tried to defend. The
central bank raised overnight interest rates to over 500 percent, a record
high for any country at that time. However, the high interest rates further
slowed the economy, and consumer confidence declined as the efforts to
defend the currency were unsuccessful. GDP growth turned negative from
1991 through 1993 and unemployment jumped from 2 percent in 1990 to
7.5 percent in 1993. These economic events had a significant impact on the
fiscal policy of the 1990s and reinforced the need to maintain fiscal
discipline.

During the initial stages of the economic crisis, the government focused its
fiscal policy on reviving the economy by increasing spending and
addressing specific crises such as the near failure of several large banks.
Because monetary policy was focused on defending the currency, interest
rates were raised significantly, acting to slow the economy and working
against the government’s attempts to stimulate the economy through fiscal
policy. The economic slowdown and large jump in unemployment had a
severe impact on the budget, mostly due to the large size of the government
as a share of the economy. Sweden has a generous social welfare system
and spending increases rapidly when the economy slows. During the early
1990s, outlays increased rapidly, from about 59 percent of GDP in 1990 to
over 70 percent in 1993. Also, tax receipts fell from over 63 percent of GDP
in 1990 to about 59 percent in 1993 due primarily to lower than expected
receipts from the 1991 tax reform and a change in the composition of GDP
toward areas with lower tax rates.11 As a result of increasing expenditures
and falling revenues, Sweden’s budget deficit peaked at over 12 percent of
GDP in 1993. Debt also increased during this period with gross debt nearly
doubling from 1990 to 1994, where it peaked at over 80 percent of GDP.
(See figure 35 for Sweden’s debt level from 1981 to 1998.)

By 1993, the focus of fiscal policy had changed from stimulating the
economy and maintaining full employment to bringing the budget back
under control by lowering deficits and stabilizing debt. In April of 1993, the
government announced a deficit reduction package which amounted to
about 5 percent of GDP and included reductions in subsidies for medical


11
 Tax receipts also dropped for technical reasons. For example, employers’ social security
contributions for sickness benefits were reduced.




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                                          and dental care, indexation of certain taxes, and increased contribution
                                          rates for the unemployment benefit system.



Figure 35: General Government Gross Financial Liabilities in Sweden, 1981 to 1998




                                          Note: Number for 1998 is an estimate.
                                          Sources: OECD Economic Outlook 63, June 1998 and OECD Economic Outlook 65, June 1999.


                                          With a stagnant economy and a deteriorating fiscal position, a real sense of
                                          crisis permeated the 1994 elections. Nearly all political parties put forth
                                          plans to bring deficits under control and revive the economy. This was a
                                          major change in focus from past elections where parties generally focused
                                          on proposing new initiatives that would lead to spending increases. The
                                          Social Democrats were returned to power after 3 years out of office and




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                           immediately began to implement a deficit reduction program. Their stated
                           fiscal policy was to balance the budget by 1998 and to stabilize debt as a
                           percentage of GDP. To accomplish this goal, the government presented a
                           series of deficit reduction packages, with expenditure reductions
                           accounting for about 60 percent of the improvement and revenue increases
                           accounting for the other 40 percent. These measures were projected to
                           total about 7.5 percent of GDP by 1998.


New Budget Process         To support its deficit reduction effort, the new government overhauled the
Designed to Control        budget process. Under the new process, the government established a
                           top-down approach whereby it set aggregate spending levels before any
Spending
                           programmatic initiatives were proposed. Under the new process,
                           Parliament enacted an aggregate expenditure ceiling and ceilings for
                           27 spending categories for the current budget year and the next 2 years.
                           The expenditure ceilings were set on a rolling basis, with a new ceiling set
                           for the third year only. Sweden’s expenditure ceilings are noteworthy
                           because they cover entitlement programs, such as social security.12

                           Several experts we spoke with felt the new budget process was a critical
                           factor in Sweden’s fiscal improvement. The multi-year expenditure limits
                           have been particularly important because they make it difficult to increase
                           spending if the budget improves more than forecast. This is especially
                           important as Sweden enters a new period of budget surpluses.


Government Sets Goal for   The government has surpassed its fiscal goals due in large part to a
Surpluses to Reduce Debt   stronger than expected economy. In 1996, when it became apparent that
                           Sweden would achieve balance sooner than expected, the government
and Maintain Investor
                           established a new fiscal policy goal to run surpluses after 1998. In 1997, the
Confidence                 government defined its long-term goal as running surpluses of 2 percent of
                           GDP, on average, over the business cycle−surpluses would gradually
                           increase after 1999, reaching 2 percent of GDP in 2001. The government’s
                           primary reason for wanting to run surpluses was to reduce the debt level
                           which shot up dramatically in the early 1990s. Also, the government wishes

                           12
                            If the expenditure ceiling for an entitlement program is exceeded in any year, it will not
                           necessarily result in benefits being cut off. Rather, the spending ceiling for entitlement
                           programs, in effect, acts as an early warning system. The government closely monitors
                           spending in these areas throughout the year, and when cost overruns become apparent, a
                           decision must be made to find extra funds from other categories, cut benefits, or raise the
                           ceiling.




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to maintain investor confidence in its fiscal and economic policies. By
running surpluses, the government hopes to increase its future fiscal
flexibility should another crisis materialize. The economic and fiscal crisis
of the early 1990s has continued to significantly affect policymakers,
resulting in a general consensus on the need for continued surpluses.
Nonetheless, there has been some disagreement over how big surpluses
should be and how extra surpluses should be used. Several political parties
have called for smaller surpluses and have proposed using them for tax
cuts or spending increases.

The budget process reforms enacted to support deficit reduction efforts
have continued to play an important role in shaping fiscal policy decisions
as Sweden has entered a period of surplus. The government established
expenditure ceilings for 1998 that would enable it to achieve the goal of a
surplus of 2 percent of GDP by 2001. However, due to continued strong
economic growth, and other technical factors, they have achieved their
surpluses sooner.13 As larger than expected surpluses have developed, the
government has reiterated its commitment to the previously enacted
expenditure ceilings. At the same time it has been able to increase spending
somewhat because of the way the expenditure ceilings work. Under
Sweden’s new budget process, all open-ended appropriations−mostly to
entitlement programs−were abolished, making all expenditures subject to
annual reviews. To provide a buffer against forecasting errors in these
programs, the government built a “budget margin” into the expenditure
limits. Thus, to the extent economic and budget forecasts turn out to be
accurate or better than expected, the government can increase spending up
to the amounts allowed under the expenditure ceilings.14 Since the
expenditure ceilings have been in place, the economy has outperformed
the forecasts, freeing up additional room for spending.

