Taxes: a question of competing efficiencies

The Economist magazine, shrine of deregulation and low, preferably flat, taxes is not usually Michael Cullen’s bible. But last week he grasped at its endorsement of his KiwiSaver to score a point off John Key.

Key, usually on the Economist’s side of the argument, promises to scrap KiwiSaver, Cullen’s tax-based toe-in-the-water attempt to lift individual saving in this grasshopper society. He has not yet offered an alternative.

The incident highlights in a very small way a large difference between the two men and their parties. This is not an election of Tweedledum and Tweedledee. With a fat fiscal operating surplus to disburse, the two parties are charting divergent paths: lighter regulation and lower taxes on one path, higher government spending and government intervention on the other.

The difference can be stated in terms of efficiency.

Most economists agree lower taxes are economically more efficient than higher government spending — that is, that there is something in Key’s claim that he will get higher economic growth by cutting personal and company taxes. That it is also electorally attractive is a bonus.

Key’s argument turns in part on whether those who get the tax cuts save some of the refund. If that in turn leads to more investment, productivity growth should lift and in turn lift growth and real earnings. United States research suggests overall people save around 20 per cent of the cut, though obviously those on higher incomes save more.

But Key has a problem with timing, say some economists usually on his side of the argument. The economy has been running at full — arguably overfull — capacity for some time. Fuelling this bonfire with tax cuts which ramp up the “fiscal impulse” is risky and adds to Alan Bollard’s headache at the Reserve Bank. Better wait until the flames die down a bit.

No politician is going to heed such caveats during the sort of fierce auction going on in this election.

Nevertheless, there is another question behind the first one: is it always more efficient to cut taxes? Quite apart from political efficiency, which is measured in votes and in 1999 backed Cullen�s spending preference, is there a point at which cutting taxes becomes counterproductive?

The theory is that “all boats rise” when low tax rates fuel higher investment and thus faster growth �- that is, even the least well off eventually benefit from tax cuts which initially give the well-off much more.

But do all boats rise? Labour would answer: only if the state ensures they do, through labour market regulation, higher minimum wages and other redistributions and that requires tax revenue.

Now stir in Key’s insistence he will not cut spending much — that is, the size of government won’t change much. Don Brash has even committed himself to maintaining spending on the arts!

At this point the line the tax-cutting United States Republicans run comes into play: it is fine to plunge the budget into deficit with tax cuts because the resultant greater economic efficiency will in due course increase revenue and balance the budget again, with everyone better off. Business New Zealand essentially argued this last week.

Back now to the Economist. Last week it cited leftish James K Galbraith (son of the famous John Kenneth) arguing that (a) a deficit is inflationary and inflation writes down nominal government debt over time and (b) pushing an economy along when it is running at its limit encourages innovation and so higher productivity. (And, indeed, business investment here rose when labour ran out a couple of years back).

Hang on, said the fiscally dry Economist: “Fiscal policy is made in a spirit of political point-scoring” � viz, this election — and, “given too much licence to roam [politicians] would soon reach the economy’s outer frontiers — and carry on right over the edge”.

Brash says, trust him to apply his Reserve Bank rigour to stop short of the edge.

But that in turn raises another “efficiency” question: what if “all boats don’t rise”? Income and wealth disparities would grow and “social efficiency”, if such a phrase can be coined, might diminish.

In rampant form, that might cause social tension which might deter investment. In mild form, such income-stretching during the 1990s gave Cullen the political leeway for his tax rise in 1999. That is, even if lower taxes were still economically efficient they had become politically inefficient.

Six years on, however, tax cuts are politically efficient again. In 1999 average weekly earnings were $34,350, well below the $38,000 at which the 33c rate cuts in. They are now $41,700. Bracket creep has chewed into disposable income and is gathering pace.

So Key doesn’t need his theoretical argument. He can just drive the political one. His new thresholds would far more than compensate for bracket creep.

Yes, but Cullen has one final argument: Key is abandoning Cullen’s commitment to moving thresholds up in relation to inflation every three years.

Cullen’s formula — adjusting 2 per cent a year, the midpoint in the Reserve Bank’s target inflation band — is anaemic. The bank lets inflation run above the midpoint more often than not.

Nevertheless, it seemed a worthy commitment. Had Cullen indexed thresholds over the past three or four years, tax would not be half the election issue he — and Key — have made it. Indexing thresholds, it seems, is both politically and economically efficient.