Cullen's budget didn't deliver tax cuts, and MSM finally notices

Sometimes today's mainstream media takes a few days to catch up. 

After Rob Muldoon delivered a budget, all the media would be asking about "fiscal drag" -- the process whereby the state inexorably steals your salary by ensuring that tax thresholds are not adjusted for inflation.  Today's media seems largely to have forgotten about the phenomenon, but we're not all so forgetful.

Two hours after Michael Cullen announced his budget last week, which included all those 'tax cuts' all the media has been talking about, this humble blog pointed out that they weren't tax cuts at all -- in fact as Liberty Scott pointed out that evening, the 'cuts' weren't even sufficient to take account of the increased tax we'd all been paying due to inflation: "at best [they] only half addressed inflation. People are still paying more in real terms in income tax than they were in 2000."  Cullen Really is Still Taxing You More.

As Julian says at Kiwiblog, this was really the main story of Cullen's budget, and it's been missed and ignored by the media -- until now. Almost all the mainstream media swallowed whole the story of tax cuts, but the Business Herald's Fran O'Sullivan finally spotted the scam and exposed it over the weekend -- pointing out, for instance that "those earning more than $80,000 (8 per cent) would basically fund their cut through the fiscal drag effect."

Nice to see the mainstream media spot the obvious, albeit a few days late.

Unfortunately there's one other fallacy they've still yet to puncture, which is "the post-Budget controversy over whether the so-called generosity of Cullen's tax cuts ... will persuade Reserve Bank Governor Alan Bollard against embarking on interest-rate cuts this year" -- a controversy based on the assumption that tax cuts are inflationary.

They're not.  As I've explained before, essentially they just change who gets to spend your money-- you, or the government.  At the visible hand in economics blog they peddle

the common view ... that tax cuts increase inflationary pressure [because] tax cuts increase “aggregate demand“, which in turn will lead upward pressure on prices, and therefore an upward shift in interest rates.

But as Paul Walker asks, "why does aggregate demand increase? Why does demand change if I spend a dollar rather than the government spending that dollar? ... [T]he real issue isn't aggregate demand but rather how does the government fund its dollar of spending now that it has given me my dollar back."

Frankly, as Phil Rennie points out, the important point to note about about tax cuts in this context  "is that they are actually less inflationary than government spending."  I agree. Eric Crampton explained why a few months ago, and the essential argument still holds:

    Even if you start from Bollard's premises, his worries about tax cuts seem odd. If the government has the money, it either saves it or spends it. If it spends the money, it tends to hire people. Hiring people also requires buying office space to put them in. What have been the two big components of inflation? Wages and non-traded goods (housing/buildings). When government spends money, it spends it in the areas most likely to push prices up.

Just think about all those bureaucrats packed into all those buildings in Wellington, for example, and wonder what that increased demand does to the price of Wellington commercial property. The chaps at The Befuddled Monkey explain this graphically (figures are for the USA):

1. "When government spends money, it spends it in the areas most likely to push prices up.
2. "...a very sizable proportion of New Zealand’s goods are being made in Asian countries (who are essentially exporting deflation).."*
3. Most price inflation occurs in areas of major government meddling, not in those in which meddling is only minor and we're still free to produce.  (Recent price rises in oil and food only make this point more accurate.)

So the moral of the story:

1. Tax cuts good.
2. Government meddling bad.
3. Cullen dishonest.
4. O'Sullivan the only political journalist with nous.
5. Some economists do know what they're talking about -- and the media should talk to them more.
6. Stick with NOT PC -- we'll see you right.

UPDATE: Matt from the Visible Hand in Economics blog objects that it is not "fully representative" to say above that the Visible Hand in Economics blog peddles "the common view ... that tax cuts increase inflationary pressure."   "I don't think that this quote is fully representative of my post," Matt responds:

   In my post I said that if government spending was also cut the tax cuts would not be inflationary. Also I made the case that tax cuts without any change in spending might not be as inflationary as we would expect given the "supply-side" response of tax cuts.
    I think it is more than fair to treat government spending as exogenous as I did [ie., as determined by conditions outside the economy], but I can understand the argument that lower government surpluses will lead to more "fiscal restraint." However, given the lack of fiscal restraint over the last decade is it fair to assume that either Labour or National are really going to hit the brakes on the growth of government?
    Also the "exporting inflation" {sic] argument is an exaggeration. As we increase demand for foreign goods our exchange rate depreciates - increasing the domestic price of foreign goods.
    However, don't get me wrong, I completely agree that government spending is more inflationary than tax cuts. But that wasn't the case I was discussing on the Visible Hand in Economics.

For the record, the paragraph of Matt's from which NOT PC quoted reflects the common Keynesian view, and reads as follows:

The common view I work off when stating that tax cuts increase inflationary pressure is that tax cuts increase “aggregate demand“, which in turn will lead upward pressure on prices, and therefore an upward shift in interest rates.

This aggregating together of consumer demand (in Henry Hazlitt's words "a retrograde step which conceals real relationships and real causation [leading to the erection of] and elaborate structure of fictitious relationships and fictitious causation") conceals three fundamental things that strongly effect the argument in this case:

1. It completely ignores saving rates -- which are generally higher for higher income earners;
2. It completely conceals the distinction between an increased demand for consumer goods (and which particular goods are being demanded) and an increased demand for producer goods (and which particular producer goods are being demanded) and the different effect on production of increased spending on the latter;
3. That government itself is not a producer, it's a consumer ('government investment' is just "a high-toned phrase for inflation or for tax-and-spend give-aways" - ref: Foundation for Economic Education).

In other words, when governments get our money it's mostly poured down an unproductive black hole with too much money chasing too few goods, whereas only some of ours is. 

It also ignores completely the most fundamental point about inflation: that (in the words of Milton Friedman) it is always and everywhere a monetary phenomenon -- inflation is a measure of how much governments and their central banks are inflating the money supply (which is what governments and their central banks tend to do), not a measure of the rise and fall of prices (which is what prices naturally tend to do).

That said, I note that Matt does draw attention to the "supply side" effect of the tax cuts -- although Eric Crampton notes, if instead of making the tax cuts 'progressive' they'd instead "knocked all the rates back somewhat , the supply side action would have been a lot more effective" -- and I take his point completely that "If society really wants lower taxes we could cut spending" (which should really read "we should insist that government spending is cut"), and to expect "fiscal restraint" from either red or blue team is like expecting sartorial restraint from Paris Hilton.