More recently, the government has proposed spending cuts to remain
beneath the expenditure ceiling. In April 1999, the government proposed
spending cuts for savings of about 7.7 billion kronor in 1999 and nearly
9 billion kronor in 2000.


13
 For example, in 1998, the government incorporated the National Pension Fund’s real estate
holdings, which resulted in an upward adjustment of the financial balance due to
government accounting rules.
14
 If budget or economic forecasts turn out to be overly optimistic, then the government
would presumably be forced to take action to stay within expenditure limits by cutting
spending. There is some additional flexibility to borrow against future year expenditures.




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                      Sweden




                      By remaining committed to the expenditure ceilings, the current debate
                      over surpluses has been limited to debt reduction and/or tax cuts. The
                      fiscal year 2000 budget projects that surpluses will exceed 2 percent of
                      GDP in the year 2000, 1 year prior to the original plan. As a result, the
                      government has proposed tax cuts as part of its fiscal year 2000 budget.
                      Specifically, the government has proposed income tax cuts worth about
                      10 billion kronor in fiscal year 2000 as well as reductions in some property
                      taxes.



Sweden Has Acted to   Like many other western economies, Sweden faces fiscal pressures
                      associated with an aging population. However, Sweden has taken steps to
Address Long-term     address some of these pressures by redesigning the state pension system
Fiscal Pressures      from a pay-as-you-go defined benefit system, to a partially funded, defined
                      contribution system.15 Further, the new system is designed to allow for
                      changes in longevity and economic performance by adjusting benefits
                      accordingly−making it essentially a self-sustaining system. Sweden also
                      provides comprehensive health coverage for its citizens, but the impact of
                      an aging population is unclear.

                      Sweden’s pension reform occurred in large part due to perceptions that the
                      system was unsustainable in the long run and was forecast to run out of
                      money early next century. Debates about Sweden’s pension system have
                      traditionally been separate from budget debates because the system has
                      been “off-budget.” This has been the case even though the pension system
                      has run annual surpluses since its inception. These funds have been
                      invested in several bond and stock funds and as a result have not been
                      available to offset other government spending.



Conclusion            Over the past two decades, Sweden has experienced two periods of budget
                      surpluses, coinciding with its two periods of strong economic growth.
                      During its first period of surplus, Sweden had no clear policy related to
                      sustaining the surplus. Attempts were made to tighten fiscal policy during
                      this period, but political consensus was difficult to reach.




                      15
                       Sweden also provides a basic pension, available to all eligible citizens regardless of
                      earnings, financed out of general revenues.




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Sweden experienced a severe economic downturn in the early 1990s and as
a result has implemented a number of economic, fiscal, and institutional
reforms. Sweden enacted a large deficit reduction program, changed the
role of the central bank and monetary policy, redesigned its budget
process, and reformed its pension system. As a result of these changes, and
an improving economy, the budget has moved back into surplus, debt has
been reduced, and the government has established a goal for surpluses
equal to 2 percent of GDP.




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United Kingdom                                                                                            Appendx
                                                                                                                iI
                                                                                                                V




              The United Kingdom experienced a 4-year period of budget surpluses from
              fiscal years 1987-88 through 1990-91.1 The government’s fiscal strategy
              never called for running surpluses, and the arrival of surpluses was
              unexpected. Once surpluses materialized, the government planned to
              gradually bring the budget back into balance. In accordance with this
              policy of phasing out surpluses and given the economic forecasts at the
              time, the government cut taxes substantially and increased spending. These
              forecasts proved to be overly optimistic and, in the early 1990s, the
              economy slipped into recession. This combination of tax cuts, additional
              spending, and slower growth led to a deterioration in the United Kingdom’s
              fiscal position. Deficits reemerged in fiscal year 1991-92 and grew rapidly
              over the next 2 years, hitting a peak of over 7 percent of GDP in fiscal year
              1993-94. Consistent with the goal of a balanced budget, the Conservative
              government adopted major tax and spending measures to reduce the
              deficit. The combination of these policies−which have been continued
              under the current Labor government−with a strong economy has brought
              the United Kingdom’s budget back into a small surplus position in fiscal
              year 1998-99. (See figure 36.)




              1
               Unless otherwise noted, the term surpluses/deficits refers to the Public Sector Net Cash
              Requirement (PSNCR), formerly known as the Public Sector Borrowing Requirement
              (PSBR). The United Kingdom’s fiscal year runs from April 1 to March 31.




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Figure 36: Surpluses/Deficits in the United Kingdom, 1980-81 to 1998-99




                                          Note: The surplus/deficit measure is the Public Sector Net Cash Requirement (PSNCR).
                                          Source: The United Kingdom Treasury Department.


                                          The Labor government that took office in 1997 developed a new framework
                                          for fiscal policy intended to prevent a return to the kind of severe “boom
                                          and bust” fiscal cycle that occurred in the late 1980s and early 1990s. The
                                          government enacted a statute requiring a Code for Fiscal Stability, which
                                          sets out the framework for developing fiscal strategy. As required by the
                                          Code, the current government has stated that its fiscal policy will be guided
                                          by two rules: (1) the “golden rule,” under which borrowing will not be used
                                          to finance current spending (i.e., total spending excluding investment); and
                                          (2) the “sustainable investment rule,” which promises to keep net public
                                          debt as a share of GDP at a “stable and prudent” level. Both rules are to be



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             applied over the economic cycle, allowing for fiscal fluctuations based on
             current economic conditions. Under these rules, the government’s fiscal
             policy allows for deficits to be used to finance investment spending,
             provided that the debt burden is maintained at a sustainable level.



