Tax Cuts, Inflation, Saving: Confusion Piled High

Please find attached an article that appeared in the Otago Daily Times on Friday 9 February.

Tax Cuts, Inflation and Saving: Confusion Piled High

Finance minister Michael Cullen argues against significant tax reductions on the grounds that they would be inflationary.

In response, some have suggested that tax cuts could be quarantined by channelling them into savings through the KiwiSaver scheme, so reducing demand and inflation pressures.

This would be to compound one economic error with another.

Responsible tax reform should not be inflationary.

First, if tax reductions were largely offset by reductions in government spending, there would be no adverse implications for demand and inflationary pressures.

Secondly, likely tax cuts would only represent a small proportion of the economy.

In recent years the government has allocated around $2 billion for new spending or tax reductions. Instead of offsetting tax reductions with spending cuts, suppose that allowance were split 50:50 between the two (the government has talked of the business tax package costing around 1 billion).

Currently the size of the economy is around $160 billion. So tax cuts of the order of $1 billion would represent only around 0.6 percent of the economy – hardly an amount likely to cause overheating.

Moreover, tax cuts of $1 billion would be less of a threat to inflation than spending increases of $1 billion because part of them would be saved. The proportion saved could be expected to be higher if they were focused mainly on reductions to the 39 and 33 percent tax rates, as the Treasury has recommended.

Thirdly, the argument assumes that firms would respond to an increase in demand by raising prices. However, competition in New Zealand has increased substantially in recent decades. The days of blanket import protection are over. Firms that face competition from imports can’t easily raise prices. The prices of exportable goods and services are also fundamentally set in world markets. Imports and exports are now a significant share of the economy. Statistics New Zealand estimates that the tradables component of the CPI is 46 percent. Therefore tax cuts could at most have an impact on 54 percent of the CPI (making the reasonable assumption that they would have no significant effect on the exchange rate).

Fourthly, and most importantly, inflation – which is an ongoing increase in the price level – is a monetary issue, not a fiscal policy issue. A one-off increase in the price level is not inflationary unless the Reserve Bank prints money. It alone is responsible for controlling the money supply and thereby inflation. Inflation is not the fault of home buyers, businesses or unions.

The United States and Australia are two countries that have cut taxes in recent years while keeping inflation low. In 2005 the governor of the Reserve Bank of Australia stated that despite four rounds of tax cuts since 2000, “Fiscal policy has not been a significant influence on monetary policy at all in Australia for the last six or seven years. Whilst ever there are not big swings in the fiscal position in either direction it has not been a factor that we have really had to take into account in our monetary policy.”

If the argument that tax cuts cause inflation were valid, we would presumably hear calls for tax increases to take pressure off interest rates. Such calls are notable for their absence.

The simplistic idea that tax cuts boost demand (ie spending in the economy) and hence inflation reflects outdated Keynesian economics. (Paradoxically, Keynes was worried about too much saving – the last thing he would have wanted was to channel tax cuts into compulsory savings arrangements.)

It also overlooks their effect on the supply side of the economy. Growth-oriented tax cuts increase the speed limit of the economy, allowing faster non-inflationary growth. Cuts in personal and company tax would reduce wage and cost pressures and increase investment, so easing capacity constraints.

It is odd to hear the argument that tax cuts are inflationary when back in the 1980s they were regarded as deflationary. Governments in both Australia and New Zealand were promoting so-called ‘wage-tax trade-offs’ – reductions in taxes to reduce the need for wage increases and thereby inflationary pressures.

A sound programme of tax reform would involve a phasing of reductions over a few years. Such an approach would not be inflationary. It follows that there is no case for denying people the opportunity to use tax reductions as they wish, and to attempt to force people to put them into savings.

How people decide between present consumption and savings (consumption in the future) is not the government’s business. People’s circumstances vary greatly. New Zealanders are not poor savers; KiwiSaver is a cumbersome solution to a non-problem.

The government should stop over-taxing productive New Zealanders (our tax-to-GDP ratio is now nearly as high as Germany’s), constrain spending and regulation to make the Reserve Bank’s job easier, cut taxes and leave people freer to decide what to do with their own money.

Roger Kerr is the executive director of the New Zealand Business Roundtable

ENDS

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