Imbalanced tax cutting is like pouring petrol on a blazing barbecue

Listener 6 November, 2004.

Keywords: Macroeconomics & Money;

With the general election just a year ahead, I have, as usual, reviewed my approach. My strategy is always to help readers try to understand economic issues, rather than tell them which way to vote. Next year I may have to modify it.

The danger is that some political parties may try to buy votes by promising to reduce the government surplus with more tax cuts and/or higher public spending. That is always a risk, but it has been compounded by the American Right’s support for George Bush’s tax cuts. Because the US dollar is the international reserve currency, the Americans can get away with a big deficit in the short run. But every respected economist believes that the US has embarked on a dangerous course. It will probably weaken the US dollar – and the US economy.

Not only have the American Right, once the keepers of fiscal probity, turned around, but also there is some muddled local thinking. When last year’s government surplus proved higher than expected, Wellington’s Dominion Post demanded further income tax cuts (September 24). It may be too much for its journalists to understand that the measure of the reported surplus, called OBERAC, tells us little about what the government actually has available. (See Stressful Fiscal Sums: Should the Government Spend More and Tax Less?)

But even the office boy knows that, given the current strength of the economy, with strong growth and labour and other shortages, stimulating further spending by tax cuts is foolish – like pouring petrol on a blazing barbecue.

It may seem odd that a Keynesian like myself should be a fiscal conservative. In fact, John Maynard Keynes did not support unlimited government deficits. Keynesianism favoured managing the government fiscal position, favouring a deficit during a depression. But we ain’t in one at the moment.

Although OBERAC is useful for accountants’ concerns, economists use other indicators for evaluating the impact of the government on the economy. A series of deductions is made from it that tends to turn the surplus into a deficit. That is because the government’s savings from its current income (which the OBERAC approximately measures) are used for capital investment (just as your household uses some of its income to buy a car, add to the house, or pay off debt).

Economists have learnt two major lessons since Keynes’s day. First, it is much easier to generate a government deficit than it is to pull it back, easier to cut taxes or increase government spending than the reverse. That is like trying to put toothpaste back in a tube.

Second, the traditional Keynesian analysis implicitly assumed low interest rates, so government interest payments do not compound faster than the economy grows, shifting the burden of taxation to future generations (as Bush has been doing). All very technical, but difficult problems don’t go away because you can’t understand them.

Perhaps I am overreacting. Does anyone take notice of our newspapers? Labour leaders Helen Clark and Michael Cullen are fiscal conservatives. New Zealand First’s Winston Peters and National’s Bill English proved they were when they ran the government finances. National Party Leader Don Brash has not yet had a chance, but as Governor of the Reserve Bank he publicly cautioned against too loose a fiscal stance, warning that interest rates would have to rise if the government did not show restraint. That’s right. Pour petrol on the fiscal barbecue and the Reserve Bank fire brigade will dowse a lot of party guests.

The danger remains that, inflamed by uninformed journalists and desperate to win votes, some parties will promise policies that wreck the fiscal stance. This column will not criticise any party that maintains the current fiscal track but proposes tax cuts offset by public expenditure cuts (or the opposite). And there is room in the future for modest tax cuts or extra public spending as the economy grows. But I promise to criticise vigorously if any significant political party is so irresponsible that its policies compromise the government budget and the sustainable economy. I hope I shan’t have to.