Not a book reviewer, apparently

PoliticsMay 25, 2017

Why the budget must include a tax cut – and fiscal discipline to go with it

Guest writer

Not a book reviewer, apparently

Budget 2017: We invited Eric Crampton to make the argument for a tax cut. Here he offers the case for a modest cut to reflect inflation, the case for a more substantial cut, and, for good measure, a dumb case

Read all our Budget 2017 coverage here.

There are a lot of dumb cases for tax cuts.

I’ll try not to make one of those here, but let’s cover those dumb ones off first

Today’s dumb case for tax cuts was once a smart case for them – in the 1970s. Economist Arthur Laffer then pointed out what everybody now knows. The government collects no tax revenue at all if the tax rate is 0%, but it also collects no tax revenue if the tax rate is 100% and everybody stops working. Between the two points you have the Laffer Curve tracking how tax revenues rise, and subsequently fall, as income tax rates increase from 0% to 100%.

Laffer argued that the United States was on the wrong side of that curve. With a top federal income tax rate at the time of 70%, he was very likely right. But now it is something that governments are aware of, and tax rates beyond the peak of the Laffer Curve should not be all that common.

New Zealand isn’t likely to be on the wrong side of the Laffer Curve today. What the curve implies instead is that tax cuts will not reduce government revenues by quite as much as a spreadsheet accounting exercise might suggest. The government picks up a bit of unanticipated tax because of the dynamic effects of lower taxes on economic growth.

But even that does not work if the tax cuts are unsustainable. Cutting taxes now does little good if people expect that higher taxes later will be needed to cover resulting deficits. I will come back to this.

For now, let’s move to a slightly more serious case for tax cuts.

Every year, inflation brings a new cohort of earners into higher tax brackets. Inflation is a lovely trick for governments. It lets them package budget inflation adjustments as spending increases, and the occasional inflation adjustment of the income tax thresholds as a tax cut. If government fails to adjust tax thresholds for inflation, as it has since 2010, you get fiscal drag.

Indexing the income tax thresholds to wage inflation, so that taxes adjusted automatically, would make more sense than leaving it to budget announcements. But it would rob governments of the opportunity to present those adjustments as being a tax cut. It’s a dumb trick, but it seems to work. If your boss gave you a salary increase that matched the rate of inflation, you wouldn’t think of it as a raise. But inflation adjusting the tax thresholds gets sold as a tax cut.

Let’s count these necessary inflation adjustments as being the smallest tax cut the government can provide. Because anything less is really a tax increase.

Unfortunately, while adjusting the tax bands to avoid fiscal drag avoids having tax increases by stealth, it probably does less to help economic performance than do cuts to actual tax rates. Why? Only people earning in the ranges affected by the inflation adjustment would see a boost in the value of the next dollar earned. Everyone else is (kindly) left with more money to spend, but doesn’t get to take home a bigger fraction of the next raise.

Suppose that the government adjusted the tax thresholds to account for wage inflation since 2010. The top income tax rate would then kick in around the $83,000 level, the 30% rate would come in at around $57,0000, the 17.5% rate would apply from about $17,000 and the bottom rate would apply below that. Treasury’s tax calculator says this would cut just under $1.9 billion from government revenues. For the same drop in government revenues, every tax rate could be cut by a percentage point and the 17.5% rate could drop by two points. Everyone would get to keep a greater fraction of the next dollar earned.

The case for more substantial tax cuts is sound, but harder. It requires the government to be willing to cut programmes that deliver little benefit. And while the government has taken a sharper eye on the effectiveness of new spending programmes under the social investment approach, too much spending simply carries over, year after year, with little attention paid to whether that spending achieves its objectives.

Interest-free student loans cost the government $600 million dollars per year and mostly benefits students who are either from wealthy families or who are likely to go on to be higher earners themselves. That’s more than what it would cost to cut the 17.5% income tax rate down to 16.5%.

Deciding not to throw $300 million at the film industry over the next four years would allow the government to cut the 30% rate down to 29.5%.

Every billion dollar programme throws away the chance to cut the 17.5% income tax rate to 15.5%.

But, even worse, while the medium-term forecasts are very rosy, with plenty of room for tax cuts, the longer-term projections have health care and superannuation costs requiring substantial tax increases or substantial spending cuts – unless somebody finds the magic formula to reverse the long-term slump in productivity.

The government’s pledged increase to the age of superannuation eligibility is not enough to materially affect things. Politics led the government to completely protect Baby Boomers from facing a higher age of superannuation eligibility, but that does rather less to help the government’s accounts in 2030 than it should.

Any real and substantial package of tax cuts requires having a government willing to take a hard look at the long-term fiscal projections. Announcing that the age of retirement would start rising in a decade’s time, rather than in 2037, with a transitional benefit for those who are not able to work past the age of 65, would have made room for real tax cuts.

