Listener: 30 January, 2006.

Keywords: Regulation & Taxation;

Some decades ago, the political Left retreated from its historic role of engaging with economics to provide a critique of the modern capitalist economy. Nowadays, insofar as it discusses the economy at all, other than in terms of nostalgia – things were better in the past – the focus is on redistribution: how the output of the economy should be shared. It is not an unimportant question, but it is not the whole of economics.

Oddly, the political Right has become as focused on redistribution, too, albeit with opposite distributional objectives. Thus, this election year’s economic discourse is likely to be about taxation. Were these columns to deal only with its misrepresentations, there would be no space for anything else. But an outline of some issues might be useful.

How big can the tax cuts be? The apparently large public surplus allows those who do not understand the underlying concepts to argue for huge reductions in tax. But most of this so-called “surplus” is already spent, so using it to cut taxes would be spending the same money twice.

However, there is likely to be some room for a cut in income tax rates later this year. What you may be sure of is that the politically astute Minister of Finance, Michael Cullen, is no Scrooge, and he will “spend the lot”, giving the biggest cuts he prudently can. Political pressures could even push him above the highest levels of sustainable cuts. If they are too high, don’t be surprised to see the Reserve Bank raising interest rates to prevent the inflation that the additional expenditure surge could generate.

It is also a safe prediction that whatever Cullen’s reduction in income taxes, his critics will say that they are not enough. But can they do more without raising interest rates (and possibly causing loss of confidence by overseas investors and a balance of payments crisis)? They can promise that “under our policies the economy will grow faster and there will be more room for tax cuts”, an undertaking that is worthless, as they can’t be sure they can make the economy grow faster. The more honest will say that they will give further tax cuts as we can grow the economy, but the government can say that, too.

The evidence that lower taxes will increase the sustainable economic growth rate (measured by long-run GDP increases) is conflicting and not very convincing. There are theoretical reasons for a trade-off between lower taxation and higher sustainable output. But the empirical evidence just does not support the theory. All we can scientifically say is that any output inhibiting effect of taxation is very small – if it exists at all. Those with political agendas will be more extravagant.

Of course, a government can give greater income tax cuts if it can cut public spending and welfare benefits. (Or hike GST, either deliberately or when it becomes clear that its promises were fiscally irresponsible.) The question of the balance between public and private spending is largely a political one. I tend to the view that the public sector should be spending relatively more on such things as culture and heritage, education, the environment, foreign aid, health and infrastructure, and on increasing opportunity and reducing inequality. You may differ. We can have a sensible discussion on our differences, but at the end of the day we may still disagree, reflecting our different political perspectives as well as empirical judgments.

These disagreements are the stuff of politics, and lead to different views on the level of taxation, a major function of which is to determine the balance between public and private spending. Those who want bigger tax cuts than Cullen will offer also want less government spending than his government does. If they get into power and implement their tax plans, they will assuredly cut back on government spending. That is a perfectly proper matter for political judgment, to be settled by party choice in an election. However, it is not always in the interests of those clamouring for our vote to be so honest about what they are promising.