In its recent New Zealand country review, the IMF argued that there could be, in some circumstances, a case for a tax cut to stimulate demand. This is nothing to do with the recent report of an accounting surplus for the last fiscal year, which involves a lot of smoke and mirrors irrelevant for macroeconomic management.
Rather, the IMF was concerned with if there is a serious economic downturn – we are not sure one is happening, but such downturns are a worldwide concern – there may be a need for a fiscal stimulus from cutting taxes, which boosts consumption, or increasing public spending.
The proposal reflects an important shift going on in macroeconomic thinking. Until recently, the weight of the conventional wisdom was that fiscal stimuli do not work. Rather than fiscal initiatives, we should, they argued, rely on monetary ones. I have always thought this was an extreme position inconsistent with the evidence and involving theoretical assumptions which were excessively strong. But whatever my view – I was not alone – today there is a widespread recognition that interest rates are now so low that monetary policy has little impact when it is needed to stimulate the economy. So even the conventional wisdom is turning towards favouring cutting taxes and increasing public spending.
The reason for the IMF focus on indirect tax cuts rather than expenditure increases is probably partly because its ideology favours the private sector, but also because it takes longer to get quality public spending under way. There is an implicit assumption here, that any policy initiative will be left to the last minute or later.
And so the IMF has proposed that the rate of GST could be cut. I want to argue that a better fiscal stimulus would come from and equivalent reduction of the bottom income tax rate, which is currently 10.5% on the first $14,000 of income.
The IMF did not suggest by how much the GST rate should be cut. The calculations here are based on I percentage point reduction in the GST rate (from 15% to 14%). If a bigger cut was considered necessary, then scale up my figures on the proposed income tax cut proportionally.
According to the Treasury, the 1 percentage point cut in the GST rate would cost the exchequer $1.325 billion a year. A cut of the bottom tax rate from 10.5% to 7.5% would cost $1.260 billion a year, roughly the same amount. Such a cut would represent an increase of $8.00 a week for just about every taxpayer including most beneficiaries.
There are some administrative advantages in the income tax cut over the GST one. Both would take about the same time to implement but the income tax would be easier, especially as any delays can be resolved in the end-of-the tax year wash-up. Moreover, announce a GST tax cut and people will hold off buying until it is implemented, which is exactly what we don’t want. Announce an income tax cut and some people may spend some of it even before it is implemented. Note too, that a cut in GST benefits those who avoid income tax – say their income comes from capital gains. Tourists are another group who pay indirect taxes but not New Zealand income tax. Both groups will miss out by the lowering of the burden of the income tax they are not paying.
Another gain is that the income tax cut would mildly increase the progressivity of the income tax system, which makes economic management easier because, as the economy expands, government revenue expands a little faster, automatically dampening a boom.
Cutting GST favours the well-off, who spend more. Spend $1000 a week and you get $10 back; spend $100 and you get a dollar. Under this proposed income tax cut just about every taxpayer would get the same amount of around $8 a week, whether they were rich or poor.
You may think $8 a week is not much. It is small because the alternative GST cut is small too, even it costs more than a billion dollars a year. But for a beneficiary it amounts to an increase in the weekly spending power of almost 3 percent in comparison to the 1 percent reduction in the cost of their budget from the equivalent GST cut; a small contribution to reducing poverty. Someone working 35 hours a week on the minimum wage would get a 1.5 percent spending boost. Your income would have to be in excess of $900 a week before you got more from the GST cut than from the tax cut.
And, yes, if I had the fiscal room, I would give some priority to cutting the bottom income tax rate to zero. Any more room and I would increase the $14,000 threshold where the next tax rate cuts in. The aim is to give a better income distribution through the market earnings system.
I confess that in the 1970s I advocated taxing bottom incomes. Perhaps I was the first to do so publicly, but Treasury had come to similar conclusions. My argument was that mothers were just beginning to enter the paid labour force, and that while their earnings may have been low they could well be contributing to a high income household.
It is not that I have changed my basic analysis, but circumstances have changed. Mothers are now an integral part of the paid labour force, beneficiaries are taxed – they were not then – and GST has been imposed. The bottom tax rate from 1979 was 14.5 percent; today it is about 24 percent if we allow for the additional impact of GST. Then the tax threshold was $4500, which would be reached by a person after 1000 hours of work; today’s $14,000 is reached after about 450 hours. (Yes, bottom-end workers are taxed today more heavily than they were under Robert Muldoon.)
But I have not changed my basic argument that our fiscal priorities have to be more support for children and increasing some key public spending. However, the opportunity that the IMF is talking about is when we need to take action urgently. We should us use it to make the income tax system fairer.