Are tax cuts inflationary?

The latest excuse from the government for not giving us tax cuts (despite an $8 billion surplus) is the fear of inflation. But do tax cuts really cause inflation?

The short answer is it depends on how you pay for them. Fundamentally, inflation is caused by an increase in the money supply without a corresponding increase in the supply of goods and services. This means prices go up and your money buys less. Therefore tax cuts can be inflationary if the government decides to print a whole bunch of money to pay for them, but no-one is seriously suggesting that.

Every year the government’s tax revenue keeps increasing, which gives them different options for how to use the money. The important point about tax cuts is that they are actually less inflationary than government spending, for a variety of reasons.

Most government spending is on ‘non-traded’ goods and services, which means domestic goods for which there is little competition. Things like electricity, hospital services, tertiary education and local rates have all been key drivers in pushing up inflation, which is why the Reserve Bank has been so concerned about government spending.

By contrast, if you give the same amount of money away as tax cuts then not all of the money will be spent. Some will be saved or invested or used to pay off debt, especially if the top rates of tax are reduced. Compare this to government spending which is, by definition, spent – all 100% of it.

Tax cuts may still stimulate demand, but the flipside is that they can also increase the supply side of the economy at the same time, which reduces inflationary pressure. Lower tax makes it more rewarding for people to enter the workforce and/or work extra hours, more rewarding to invest in new machinery and technology, and reduces wage pressures on firms. All of this helps the economy grow faster and more sustainably.

This is particularly the case with the proposed Australian tax cuts. Both the Liberal and Labour parties are extending the tax-free threshold, with the aim of encouraging women and semi-retired people to enter the workforce.

Core government spending in New Zealand is now $20 billion a year higher than it was on 2000. Therefore it’s surprising to hear Dr Cullen so worried about the impact of even $1 billion of tax cuts, when he has presided over a spend-up of this magnitude.

In short, tax cuts are less inflationary than government spending because they shift spending from the public sector to the private, and individuals tend to use the money in more productive ways than politicians.

It’s worth pointing out here that increasing spending and giving tax cuts (say through extra borrowing) would probably be inflationary, because it would increase the overall money supply. This seems to be the policy of the National Party, and while there are good arguments in favour of this (it is quite sensible to borrow for capital spending rather than using cash) it would be preferable if they took a stronger line on controlling the growth of government spending instead.

This brings us to another myth about tax cuts – that they require cuts in government services. In reality, all you have to do is keep spending at the same level (or even allow small increases) and a massive amount of money soon becomes available for tax cuts.

Here is one example that Labour or National could adopt. Next year the budget has $3 billion set aside for ‘new operating initiatives’, which is likely to involve a big election-year spend-up. Instead of spending it all though, we could cut the top two rates on income tax to 30% (down from 39% and 33%) and lower the middle rate to just 18%. This would mean:

• A person on the average wage ($46,000) would save nearly $1000 a year in tax.

• A boost to New Zealand’s growth and productivity by encouraging work, investment, saving and paying off debt.

• Lower inflationary pressure.

• It would help us attract workers and compete with Australia.

• And we wouldn’t have to cut a single dollar of government spending.

How about it, guys?

Phil Rennie is a Policy Analyst with the Centre for Independent Studies