Background   The United Kingdom is a unitary state composed of England, Scotland,
             Wales, and Northern Ireland. The United Kingdom has two main levels of
             government: the central government and local authorities. The central
             government is the dominant fiscal decision-maker with direct or indirect
             control over most government revenue and spending, while local
             authorities are primarily responsible for service delivery in education,
             housing, and social services.2

             The government is a parliamentary system, with a Parliament composed of
             two chambers−the House of Lords and the House of Commons. The House
             of Lords (approximately 1,300 members) has limited powers in the
             legislative process and virtually no power on budget matters. The House of
             Commons (659 members) is elected and is responsible for the passage of
             legislation and scrutiny of public administration. The government is headed
             by a Prime Minister, who is the leader of the majority party in the House of
             Commons, and an appointed Cabinet of about 20 members, who are also
             Members of Parliament.

             A general election is held at least once every 5 years. Two parties have long
             dominated British politics: the Labor Party and the Conservative Party. The
             current Labor government, headed by Prime Minister Tony Blair, was
             elected in 1997. Labor has a large legislative majority with 415 seats to the
             Conservatives’ 162 seats.3 Prior to Labor’s electoral victory in 1997, the
             Conservatives had held power since 1979. The Conservative governments
             were led by Prime Minister Margaret Thatcher from 1979 to 1990 and Prime
             Minister John Major from 1990 to 1997.




             2
              The Government is in the process of devolving power to Scotland, Wales, and Northern
             Ireland. Powers were officially transferred to the Scottish Parliament and the National
             Assembly for Wales on July 1, 1999. The Northern Ireland Assembly met for the first time on
             July 1, 1998, but the United Kingdom Parliament has not yet transferred power to the
             Assembly.
             3
             The number of seats is as of April 1, 1999.




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The United Kingdom’s      The United Kingdom’s economy is less than 16 percent of the size of the
Economy                   United States’ economy. The United Kingdom is more dependent on trade
                          than the United States, with exports accounting for over 22 percent of GDP
                          in 1996−compared to about 8.5 percent for the United States.

Recent Economic History   Over the past two decades, the United Kingdom has experienced periods of
                          both deep recession and robust growth. After recovering from a major
                          recession between 1979 and 1981, the economy grew at an annual average
                          rate of more than 3 percent in real terms for nearly a decade. Growth was
                          especially robust in the late 1980s. However, inflation, which had fallen
                          significantly from double-digit levels in the early 1980s, began to show
                          signs of rising. During 1988 and 1989, the government responded to the
                          growing inflationary pressure by imposing a series of interest rate hikes. In
                          1990, the economy went into a recession that lasted until 1992. The
                          economy began to recover in the second half of 1992 and has continued to
                          expand since then. (See figure 37.)




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Figure 37: GDP Growth in the United Kingdom, 1980 to 1998




                                         Source: The United Kingdom Office of National Statistics.


                                         The economy often has a powerful impact on a government’s finances. For
                                         example, recessions typically reduce a government’s tax revenues while
                                         increasing spending on programs like unemployment insurance. During the
                                         past two decades, changes in the United Kingdom’s fiscal position have
                                         closely followed the economic cycle. Deficits gave way to surpluses during
                                         the 1980s expansion. Then, with the onset of the recession in the early
                                         1990s, deficits reemerged before steadily declining in tandem with the
                                         sustained economic growth of the mid- to late 1990s.

                                         Controlling inflation has been the chief goal of monetary policy over the
                                         past two decades. Until 1997, monetary policy was under the control of the



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                     government. When the Labor Party assumed power in 1997, it delegated the
                     power to set interest rates to the Bank of England−the United Kingdom’s
                     central bank. Under this system, the Government sets an inflation target
                     that the Bank has to achieve and the Bank’s Monetary Policy Committee
                     decides how to meet the target.


The Budget Process   The governing political party effectively controls the entire budget process.
                     Spending and tax decisions are made primarily within the Treasury.

                     Under the previous Conservative government, the Treasury controlled
                     budget resources by setting targets for total spending and establishing cash
                     limits for specific programs. The broad spending target, known as the
                     Control Total, covered about 85 percent of the budget. It excluded interest,
                     privatization proceeds, and the portion of social security directly affected
                     by the economic cycle (e.g., spending for unemployment compensation).
                     Within the Control Total, specific cash limits were set for individual
                     programs. Spending plans were made for a 3-year period but were reviewed
                     annually. A reserve fund controlled by the Treasury was included in the
                     spending total and departments were allowed to request funds from the
                     reserve to cover program spending in excess of the cash limits.

                     The current Labor government has modified the budget planning process.
                     Under the new system, spending is split into two categories with separate
                     control mechanisms. Each category covers about 50 percent of total
                     spending. The first category is subject to Departmental Expenditure Limits
                     (DELs), which are set for 3 years and, unlike in the previous process, will
                     generally not be reviewed annually. The second category of spending is
                     referred to as Annually-Managed Expenditure (AME) and covers spending
                     that is more difficult to control. Its largest components are social security
                     benefits, interest, and local government expenditure. Spending covered by
                     AME will be subject to annual review and considered as part of total
                     spending for purposes of meeting the government’s fiscal goals. The budget
                     still has an annual reserve, but it is significantly smaller than in the past.
                     This reserve is intended more for emergency spending than as a source of
                     supplemental funds for agencies.

                     Another process change under the Labor government is the greater
                     emphasis given to distinguishing between current and capital spending. For
                     spending that is subject to DELs, there are separate current and capital
                     limits. The government also plans to adopt a form of accrual budgeting,
                     called Resource Accounting and Budgeting (RAB), that the previous



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                            government originally proposed in the mid-1990s. RAB is being adopted to
                            improve the measurement of the costs of government activities and to
                            clarify the distinction between current and capital spending.


Measuring Fiscal Position   Prior to 1998, the main measure of the surplus/deficit was the public sector
                            net cash requirement (PSNCR), referred to at the time as the public sector
                            borrowing requirement (PSBR). The PSNCR includes receipts and
                            expenditures at all levels of government, including privatization proceeds,
                            and is similar to the United States’ unified budget. Privatization proceeds
                            provided an additional source of revenue during the 1980s and part of the
                            1990s. The Conservative governments often presented their fiscal
                            projections with and without privatization proceeds.

