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Senior Cabinet Minister Steven Joyce, who last year described Novopay as "a dog" today said a Government-owned company would assume management of the system from Australian company Talent2 from October this year.
He said "pretty good progress" had been made in recent months to fix the system which has been plagued with problems including large numbers of over and under payments to teachers since it was introduced in 2012.
However remaining issues prompted contractual issues in recent weeks and Talent2 had not been prepared to provide extra resources necessary for further development of the system.
It had become clear "that the best outcome would be a change in the provider relationship".
Opposition parties seized on today's announcement as yet another admission from the Government that the system had been a costly disaster, but Mr Key defended the decision.
"If you look forward, the sector will take quite a lot of confidence that effectively the Government is taking over the programme and the project. They'll know it will be properly resourced and properly looked after."
When reminded that Mr Joyce had called it a dog he said, "Yeah but I think it's come a long way since then".
"It's actually fundamentally operating pretty well. This is a very complex sector there's a lot of different pay scales for teachers, it's not an easy thing. But the Government has stabilised it and got it working reasonably effectively and I think a lot of teachers will say thank goodness the Government now has some control over the process."
He said it was possible to make the argument the Government should have assumed control earlier, "and hindsight's a wonderful thing".
However the Government had now made "the right call" over the system which he said was originally signed up to by the previous Labour Government.
President of the New Zealand Principals' Federation Philip Harding said his members were encouraged that Talent2 had withdrawn from managing the system, but warned "there is a long way to go before principals will have any confidence in the system".
"The announcement does not cure the Novopay shambles that the sector has been battling for the last three years.
"The same challenges of random errors, frustratingly slow problem resolution, inaccurate personnel data, and significantly increased workload will continue," he said.
"Success will be determined by the way the new entity is managed, and more importantly, resourced to deal to these priorities."
Meanwhile, Mr Joyce earlier confirmed Talent2 will pay the Ministry of Education between $18 million and $22 million including $7m cash and other considerations such as license to use the core software by way of a settlement.
That sum was set against the $45 million the Government had paid to address the problems with the system. Overall Novopay had cost $110 million to date.
Mr Joyce said the agreement for the Government to take over should"not necessarily be seen as failure on anyone's part any more than it had been".
It was, he said, "the next logical step".
"This decision has been made in the best interests of all parties -- staff administrators, schools and the Government."
Talent2 said the "mutual agreement" settled a "flawed contractual arrangement" between itself and the Ministry of Education.
"This change allows Talent2 to better focus resources and investment on its core payroll business and broader New Zealand client base."
Labour's education spokesman Chris Hipkins said the announcement today would be "cold comfort to teachers and school staff still struggling with Novopay" and Talent2 was "dropping a hot potato in the taxpayer's lap".
"Goodness knows how much more [money] will be shovelled down this black hole before the problems are finally fixed."
He questioned why Education Minister Hekia Parata signed off on the system and why it had taken Mr Joyce so long "to finally decide to take action".
"Teachers and school staff have waited long enough for Novopay to be fixed. It has taken up their valuable teaching time, as well as hours and hours of school administration. Students and parents have also paid the price for this ongoing uncertainty."
NZ First education spokeswoman Tracey Martin said Mr Joyce had "admitted defeat" in cutting Talent2 loose.
"Mr Joyce cannot fix a system that National got so wrong in the first place, and has wasted tens of millions of taxpayers' dollars on."
- By Adam Bennett of the New Zealand Herald