Should we have tax cuts without cutting government spending?

Listener: 20 May 2006.

Keywords: Macroeconomics & Money;

This columnist made himself highly unpopular in the 1980s by arguing for fiscal conservatism; ie, restraining the size of the government deficit between its revenue (mainly taxation) and government spending. Even the Treasury abandoned fiscal conservatism, arguing in 1984 that “with a floating exchange rate there is less risk that poor monetary and fiscal policies will impoverish those industries exposed to world trade while generating spiralling external debt”.

That was wrong, both in theory and practice. The Labour government in the late 1980s ran huge government deficits with spending far exceeding revenue, covering the gap by borrowing and by selling state assets – a strategy not unlike mortgaging and selling your house to pay for your high life. The exchange rate rose, exposing the tradeable sector to its world competitors, external debt spiralled and the economy stagnated for six years.

The structural government deficit was eliminated in 1991 by the Minister of Finance, Ruth Richardson. (I disagreed with her specific measures because they hurt the poor and they were so sudden that the economy collapsed.) Richardson’s courage (or folly) ended her political career, for she lost the finance portfolio in 1993, and left Parliament soon after. But her elimination of the fiscal deficit laid a foundation for the strong economic growth of recent years.

Reserve Bank Governor Don Brash was a beneficiary. Had the irresponsible deficit continued, monetary policy would have been a more difficult process, with an outcome of significant inflation, or more stagnation (or both).

Today there is a general consensus on the orthodoxy of fiscal conservatism, although there are disagreements over other aspects of fiscal policy. (One lobby wants lower taxation paid for by lower government spending.) The Treasury is fiscally conservative again, and the current Minister of Finance, Michael Cullen, is also a committed conservative – in this dimension, anyway.

Sadly, most journalistic commentators are not. You will see it in the headlines after the coming Budget when Cullen will be called “Scrooge”. But he will run as large a fiscal deficit as he dares, using any additional available funds for public spending on health, education, prisons and so on, rather than cutting tax. You, or any commentator with a different political stance, may favour cutting income taxes rather than increasing spending. But that is not saying that the fiscal deficit should blow out.

The deficit? Isn’t there a huge operating surplus in the government accounts? Well, yes, as measured, but most of that is then spent on capital investment and the like. So NO, really. The true fiscal deficit, the government’s net impact on the economy, is probably near zero for this stage in the business cycle. Given the government’s spending plans, there is no room for a tax cut. If there was, Cullen would give one.

Yet, predictably, following the Budget announcements there will be calls for tax cuts. This column has no trouble with the Act Party’s demands, for they want to leave the extra money in your hand to enable you to purchase the health and education (and probably some other things) that they plan to privatise.

But if election policies are any indication, it is National that is unorthodox, all the more surprisingly, given that the party is led by the major beneficiary from fiscal conservatism, Brash. Richardson must have wept when she saw the party’s 2005 promises of tax cuts, spending increases and guarantees not to cut some of the biggest sectors. Had National’s policy been implemented, the exchange rate would have risen, the export sector would have been crushed, and economic stagnation would have followed. And it is so hard to regain fiscal discipline, as Richardson knows.

National’s excuse might be that the official data came out too close to the election for them to do their sums. That was over six months ago. So let them publish their own Budget showing the deficit that they would generate after their tax cuts and spending plans. If they keep to their manifesto promises, they will be shamed out of court.

This column will not be welcomed by the fiscal irresponsibles. Been there, done that.

A Listener column that explained the government accounts is Stressful Fiscal Sums: Should the Government Spend More and Tax Less? (December 13, 2003) See also Notes on OBERAC. The Cash Surplus and Other Measures in the Government Accounts.