                            Under the Labor government, the Treasury has switched to public sector
                            net borrowing (PSNB) as the main overall budget measure.4 PSNB differs
                            from the PSNCR by excluding privatization proceeds and other financial
                            transactions.5 While these measures have varied substantially in the past,
                            Treasury projects that they will be very similar over the next several years,
                            with differences ranging from 0.1 to 0.4 percent of GDP. The PSNB measure
                            is a comprehensive measure of revenue and spending. It includes, for
                            example, local government and capital spending budgets. In 1998, the
                            government changed its budget measurement to conform to the 1995
                            European System of Accounts in order to facilitate comparisons with other
                            European Union countries. The effect of this change was to slightly raise
                            projected PSNB over the 5-year forecast period.

                            In addition to the PSNB measure, the Treasury also emphasizes the
                            “current” surplus/deficit and the public sector net debt to GDP ratio, which
                            are used to assess performance against the golden rule and the sustainable
                            investment rule respectively.6 PSNB is equal to the current surplus/deficit
                            minus net investment spending.7 The public sector net debt to GDP ratio is



                            4
                            Although it is given less emphasis, the PSNCR is still reported.
                            5
                             Other financial transactions include loans made by the public sector and accruals
                            adjustments, which reflect the precise timing of payments.
                            6
                            The net debt measure is net of certain liquid assets.
                            7
                            Net investment excludes depreciation and asset sales.




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                              used to monitor the government’s progress at keeping the debt burden
                              under control.



Fiscal History of the         The United Kingdom experienced persistent budget deficits from the mid-
                              1970s to the mid-1980s. Beginning in 1979 when a new government came to
United Kingdom, 1980s         power, deficit reduction efforts combined with several years of strong
and 1990s                     economic growth led to a 4-year period of surpluses beginning in fiscal year
                              1987-88. The government’s fiscal policy during its surplus period was a
                              gradual return to balance. A recession beginning in 1990 led to a return to
                              budget deficits, which grew quickly, peaking at 7 percent of GDP in fiscal
                              year 1993-94. The government responded with renewed efforts to reduce
                              budget deficits. A new government came to power in 1997 and continued
                              the previous government’s deficit reduction efforts, leading to a small
                              surplus in fiscal year 1998-99. This government has put in place a new
                              framework to guide fiscal decision-making. Under this framework, the
                              government has set as its fiscal policy to increase investment spending
                              without increasing the debt burden.


Deficit Reduction Efforts     From the mid-1970s to the mid-1980s, the United Kingdom experienced a
Plus Strong Economic          period of persistent budget deficits. When Margaret Thatcher’s
                              Conservative government came to power in 1979, it emphasized a
Growth Led to Budget
                              commitment to lower deficits, spending restraint, and a reduced tax
Surpluses in the Late 1980s   burden. After substantial deficit reduction efforts and several years of solid
and Early 1990s               economic growth, the United Kingdom reached surplus in fiscal year
                              1987-88.




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The success of deficit reduction was due primarily to spending restraint,
although increased revenue also contributed. (See figure 38.) During the
decade, annual real growth in total spending averaged 1.3 percent−a
significant drop from the average 1970s level of 3.3 percent. Program
spending was cut in the areas of transportation, trade and industry, and
housing. Investment spending was scaled back significantly, as was the
public sector workforce. The government also reduced its current and
future pension expenditures by changing the indexing of the basic benefit
from wages to prices and cutting future benefits in the earnings-related
pension program. While revenue declined as a share of GDP during the
1980s, increased revenue from tax changes, economic growth,
privatizations, and oil revenue all contributed to the success of deficit
reduction.8




8
For further details on the United Kingdom’s deficit reduction efforts, see Deficit Reduction:
Experiences of Other Nations (GAO/AIMD-95-30, December 13, 1994), pp. 191-215.




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Figure 38: Receipts and Expenditures in the United Kingdom, 1980-81 to 1995-96




                                         Source: United Kingdom Treasury Department.




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                             The economy was growing rapidly when the budget entered surplus−over
                             4 percent per year from 1986 through 1988. According to recent estimates,
                             this growth caused the United Kingdom’s economy to exceed the level of
                             output estimated to be consistent with stable inflation. The United
                             Kingdom was experiencing an economic boom. Wages and salaries were
                             growing rapidly, housing prices were soaring, and personal savings were
                             declining. These factors helped drive substantial growth in consumption.
                             Imports also increased at a fast pace, propelling the trade balance into
                             deficit.9


Government Aimed to          When the first surplus materialized, the government adjusted its fiscal
Gradually Phase Out Budget   strategy from a focus on deficit reduction to attempting to gradually phase
                             out surpluses. For example, in the 1988-89 budget, the first budget prepared
Surpluses
                             during the surplus period, the government adopted a goal of balancing the
                             budget over the medium term, which meant phasing out the surplus. The
                             government explained its goal as follows: “[A balanced budget] is a prudent
                             and cautious level and can be maintained over the medium term. It also
                             provides a clear and simple rule, with a good historical pedigree.”

                             The fiscal year 1988-89 budget projected that after a small surplus in 1988-
                             89, the medium-term goal of balance would be reached in the following
                             year and maintained over the rest of the forecast horizon.10 However, the
                             1988-89 surplus turned out to be much larger than expected, and in the
                             fiscal year 1989-90 budget the government anticipated a more gradual
                             elimination of surpluses over several years. However, as the economy
                             slowed and slipped into recession, the surplus decreased more rapidly than
                             expected. Beginning with the 1989-90 budget, the Treasury’s estimates were
                             consistently too optimistic. (See figure 39.) By fiscal year 1990-91, the
                             budget had returned to approximate balance, and deficits reemerged the
                             following year.




                             9
                             The trade balance is a measure of the difference between a nation’s exports and imports.
                             10
                               During the late 1980s, the forecast period was 4 years--the budget year plus 3 years. In the
                             fiscal year 1992-93 budget, the Conservative government extended its forecast period to
                             5 years--the budget year plus 4 years. The Labor government uses this same forecast period.




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Figure 39: Projected Surpluses/Deficits and Actual Results in the United Kingdom, 1986-87 to 1993-94




                                          Note: Surplus/deficit measure is the public sector net cash requirement.
                                          Source: United Kingdom Treasury Department.


