Monday, May 26, 2008

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:

CPIandGovtj    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.

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5 Comments:

Anonymous LGM said...

Also worth noting that inflation is what the Reserve bank is doing to the money supply. Hence some of the price rises are caused by the loss of value of the currency.

Paraphrasing:
Theft to the left of them,
Theft to the right of them,
Into the Cullen's valley of penury ride the Kiwi taxpayers!

LGM

5/26/2008 09:54:00 am  
Blogger Crampton said...

The implicit assumption on inflation, from those arguing that tax cuts are inflationary, has to be that the government would simply have sat on the money otherwise and not spent it. We can either imagine Cullen rolling about in a big silo full of cash, or the government investing the money overseas to pre-fund future superannuation claims. In those cases, we can maybe start building a case for tax cuts to be inflationary. I'm not saying I'd believe that case, but those are the only conditions under which it starts to possibly make sense. If in the more likely case tax cuts displace government spending, it's ridiculous to think them inflationary. If anything, government spending is likely to be more inflationary than private spending because private spending will have more "leakages": money spent on imported goods or on paying down debt, neither of which can in any way push up domestic prices.

And, of course, all of that is predicated on one's belief in "demand-pull" inflation. I tend to think rather that government spending (or tax cuts, if you want to argue that they come at the expense of government savings) will affect only relative prices. If government spends money, it bids up the price of bureaucrats and of Wellington office space as compared to other things in the economy. If private individuals spend money, the price of other things are bid up somewhat. But the overall price level is determined by the aggregate supply of money.

I suppose I'd throw in a slight revision to my prior comment: current inflation is driven more by tradeables (whereas the last time that inflation for 5 quarters ran outside the RBNZ target zone, it was driven by nontradeables). That doesn't affect the overall analysis though: New Zealanders spending on imported goods still has near-zero effect on world prices while government spending on goods in relatively inelastic supply still has a relatively larger effect on domestic prices.

I'd still call Cullen's move a tax cut, though it's perhaps semantics. It's a tax cut relative to what we'd be paying had he not made the cut; we're still paying more than we were prior to his beginning his tenure as Finance Minister. So it's certainly not a tax cut relative to the taxes folks were paying circa 1999, but it's a cut relative to what we otherwise would have been paying next year.

5/26/2008 10:40:00 am  
Anonymous ISeeRed said...

Kudos to NotPC. Again, blogs lead, MSM reluctantly follows.

5/26/2008 03:08:00 pm  
Blogger Matt Nolan said...

"At the visible hand in economics blog they peddle"

I don't think that this is quote is fully representative of my post. 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, 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 breaks on the growth of government?

Also the "exporting inflation" 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 tvhe.

5/27/2008 11:05:00 am  
Anonymous LGM said...

Matt

Inflation and price rises are not the same thing. One is a cause, the other is a result.

Inflation is the practice of introducing unbacked fiat money into the market by a central bank. When central bank introduces new fiat money (prints paper, creates "currency out of thin air", etc) it devalues that which is already in circulation. That results in price increases (supply and demand- more money chasing the same goods and services).

Price increases for goods and services are one result of the inflation of the money supply caused by the actions of the central bank. Another is erosion of savings. Yet another is the boom-bust cycle.

Do not confuse cause with effect.

LGM

5/27/2008 05:30:00 pm  

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