GST cuts and Dr Cullen’s conditions
Thu 17 Apr 2008 by Matt Nolan.

The government is looking for a way to cut taxes within the confines of its "four conditions".   Given the difficulty associated with achieving these conditions through personal income taxes, it is possible that the government may look at other forms of tax cuts, such as reducing the GST rate.   However, any belief that a reduction to the rate of goods and services tax will be more likely to satisfy these conditions is misguided.

The four conditions on tax cuts are:

  1. government services must not be cut,
  2. no borrowing to fund tax cuts,
  3. no additional inflationary pressure,
  4. no increase in inequality.

Taking these conditions as gospel (which is not necessarily obvious, see Chris Worthington’s article), let’s think about how GST rate cuts compare to a similar cut to personal income tax rates.

To start with we can treat the first two conditions as the same thing – tax cuts must not cost more than a certain amount.   Using Treasury calculations, the costs of a 1% cut in either the income tax rates or the GST rate are similar, implying that equivalent cuts will provide the same level of stimulus and have the same fiscal cost.   If one is affordable, the other will be.

The third and fourth conditions are ones that the government may feel it is more likely to satisfy with a cut in GST taxes than a cut in income taxes.

Starting with the goal of no additional inflationary pressure, a cut in income taxes is likely to drive up inflation by increasing demand for goods.   If we make the extreme assumption that lower income taxes do not greatly increase the "supply of labour" then the net impact of lower taxes will be additional inflationary pressures (otherwise the third condition may not be an issue).

If we cut GST taxes instead then we are lowering the price of goods, and as a result the government may believe they are reducing inflationary pressures.   However, inflation is the rate at which prices grow – not the price level.   The distinction between these two factors is important, as it is the rate of price growth that causes disruptions to the economy.   This tells us that, as long as a cut in the GST rate does not impact on individuals’ expectations of future price growth (which it shouldn’t given that everyone knows if it is happening) it will not dampen inflationary pressure.  

Even though this shows that a cut in the GST rate will not satisfy the third condition (unless an equivalent cut in income taxes also would), the government may feel that a cut in GST taxes would provide a greater level of equality than a cut in income taxes.

Such feelings are based on a belief that a goods and services tax is more regressive (impacts more heavily on) the poor than the wealthy, given the fact that those on low incomes tend to spend a greater proportion of their income.   If we were only interested in equality during a single point in time then this would be true – however when we discuss inequality we are interested in equality over peoples’ lifetime.  

The purpose of borrowing or saving is to shift your ability to buy goods across your whole life – in this sense all saving is deferred consumption.   As a result, the decision about whether to borrow or save will depend on how the individual or household’s income compares to their lifetime wealth.   This distinction is important as the major borrowers will be people who are expecting high lifetime wealth but currently have a low level of income (such as university students).   When discussing equality we shouldn’t be looking at a person/household’s current income, but the income that they make over their entire life.

What does this tell us about a tax on consumption?   Well since those that are saving are people who are expecting a low future income (eg saving for your retirement), a GST tax will hit this money in due course.   As people generally aim to spend their whole income over their life, a goods and services tax will not have a disproportionate impact on those we truly feel are poor – households with low lifetime wealth.

So cutting GST rates is no more likely to satisfy the government’s four conditions than a cut in income tax rates.  

In fact it is likely that a cut in the GST rate will be less economically efficient than an equivalent cut in income taxes.  According to the McLeod report (2001), GST, at its current rate is a less costly method of raising a certain level of revenue than income taxes.   The implication of this is that, in terms of efficiency, any future tax cut should be achieved by lowering incomes taxes – not GST rates.

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