How inflationary are tax cuts?

How inflationary are tax cuts

For the last few years, the government hasput off cutting taxes because of their inflationary impact.   Now, with thegovernment willing to cut taxes, the Reserve Bank is unhappy because of theirinflationary impact.   This begs the question, how inflationary are tax cuts?

The common view is that tax cuts areinflationary as they increase the demand for products.   As a result, if a taxcut was met with a corresponding cut to government spending, inflationarypressures would not increase.   However, a recent survey by New Zealand BusinessCouncil for Sustainable Development found that over half of New Zealanders donot want tax cuts with a corresponding cut in services.   Although a cut inspending does not necessarily imply a cut a services, we will put this issue toone side and focus on the inflationary impact of a stand-alone tax cut.

Given that tax cuts increase demand, anydifficulty the firm has in increasing production will lead to an increase inprices instead.   The difficulty associated with increasing production is evenmore severe when the economy is running near full capacity, as it is now.  

An extreme example is an economy where nomore goods can be produced.   In this case if everyone’s income rose by 2%,there would be no extra goods to consume and prices would be ‘bid up’ by 2%.  The Reserve Bank is worried that we are in a similar situation.

The Reserve Bank’s mandate is to ensurethat New Zealand’s inflation outcomes are between "1 to 3 percent onaverage over the medium term".   Although this definition is a bit fuzzy, itgenerally implies that the Bank must try to keep the average of inflation overa three-five year period between 1% and 3%.

Over the medium-term, tax cuts do more thanincrease household’s demand for goods and services.   Lower taxes offerhouseholds a higher return on their labour input, which will persuade morepeople to enter the labour market, or may convince employees to work a fewextra hours.   Also a lower tax rate would make it easier for firms to attractlabour from overseas and prevent local born workers leaving.

When extra workers enter the labour marketit slows inflation in two ways:

  1. The more people that are willing to work, the more competition for jobs there is, which slows wage growth.   As wages are a cost to the firm, this implies firm costs grow more slowly, which leads to slower growth in prices.
  2. The more people working, the more goods and services that can be produced, creating extra products for New Zealanders to consume.

This ‘supply side’ view of tax cuts hasbecome popular in Australia.   The Australian Treasury believes that thecumulative effect of tax cuts since July 2000 (when new tax laws wereintroduced) has, by itself, increased labour supply by 300,000 people.   This is2.8% of currently employed people and 21% of the total increase in laboursupply over the last seven years!   

Many people believe that an equivalentincrease in labour supply is not likely in New Zealand, given thatparticipation rates are generally already higher in New Zealand than Australia.   However, this depends on the structure of the tax cuts.   The effectiveness of theAustralian tax package came about as it enticed secondary earners into thelabour market, and attracted workers from overseas.   An equivalent series oftax cuts in New Zealand would function mainly by attracting back some of the hordeof New Zealanders moving overseas, and prevent a fresh cohort of New Zealandersjoining them.

According to estimates by the New ZealandInstitute of Economic Research if New Zealand shifted to a similar bundle oftaxes as Australia, the initial injection into the economy would be $4bn.   Toput this figure in perspective, annual nominal private consumption is $100bn, soif all the tax cut is spent by households, then initially the value of consumptionwould increase by 4%.   This would provide a significant fiscal stimulus, evenif employment leapt by 2.8%.

However, this is not the whole story as atax cut would influence savings.   Government savings (budget surpluses) havebeen strong over the last few years and as the government has recentlyadmitted, these surpluses have been structural (permanent).   This is importantas household recognise that consistently high surpluses are politicallyunsustainable.   As a result, households and businesses will have borrowed moneysafe in the knowledge that taxes will be cut at some point.  

In fact, our hefty current account deficitis an indicator that New Zealand households and firms are doing just that (as acurrent account deficit implies that we are borrowing from the rest of theworld to fund consumption and investment).

Since New Zealanders are already spendingtheir future tax cuts, this suggests that a cut in New Zealanders taxes willmainly be used to pay down debt, rather than as a means to increaseconsumption.

As an appropriately designed tax package willincrease the supply of labour and households are likely to save a significantproportion of any tax cut, the medium term impact of tax cuts may not besignificantly inflationary.




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