Four meaningless criteria for tax cuts

Michael Cullen has been adamant about theprinciples that will guide tax cut policy under the Labour government.   But hiscriteria are not nearly as binding as they might initially sound – a point thatwas forcefully rammed home by the prime minister’s assurance that the criteriawould indeed be satisfied and tax cuts will be forthcoming.

To discuss the first two criteria intandem, Cullen has suggested that the government will neither borrow nor cutservices to pay for tax cuts.   But in economic terms, the cost of something isalways the opportunity cost of the best foregone alternative.   By definition,the cost of tax cuts is foregone services or foregone debt repayment (unlessthe finance minister had undergone a conversion to supply-side economics, andnow believes that tax cuts increase revenues).

So what do the first two criteria reallytell us? Presumably, no extra borrowing is just a restatement of the government’slong-standing goal of holding the debt-to-GDP ratio constant.   As I argued inan earlier column (15/12/07), this means running cash deficits of around $2bnper year.   Starting from the current cash surplus, this criterion allows thegovernment an extra $5bn of spending or tax cuts in coming years (over andabove the amount allowed by the normal growth in tax revenues).  

"No cuts to services" is an equally obscurecriterion.   Government spending expands along with the economy every year, soservices are hardly ever cut in a nominal sense.   And budget projectionsalready allow for spending increases to maintain expenditure in real (afterinflation) terms.   So even if the government used all of its $2bn annual budgetallowance for new spending to fund tax cuts, services still wouldn’t be "cut"in real terms.

So under the "strict" guidelines of thefirst two criteria, the government is allowed a tax cut programme of no morethan $5bn total over the next three years.   By point of comparison, the incometax regime proposed by the National party at the 2005 election would cost$2.6bn.

It is on the third criterion – that taxcuts will not exacerbate inflationary pressures – that Cullen begins to findhimself in serious logical strife.   There are only two ways that tax cuts won’tincrease the fiscal stimulus and add to inflationary pressures.   The first isif tax cuts are offset by reducing spending (which Cullen’s second criterionruled out).   The second is if tax cuts are funded from upside surprises in taxrevenues (stemming, for example, from the dairy boom), in which case the "taxcuts" aren’t tax cuts at all in net terms.

So what does the third criteria mean inreality?   The government’s latest fiscal projections already feature asubstantial fiscal stimulus, and the Reserve Bank’s monetary policy decisionsalready incorporates the impact of that expected stimulus.   Cullen’s third criterionis presumably just a promise not to make a bad situation worse, and does not implyany further restriction on the government’s options than the first two criteriadid.

Cullen’s fourth criterion – that the taxcuts won’t lead to greater inequality – comes closest to relevancy, but even itis misleading.   Since income tax payments are highly skewed to begin with (14%of taxpayers pay 53% of income tax), it is very difficult for tax cuts not to"favour" the rich.   Seemingly fair proposals, like a proportionate reduction ineveryone’s income tax, would fail a strict interpretation of this criterion.

The tax-cut option this criterion impliesis a tax-free income threshold (making income below $6000 tax-free would costaround $2bn p.a.).   But that option lacks appeal no matter your goals.   Themain benefits of cutting taxes come through reducing deadweight losses tosociety, and increasing incentives to work.   The former goal argues forreducing the top marginal rates (where the deadweight costs are greatest).   Howeverincreased work incentives would be best achieved by reducing marginal rates formiddle income households most likely to be caught in the "working for families"welfare trap of high abatement rates.   A tax-free threshold is unlikely toachieve either function.

Alternatively, if the policy goal is toreduce inequality, tax cuts are a terribly inefficient instrument.   People inpoverty tend to be paying very little in the way of taxes to begin with, and wouldreceive little of the overall benefit from tax cuts.   Transfers, not taxprogressivity, account for the majority of income inequality reduction in developednations.

As guiding criteria for policy, Cullen’s taxcut principles are meaningless. As political criteria, they will no doubt beinvaluable.   Labour’s tax cuts will almost certainly violate Cullen’s criteriaby entailing less spending and more borrowing, more inflationary pressures, andincreased inequality.   But National’s tax cuts will presumably do the same,only more so.   Cullen’s criteria simply allow the Labour government to defendan arbitrary line in the sand.  

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