                                          Because of the government’s policy to return to balance, the political
                                          debate during the surplus period focused not on whether to run surpluses
                                          but on how to use extra resources for new policy initiatives. The opposition
                                          Labor Party favored more spending on health and social services. However,
                                          the government chose to cut taxes significantly while also allowing for
                                          some increased spending. The government’s spending increases were
                                          allocated for priority areas such as health, law and order, defense,
                                          education, roads, and the disabled. In general, however, spending was
                                          decreasing as a percent of GDP−from about 41 percent in fiscal year
                                          1987-88 to about 39 percent in 1990-91. These policy changes in the late
                                          1980s supported the government’s goal of phasing out budget surpluses,
                                          but they also contributed to the large deficits that unexpectedly emerged in
                                          the early 1990s. The following is a year-by-year summary of the major
                                          budget actions during the United Kingdom’s surplus era.




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Fiscal Year 1988-89 Budget   Tax-cutting was an important priority for Prime Minister Thatcher’s
                             government, and it continued to dominate the fiscal agenda during the
                             surplus period of the late 1980s. The fiscal year 1988-89 budget introduced
                             tax cuts with a first-year impact of about £4 billion, around 1 percent of
                             GDP.11 The tax cut package mainly consisted of reductions in personal
                             income taxes with a cut in the lowest marginal rate from 27 percent to
                             25 percent and in the top rates to a maximum of 40 percent.

                             The budget clearly spelled out the expected impact of tax cuts on the
                             government’s fiscal position. The budget estimated that the surplus would
                             be about £7 billion for fiscal year 1988-89 without the tax cuts and about
                             £3 billion in 1988-89 with them. The government explained the remaining
                             surplus by saying it could have chosen to cut taxes by a larger amount, but
                             that because of its gradualist approach to fiscal policy, “only part of [the]
                             room for tax reductions has been used.”12

                             On the spending side of the budget, the government’s main goal throughout
                             the 1980s and 1990s was to reduce total spending as a share of GDP. Since
                             the early 1980s, spending as a share of GDP had fallen substantially and the
                             1988-89 budget supported a continuation of this trend, referring to
                             continued spending restraint as “a vital element of the government’s
                             economic strategy.” Real (inflation-adjusted) spending−excluding
                             privatization proceeds−was projected to grow by less than 1 percent per
                             year from fiscal years 1986-87 through 1990-91.13 At the same time, the
                             budget provided some increased spending for priority services such as
                             health, law and order, defense, education, and capital investment. These
                             increases could be made while meeting the government’s objective of
                             reducing spending as a share of GDP in part because, as GDP expanded
                             rapidly, reduced interest payments on the debt helped restrain spending
                             growth.




                             11
                              The data on tax changes presented in this appendix are measured against an indexed tax
                             base. The tax system in the United Kingdom is automatically indexed for inflation each year
                             unless Parliament decides differently.
                             12
                                  Financial Statement and Budget Report 1988-89, HM Treasury (United Kingdom), p. 11.
                             13
                              Privatization proceeds are treated as negative spending; therefore, these proceeds reduce
                             total spending.




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Fiscal Year 1989-90 Budget   The fiscal year 1989-90 budget was prepared during what, in retrospect,
                             turned out to be the high water mark of the surplus period. The 1988-89
                             surplus came in at about 3 percent of GDP−compared to a projected
                             borrowing requirement of 1 percent of GDP. This surprising fiscal
                             performance can be explained by 3 main factors: (1) a strong economy that
                             resulted in rapid revenue growth and lower spending for income support
                             programs, (2) higher-than-expected inflation, which also boosted
                             revenues,14 and (3) a high volume of privatization proceeds. This favorable
                             position suggested to policymakers that surpluses were more persistent
                             than earlier anticipated, and they budgeted accordingly. While the overall
                             goal of phasing out the surplus and balancing the budget remained the
                             same, the 1989-90 budget projected a surplus of similar size to the previous
                             year−about 3 percent of GDP−with smaller surpluses through the 1992-93
                             fiscal year.

                             Budget plans for the 1989-90 fiscal year were consistent with the
                             government’s goals of cutting taxes and reducing spending as a share of
                             GDP. The main tax changes were cuts in National Insurance Contributions
                             and, for that year, non-indexation of most excise taxes.15 The total tax
                             package was estimated to cost about £2 billion in the first year, about
                             0.5 percentage points of GDP. Spending plans again called for restraint,
                             with the budget projecting a continuing decline in spending as a percentage
                             of the economy.

Fiscal Year 1990-91 Budget   The actual fiscal year 1989-90 surplus was only 1.4 percent of GDP−roughly
                             half as large as anticipated. While the economy had already begun to slow
                             in 1989, this was not a major driver of the smaller surplus since revenue
                             collections, particularly for corporate taxes, are subject to a time lag.
                             Rather, the shrinking surplus stemmed from lower privatization proceeds,
                             higher capital spending by local authorities, and a greater number of people
                             switching to private pensions than expected, which reduced National
                             Insurance Contributions.16



                             14
                               Even in indexed tax systems, higher inflation produces more tax revenue because it
                             increases the size of taxable incomes.
                             15
                              The National Insurance Contribution is a payroll tax that covers a variety of social
                             programs, including public pensions.
                             16
                              Under the government’s 1986 pension reform, workers who switch from the public pension
                             system to a private plan receive a rebate of part of their National Insurance Contribution.




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                           The fiscal year 1990-91 surplus was projected to be about 1.3 percent of
                           GDP, approximately the same size as the fiscal year 1989-90 surplus.
                           Compared to the prior two budgets, tax initiatives were relatively modest
                           and were projected to result in a net increase in revenues. Spending was
                           expected to grow at the same rate as the economy, with additional
                           resources for priority areas such as health, transportation, the disabled,
                           and lower income families. For fiscal year 1991-92, a smaller surplus was
                           projected followed by balanced budgets in the last 2 years of the forecast
                           horizon. However, with the slower growth of 1989 turning into a recession
                           in 1990, the actual result for fiscal year 1990-91 was a small surplus,
                           marking the end of the surplus period.

                           The United Kingdom’s period of surpluses substantially reduced the
                           nation’s debt both in nominal terms and as a share of GDP. Over the 3 years
                           from fiscal years 1986-87 through 1989-90, the debt declined from
                           £172 billion to £150 billion, and the debt to GDP ratio dropped from over
                           40 percent to less than 30 percent. Along with the declining debt burden,
                           the government’s interest expenditures as a share of total spending fell
                           from 11 percent to 9 percent.