The fundamental lesson is that tax cuts require greater fiscal discipline – at least on this side of the Laffer curve.

Dr Eric Crampton is Chief Economist with the New Zealand Initiative in Wellington

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Keep going!

Finance Minister Steven Joyce looks over a copy of his budget speech during the printing of the budget at Printlink on May 23, 2017 in Wellington. (Photo by Hagen Hopkins/Getty Images)

PoliticsMay 25, 2017

A beginner’s guide to the bewilderments of budget day

Morgan Godfery

Contributing writer

Finance Minister Steven Joyce looks over a copy of his budget speech during the printing of the budget at Printlink on May 23, 2017 in Wellington. (Photo by Hagen Hopkins/Getty Images)

Budget 2017: What does it all mean and why should we care? Over to you, Morgan Godfery

Read all our Budget 2017 coverage here.

The only thing duller than accounting is government accounting. What’s an “OBEGAL”? Why are politicians debating “appropriations”? What kind of terrible person would volunteer for the “budget lock-up”? For “ordinary New Zealanders” – sometimes known as “mainstream New Zealanders” or “mum and dad investors” – the government’s budget is impenetrable. Journalists do their best to make things interesting, inventing cute nicknames like “the chewing gum budget” in 2005 or the “the block of cheese budget” in 2008 – the early favourite for 2017 is “the Labour Party budget” – but the budget’s meaning and context always seems to remain out of reach.

No one’s telling you what an OBEGAL is.

In fact, it’s hard to figure out what “the budget” itself means. In a simple sense it’s the money the government plans to spend and receive over the next 12 months. In a constitutional sense it’s a government bill, the Appropriation (2017/2018 Estimates) Bill, that parliament must approve. In a political sense it’s a media “set piece”. Ministers drop hints during breakfast, state sector leaders spend weeks talking in metaphors – “every ice age ends”, said RNZ CEO Paul Thompson, referring to the public broadcaster’s expected funding boost – and opposition politicians pull all-nighters hoping to uncover a golden “gotcha” in the budget documents.

Bill English poses with a copy of his budget speech during the printing of the budget on May 24, 2016. (Photo by Hagen Hopkins/Getty Images)

But for outsiders, those documents are sometimes difficult to interpret. Appropriations – spending categories – are usually general. Each category is given a vague, new age-sounding designation like “Relationships and Information”. The preface to the figures usually touts how much Government is spending on, say, Whānau Ora over the next four years rather than the next 12 months. Bureaucratic measures like OBEGAL – the “operating balance before gains and losses,” which is one measure the Government uses to help determine the deficit or surplus – sometimes go unexplained. It’s also unclear in most years whether, say, funding for health is going up in real terms or merely nominal terms.

That said, in New Zealand the budget is as transparent and accessible (if not more so) than anywhere else in the world. In one sense this is terrifying – if you think our budget is hard to understand, try decoding US federal budgets – but in another sense it’s reassuring. It’s pretty hard for any New Zealand Government to pull a swifty. The Accounting Standards Review Board reviews and approves “generally accepted accounting principles” for the state sector, budget documents are based on accrual accounting and they’re audited according to a life-cycle auditing approach. The Public Finance Act also establishes a tight framework for how Governments borrow and spend public money.

Granted, this might be as good as meaningless, further proof the only thing more boring than accounting is Government accounting. But also: politics! The budget helps determine whether your school or your children’s school is forced to make decisions between hiring teacher aids or buying library books. The budget helps determine whether one paramedic or two paramedics are taking care of you or someone you know in an emergency. In fact, in one pre-budget announcement the Minister of Health promised almost $60m to end single-crewed ambulance in rural areas. The catch: most of that money will go towards training and hiring “assistants”, not paramedics.

This is the interesting thing about the budget: it’s all about the big things. The small details – that is, how the big money is spent – are the act of governing. When, say, the Minister for Māori Development presents the budget for Vote Māori Affairs, he’s simply proposing an appropriation. He’s not explaining, line by line, account by account, the precise details of his policy and political choices. He’s announcing how much money there is to spend in the next 12 months under each appropriation type. But the work of allocating money within those budgets, say the act of funding papakāinga housing, that’s the day to day work of governing.

In other words, the most important choices aren’t just made on budget day. Important choices that impact people’s lives are made every day. The Minister for Immigration can alter the “Immigration Instructions” making it harder for people to enter New Zealand to work or care for their family. The Minister for Social Development can amend welfare entitlement regulations making it harder for people to secure the support they need when, say, they’re between jobs. The controversial Sky City Convention Centre, where the Government scored a sweet convention centre deal through regulatory and legislative concessions, never appeared on the Government books.

Budget day gets blockbuster coverage – Paddy Gower is going to be amped – but every day in politics should receive the same kind of intense scrutiny.

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