Opinion & Commentary
Tax cuts can help fight inflation
Unlike previous elections, this year’s federal campaign is likely to see only cautious spending and tax cut promises from the major parties. Both worry that more spending or less taxing would be inflationary, and prompt the Reserve Bank to increase interest rates. Yet there is little evidence that fiscal policy is an important influence on interest rates. In particular, tax cuts need not put upward pressure on interest rates.
In recent years, the federal government has sought to keep the change in the budget balance broadly steady as a share of GDP, to avoid the sharp fiscal contraction that would otherwise result from stronger than expected revenue collections.
Since 2001-02, the underlying federal budget surplus has ranged from 1 percent to 1.7 per cent of GDP, so the change in the budget balance from one financial year to the next has typically been less than one percent of GDP. For this reason, RBA Governors Macfarlane and Stevens have both indicated that fiscal policy has not been a major consideration for monetary policy in recent years.
There is nonetheless a widely held view that the government should somehow assist monetary policy in demand management, by favouring the accumulation of budget surpluses over tax cuts or new spending, to avoid putting upward pressure on demand, inflation and interest rates. Tax cuts, in particular, have been singled out as likely to put pressure on inflation and interest rates.
Since the federal government has been running budget surpluses, the federal government makes no call on domestic capital markets. Although tax cuts and smaller budget surpluses would reduce the amount of government saving, the implications for private and overall national saving are not so straightforward. Increased government saving does not necessarily increase national saving, because of offsetting dissaving by the private sector.
Both international and Australian studies suggest that a one percent increase in public saving typically sees a one-third to one-half percent reduction in private saving. This private saving offset argues against the use of fiscal policy for demand management purposes. It also explains why researchers have struggled to find a strong relationship between fiscal policy and interest rates.
The international and cyclical influences on Australian interest rates can be expected to overwhelm any effect from changes in government and national saving. As a small open economy, Australia is a price-taker in global capital markets and so Australian interest rates tend to be correlated with movements in global financial markets at the expense of domestic influences, as the recent volatility related to credit market developments in the US demonstrates.
With an open capital account, the domestic saving-investment balance does not determine the level of domestic interest rates, since Australians can call on the savings of foreigners. While Australia has a strong fiscal position relative to comparable countries, it also has relatively high interest rates, which argues against the budget balance being important in the determination of the level of interest rates.
It is worth recalling that the high interest rates of the late 1980s were associated with some of the largest budget surpluses as a share of GDP since the early 1970s. The federal government ran an underlying cash surplus of 1.7% of GDP between 1988-89 and 1989-90. The change in the federal budget balance was consistently contractionary between 1983-84 and 1989-90. There were four years of budget surpluses between 1987-88 and 1990-91.
Changes in interest rates are positively, not negatively correlated with changes in the budget balance, because both are positively correlated with the business cycle. These business cycle influences on interest rates are very large relative to any plausible contribution from the budget balance.
It is often argued that a deterioration in the budget balance will increase demand pressures relative to supply, if only at the margin, adding to upward pressure on inflation and interest rates.
This ignores the supply-side of the equation. Reductions in taxes can be useful in inducing increased labour supply. But the benefits of tax cuts extend well beyond their positive implications for labour supply, to issues relating to the distortions, compliance and collections costs that flow from the operation of the tax system.
Tax cuts have the capacity to increase supply more broadly, not just in the labour market, easing capacity constraints and reducing inflation pressures.
The appropriate focus for fiscal policy is precisely these microeconomic and supply-side issues, not demand management.
Dr Stephen Kirchner is an economist with Action Economics, LLC and principal of Institutional Economics (www.institutional-economics.com). A longer version of this article appears in the Spring 2007 issue of Policy.