Large Deficits Appear in   By the time the fiscal year 1991-92 budget was released, the economy was
Early 1990s                clearly in recession, and it was apparent that deficits were back on the
                           horizon. The government retained its goal of a balanced budget over the
                           medium term, but now it estimated that this goal would not be reached
                           again until fiscal year 1994-95, the last year of the projection period. Actual
                           deficits over the next several years were much higher than the Treasury’s
                           estimates, peaking at more than 7 percent of GDP in fiscal year 1993-94,
                           and the budget did not return to balance until near the end of the decade. In
                           the 1993-94 budget, the government acknowledged the worsening situation
                           by projecting that it would not reach a balanced budget within the forecast
                           period.




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                                 Policy decisions interacted with the recession to fuel rising deficits. A
                                 Treasury analysis of spending from fiscal year 1988-89 to 1992-93 found that
                                 policy initiatives were a significant factor in explaining a substantial
                                 increase in real program spending over the period. For example, the
                                 1991-92 budget contained cuts in corporate taxes and the 1992-93 budget
                                 cut the basic rate of income tax on a portion of taxable income. On the
                                 spending side, the 1991-92 budget increased the child benefit, which had
                                 been frozen for 4 years, and reestablished a policy of indexing the benefit
                                 to inflation. The fiscal year 1992-93 budget provided increased spending for
                                 health care and transportation. A number of officials and experts that we
                                 interviewed attributed the loosening in fiscal policy in 1991 and early 1992
                                 at least in part to the upcoming general election.17 A statistical analysis
                                 conducted by a British think tank on spending during the period is
                                 consistent with this interpretation.

Economic Estimates Presented a   To explain the deteriorating situation in the early 1990s, it is useful to start
Misleading Picture of Fiscal     with the perceptions of fiscal strength in the late 1980s. The surpluses of
Strength                         the late 1980s provided a misleading picture of the United Kingdom’s fiscal
                                 condition. With the benefit of hindsight, fiscal analysts and policymakers
                                 with whom we spoke in the United Kingdom generally agree that the
                                 budget surpluses were largely due to the strength of the economy during
                                 what turned out to be the peak period of the business cycle. The Treasury
                                 now estimates that when the United Kingdom realized a surplus of
                                 3 percent of GDP in fiscal year 1988-89−its largest of the period−the
                                 structural budget was only modestly in surplus. (See figure 40.)




                                 17
                                  The Conservative government under Prime Minister John Major was reelected in April
                                 1992.




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Figure 40: Actual and Structural Surpluses/Deficits in the United Kingdom, 1986-87 to 1998-99




                                          Note: Surplus/deficit measure is the public sector net cash requirement.
                                          Source: The United Kingdom Treasury Department.


                                          While the Treasury did produce structural budget estimates in the late
                                          1980s, these estimates were not a major focus of fiscal policy
                                          decision-making. Officials told us that policymakers did not really
                                          distinguish between cyclical and structural results; instead, they tended to
                                          believe that “a surplus is a surplus.” However, even if structural estimates
                                          had been taken more seriously, they might not have helped much because
                                          the estimates made at that time were off the mark. The Treasury, along with
                                          some independent analysts at the time, underestimated the extent to which



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                                         the economy was growing above its trend level. So, according to the
                                         projections of the time, it was believed that the United Kingdom’s economy
                                         could continue growing steadily without generating an increase in inflation.
                                         This forecasting error was a major reason why, beginning in the late 1980s,
                                         the Treasury’s budget forecasts proved overly optimistic. For example, the
                                         Treasury’s estimates of real economic growth were consistently too high
                                         during the late 1980s and early 1990s. (See figure 41.)



Figure 41: Projections of Real GDP Compared to Actual Results in the United Kingdom, 1988 to 1994




                                         Source: The United Kingdom Treasury Department.


Policy Choices Contributed to            In general, policymakers overestimated the strength of the government’s
Renewed Deficits                         finances. The Conservative government assumed that the surpluses in the
                                         late 1980s largely reflected a structural improvement driven by sustainable
                                         economic growth. This assumption may have contributed to the decision to
                                         enact significant tax cuts. With hindsight, analysts contend that this
                                         decision turned out to be an inappropriate loosening of fiscal policy.



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                                 Treasury now estimates that the fiscal year 1988-89 budget with its
                                 substantial tax cuts contributed to a significant increase in the structural
                                 deficit.

                                 In the early 1990s, increased spending also contributed to a rising
                                 structural deficit. In an analysis conducted at that time, the Treasury
                                 concluded that, from fiscal years 1988-89 through 1992-93, spending growth
                                 rose substantially for most programs. Total program spending grew at an
                                 annual average rate of 3.8 percent during this period compared to less than
                                 1 percent for the previous 6 years. The analysis concluded that policy
                                 choices contributed to this growth over and above the impact of the
                                 recession. For example, average real growth in health spending of
                                 4.3 percent during this period reflected policymakers’ response to rising
                                 public demand for services. In addition, the government increased
                                 transportation spending by nearly 10 percent per year in real terms, partly
                                 to alleviate road congestion and finance other major investment projects.

The Economy’s Impact on Fiscal   While policy decisions clearly contributed to the growing deficits, the
Position                         recession was also a major factor. Estimates of its impact vary. Data from a
                                 recent Treasury analysis suggest that the economic cycle was responsible
                                 for a little more than 50 percent of the deterioration, with policy choices
                                 accounting for the rest. Two earlier studies by other analysts reached
                                 similar conclusions. However, in its 1994 survey of the United Kingdom, the
                                 Organization for Economic Cooperation and Development (OECD)
                                 estimated that the economy was responsible for about two-thirds of the
                                 weakening in the fiscal position.

Privatization Proceeds Also      Privatization proceeds also had a noticeable effect on the United Kingdom’s
Affected Fiscal Position         fiscal position during the late 1980s and early 1990s. Revenue from
                                 privatization (which was counted in the budget as negative spending)
                                 peaked as a share of the economy in fiscal year 1988-89 at about
                                 1.5 percent, dipped in fiscal years 1989-90 and 1990-91, rose substantially in
                                 fiscal year 1991-92 and then began to decline. Given this path, privatization
                                 proceeds did contribute significantly to the period of surpluses but were
                                 only a minor factor in explaining the rising deficits of the early to mid-
                                 1990s. Although the government recognized the one-time nature of
                                 privatization by showing its expenditure projections with and without
                                 privatization proceeds, its fiscal target of a balanced budget included such
                                 proceeds.




