John Key wants to cut taxes, maintain spending and not saddle future generations with debt. But no country can cut its revenue and increase expenditure at the same time, so conflicted Key faces a hard choice

So John Key's still playing it coy on 2010 and 2011's tax cuts and yet is promising to borrow a whopping $40 billion over the next three years. Amidst the Prime Minister's tentative appearance on Q+A yesterday morning were some interesting nuggets of information.

I haven't spelled it out yet on Pundit, but a couple of weeks ago I started work as a producer on Q+A. (If we tried to live on our Pundit income, Eleanor and I would have starved months ago!). All of you in the Pundit community should be aware of my bias towards the show that now pays for my daily bread, but don't feel afraid to debate what happens on the show. Lord knows, there's little enough political current affairs on TV these days, so what little there is must be worthy of discussion.

I must say I'm surprised by the lazy angles the print media have taken from Key's comments on the show. The Herald's lead this morning about workers being able to sell their fourth week's annual leave could be sub-titled "National once again promises to do what it's said it will do many times before". Where's the news?

No surprise though that every paper picked up on Key's admission that only "one or two" companies have so far shown any serious interest in the nine-day fortnight. Remember, at the Jobs Summit this was presented as a $40m a year scheme for 100,000 workers that would help upskill the workforce. Three week's later and we're talking about two companies (with around 500 workers, as the DomPost discovered with some decent follow-up).

I was most struck, however, by Key's refusal for the second time to guarantee the tax cuts scheduled for 2010 and 2011 and his admission that the government would borrow $40 billion "at least" over the next three years. That's not a number I've heard mentioned before and it's not a small sum. Key went onto talk about debt levels "blowing out".

Guyon Espiner asked: "Does that frighten you?"

Key: "Well, we can't have that on an ongoing basis. Let's be under no illusion here. We can't have an upward track of debt going on forever because we saddle future generations. So we are focused on that."

GE: "But you're still prepared to sacrifice that revenue by cutting taxes..."

JK: "Well if you look at tax cuts they do make an adjustment to your revenue. Treasury's done some work on that and it's about a five percent reduction in your revenue. Compared to actually controlling your expenditure and being more careful about your expenditure that's the single most important thing the government can do."

It's a fascinating exchange because it illustrates the bind this government is in. It's this debate, I think, that will some time in the next year or three reveal who Key is at his core, because it will force him to choose between the centre and the right.

Key has painted himself as a centrist. And while that's never quite been the case, he can't be seen to be cutting social entitlements, or he will go the way of other National leaders of the past 20-odd years.

National has also been so fervent about tax cuts for so many years now, it would struggle to explain backing away from them. It's base, especially, would be up in arms.

Yet no business can cut revenue and sustain increasing expenditure for long before it hits the rocks. The same goes for a country. Yet that's the course Key and Bill English are trying to navigate. Note that Key said Treasury estimates that the tax cuts will see government income drop by five percent. That's not small change.

So National's only option for the foreseeable future is to borrow. And borrow.

Key clearly didn't want to get into that debate. Instead, he trotted out his safety-first line about not wanting to "saddle future generations". To me that indicates not just spin alone, but an internal wrestling match. His refusal to commit to the tax cuts suggests he fears that they could lead him, and the country, to ruin. Key is a man being pulled in two directions at once. But the fact is that if he wants to hold to the centre, he can't proceed with them in their current form because they will force him to cut government services.

Economist Brian Easton said this on March 16 in a speech to a the Policy Evolution Conference in Wellington:

The government is dealing with the international crisis in a perfectly orthodox way, by increasing the fiscal deficit – the amount it spends above its revenue – in order to maintain demand in the economy. (Perhaps that is the outboard motor.) However there is a limit to how much the government can borrow. The government has opened the deficit as much as it dares – as much as it thinks it can prudently borrow. It daren’t have a bigger deficit because it may not be able to find willing lenders at reasonable cost. Indeed there is even the possibility that if the world financial system remains gummed up, we may not be able to borrow the amount that the fiscal stance is currently committed to.

Let me repeat Easton's point again: "it [the government] may not be able to find willing lenders...". That should send a shiver down all our spines. Even if the country needed more money, we may have hit the limit of our national credit card. Anyone who's been there in their personal life knows it's no fun.

Easton continues to the obvious conclusion:

When the economy moves out of recession from 2010, revenue remains below expenses. The small surpluses of the pre-2009 regime are replaced by an ongoing structural deficit of around $7 billion a year. (A ‘structural’ deficit persists over the business cycle.) The revenue losses from the tax cuts are not reversed by the recovery.

The government may be able to borrow $7b in a few exceptional years (especially to cover a recession) – as I have said, ‘may’ is the operative word. Borrowing that amount every year will be difficult – perhaps impossible. The debt servicing could well become unmanageable as the government debt rapidly grows and its net worth diminishes.

Unlike other countries' temporary fiscal stimuli, our tax cuts are permanent. The revenue never returns. And the borrowing, as we've seen, can't go on and on. So we come back to that eternal political dilemma: Cut spending or increase taxes (or, at least, not cut taxes). Key needs to stop pretending and admit to the hard choice he faces. Easton again:

The total cutting requirement, amounting to about ten percent of total expenses (or 6 percent with the GST hike), is daunting. Do not confuse it with the usual re-prioritisation program in which an incoming government cuts some of the previous government’s spending, and puts in its own favourites instead...

Whatever the marginal spending cuts in minor expenditure portfolios such as culture, the environment and foreign affairs, and the effect of increases in user charges – which are indirect taxes by another name – any large government expenses cut almost certainly has to target the big ticket items of education, health and welfare.

So to answer Espiner's question on Key's behalf, "yes, I am frightened. More than a little".