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Deficit Reduction in the    The government responded to the rising deficits of the early 1990s by
Mid- to Late 1990s          increasing taxes and restraining spending growth. This policy of fiscal
                            restraint was continued by the Labor government elected in April 1997.
                            These efforts have succeeded−the deficit has fallen in every fiscal year
                            since 1993-94–and the budget is now approximately in balance. During this
                            period, revenue as a share of GDP rose by over 3 percentage points while
                            spending declined by over 4 percentage points.18 An OECD analysis
                            concluded that the United Kingdom’s fiscal progress between 1993 and
                            1997 is “among the most impressive” of the OECD’s member countries.19

                            The major deficit reduction efforts began with the fiscal year 1993-94 and
                            1994-95 budgets. Both budgets included significant revenue raising actions,
                            including a freeze on income tax allowances, increased excise taxes, and
                            restrictions on mortgage interest relief. These actions are estimated to have
                            raised revenues by more than 2 percent of GDP. Since taking power in 1997,
                            the current government has also raised taxes.

                            Along with tax increases, the budgets of the mid-1990s contained
                            substantial spending restraint. Major reductions initiated in these budgets
                            included a freeze on departmental operating costs (including salaries) and
                            cutbacks in defense and housing programs. Capital investment and health
                            care have also been subject to significant spending restraint. While
                            continuing this policy of keeping total spending in check, the Labor
                            government has pledged to significantly increase spending on capital
                            investment and health care.


The Current Government’s    The current government has developed a new framework for fiscal policy
Fiscal Policy Is Based on   that reflects “lessons learned” from the United Kingdom’s past
                            experiences.20 The fiscal strategy emphasizes a greater focus on the
Lessons From Past
                            structural budget, a more explicit distinction between current and capital
Experiences                 spending, and firm multi-year spending ceilings that will not be subject to
                            annual review. The Labor government has also stressed transparency and


                            18
                                 These changes are based on data that exclude financial transactions.
                            19
                                 OECD Economic Surveys: United Kingdom, 1998, p. 49.
                            20
                             The new monetary policy framework is also an important part of the Labor government’s
                            overall economic strategy. Giving control of interest rates to the Bank of England is
                            expected to improve the prospects for keeping inflation in check and preventing sudden and
                            rapid adjustments in interest rates.




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                                    openness so that the public can easily evaluate the government’s goals and
                                    its progress in meeting them. During the 1997 election, Labor emphasized
                                    its commitment to a prudent fiscal policy by adopting the Conservatives’
                                    spending targets for the first 2 years of the new Parliament and pledging
                                    not to raise either the basic or top income tax rate throughout the full
                                    Parliamentary term. However, the Labor government does not currently
                                    call for surpluses as part of its fiscal policy.

Labor’s Code for Fiscal Stability   Labor has established a statutory basis for its fiscal policy approach with a
                                    new law requiring the government to issue a Code for Fiscal Stability. The
                                    law’s purpose is to make fiscal decision-making more transparent and
                                    enhance accountability by requiring the government to present a fiscal
                                    strategy and meet certain reporting requirements. The statute itself is very
                                    general, allowing the incumbent government wide discretion in developing
                                    a specific fiscal strategy. The statute lays out 5 principles to guide fiscal
                                    policy: transparency, stability, responsibility, fairness, and efficiency. The
                                    statute also requires the issuance of several reports with details of the
                                    government’s fiscal plans.

                                    The current Labor government’s fiscal strategy is guided by two rules:
                                    (1) the “golden rule,” under which borrowing will not be used to finance
                                    current spending (i.e., total spending excluding investment); and (2) the
                                    “sustainable investment rule,” which promises to keep net public debt as a
                                    share of GDP at a “stable and prudent” level. Both rules are to be applied
                                    over the economic cycle, allowing for fiscal fluctuations based on current
                                    economic conditions.

                                    The golden rule is intended to ensure control of public finances while
                                    allowing for deficit financing of capital investment, net of depreciation and
                                    asset sales. The government defines investment as “physical investment
                                    and grants in support of capital spending by the private sector.”21
                                    Investment spending was significantly restrained under the Conservative
                                    government’s deficit reduction efforts, and several people that we
                                    interviewed agree that investment needs to be increased. The Labor
                                    government has made boosting public investment a major priority,
                                    proposing to nearly double it as a share of the economy−to 1.5 percent of
                                    GDP−over the course of the current Parliament. A Treasury official told us



                                    21
                                     Fiscal Policy: current and capital spending, HM Treasury (United Kingdom), 1998, p. 7,
                                    footnote 2.




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that this increase has been viewed as roughly the amount needed to cover
the underfunding of capital over the past several years.

While investment spending is a priority, the sustainable investment rule is
intended to ensure that financing such spending does not result in an
imprudent rise in debt. According to a Treasury official, the government’s
debt to GDP target of less than 40 percent was chosen based on analysis
showing that a net debt to GDP ratio of around 40 percent is sustainable in
the long term. The government has indicated that, other things being equal,
it is desirable to reduce public sector net debt to below 40 percent.

Taking both fiscal rules into account, the Labor government’s overall fiscal
policy allows for running small budget deficits. In its fiscal year 1999-2000
budget, the Treasury estimated that the United Kingdom would register a
small surplus for public sector borrowing in fiscal year 1998-99, and it
projected small deficits for the next 5 years.

To help meet its fiscal objectives, the Labor government has completed a
comprehensive assessment of existing programs with plans to conduct
similar reviews every 3 years. This review process is designed to align
existing programs with the government’s priorities and generate ways to
improve efficiency. Results of the first review were published in the
summer of 1998. Based on the results, the government has targeted real
growth in current spending at 2.25 percent per year over the remainder of
Parliament’s term; the review also called for net investment to double as a
share of GDP. Within the spending total, the government has set 3-year
ceilings for each department with separate ceilings for capital and current
spending.22

The current government’s fiscal policies have been popular but not without
controversy. For example, Conservative Party officials we met with
worried that under the golden rule it would be easy for the government to
redefine capital spending in order to meet the rule. In addition, they believe
that allowing for borrowing for capital investment is not always prudent
because the financial return on government investments is questionable.
The Conservative Party officials also said the current government ought to
aim to repay or reduce the debt as a percentage of GDP. The officials then



22
 As noted earlier, the 3-year limits apply to about half of total spending. The other half of
spending is reviewed annually.




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                             added that the Conservatives’ objective would be to balance the budget
                             over the cycle and bring down the debt as a percentage of GDP.

Incorporating the Economic   A sharper focus on the economic cycle is a general feature of the Labor
Cycle Into Fiscal Planning   government’s policy that explicitly reflects the lessons learned from the
                             past. A recent Treasury report explains the importance of taking the cycle
                             into account.

                             “Experience has shown that serious mistakes can occur if purely cyclical improvements in
                             the public finances are treated as if they represented structural improvements, or if a
                             structural deterioration is thought to be merely a cyclical effect. The Government therefore
                             pays particular attention to cyclically-adjusted indicators of the public sector accounts.”23

                             Incorporating the effects of the economic cycle into policy planning
                             requires an estimate of several key variables, including the actual and trend
                             levels of GDP and the trend rate of GDP growth. Trend growth is an
                             estimate of the maximum rate at which an economy can grow over the long
                             term without causing inflationary pressure. Actual and trend growth
                             estimates are used to prepare an estimate of the structural budget
                             deficit/surplus, i.e., the underlying condition of the budget adjusting for the
                             effects of the economic cycle. In the past, the Treasury did prepare
                             estimates of the structural budget position, but it did not publish this
                             information. As part of the Labor government’s commitment to greater
                             openness, the Treasury now publishes structural estimates. The Treasury
                             cautions that while all economic and budget projections are subject to
                             large errors, estimates of the structural position are even more tenuous.

                             The government states that it uses a cautious assumption for trend
                             economic growth of 2.25 percent in its budget formulation. To obtain an
                             independent review, the government asked the National Audit Office
                             (NAO) to evaluate the trend growth assumption.24 The NAO concluded that
                             the Treasury’s assumption for trend growth was reasonable. For an
                             additional degree of caution in its structural estimates, the Treasury also
                             presents a more pessimistic projection. This projection assumes that the
                             economy is further above trend output than in the main estimate, meaning



                             23
                              Stability and Investment for the Long Term: The Economic and Fiscal Strategy Report
                             1998, HM Treasury (United Kingdom), June 1998, p. 45.
                             24
                              The government also asked the NAO to review several other assumptions, including the
                             unemployment rate and the proportion of national income generated by capital and labor.




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                       that future growth will likely be lower as the economy returns to the
                       underlying trend.



The United Kingdom’s   The population of the United Kingdom is aging, although at a slower rate
                       than other major industrial countries. Due to the post-World War II baby
Long-term Outlook      boom and increases in life expectancy, the ratio of workers to retirees in
                       the United Kingdom is projected to drop from over 3 to closer to 2 between
                       1998 and 2040. While several analysts that we interviewed expressed some
                       concern about population aging, they were fairly sanguine about its likely
                       impact on the government’s fiscal situation, especially when compared to
                       the outlook for other nations. While one factor in the United Kingdom’s
                       comparatively better outlook is slower population aging, another important
                       reason is the major pension reforms enacted over the past two decades.
                       These reforms have significantly reduced the government’s future
                       commitments.

                       While pension spending appears to be under control, population aging is
                       expected to increase pressure on health care spending in the future.
                       According to a Treasury analysis, demographic factors could add about
                       0.7 percentage points to the annual growth rate of public health spending,
                       which accounted for about 5.7 percent of GDP in 1997, over the next three
                       decades. However, analysts we interviewed from the United Kingdom’s
                       National Health Service told us that they consider population aging to be a
                       less significant source of future cost pressure than improved technology
                       and public expectations.

                       The current Labor government has acknowledged the need to use a
                       long-term fiscal outlook to evaluate the sustainability of future policy and
                       consider intergenerational equity. Specifically, the Code for Fiscal Stability
                       requires the government to publish budget projections for a period of at
                       least 10 years. In the March 1999 budget, the Treasury published 30-year
                       projections that show that current policy is sustainable under their main
                       assumptions. It is important to note, however, that the government has
                       recently announced several policies−such as welfare, pension, and labor
                       market reforms−to help ensure the sustainability of public finances in the
                       long term. In addition to its own long-term analysis, the Treasury is
                       supporting research on generational accounts that is being conducted by
                       the independent National Institute of Social and Economic Research.




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Conclusion   The United Kingdom experienced a period of budget surpluses in the late
             1980s and early 1990s that was largely the product of a booming economy.
             Upon achieving surplus, the United Kingdom’s fiscal strategy was to return
             to a balanced budget over the medium term. Influenced by overly
             optimistic budget projections, the Conservative government in power at
             that time chose to cut taxes substantially and increase spending as part of a
             strategy of phasing out budget surpluses. As the British economy slipped
             into recession in the early 1990s, the fiscal situation deteriorated rapidly
             and large deficits emerged. These deficits resulted from both the recession
             and policy choices made during the period. With the benefit of hindsight,
             the current Labor government focuses more on the budget’s structural
             position to adjust for the impact of the economic cycle. The Treasury now
             publishes estimates of the budget’s structural position and includes a
             pessimistic projection along with its baseline forecast to help convey a
             sense of the risks involved if budget forecasts prove overly optimistic. The
             United Kingdom achieved a small budget surplus in fiscal year 1998-99 due
             to deficit reduction efforts and a strong economy. The government’s main
             fiscal policy is to maintain its net debt to GDP ratio at a “stable and
             prudent” level, allowing for some borrowing to finance capital investments.




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Appendix VII

GAO Contacts and Staff Acknowledgements                                                              Appendx
                                                                                                           iI
                                                                                                           V




GAO Contacts           Thomas M. James, (202) 512-2996
                       Bryon Gordon, (202) 512-9207



Acknowledgments        In addition to those named above, Andrew Eschtruth, Mindy Frankfurter,
                       Richard Krashevski, and Tuyet Quan Thai made key contributions to this
                       report.




(935264)       Leter   Page 207                       GAO/AIMD-00-23 Budget Surpluses in Other Nations
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