The only real tax cut is a spending cut

Dr Eric Crampton
The Post
8 April, 2024

American supply-side conservatives got one big thing right two decades ago, but they got a bigger thing wrong. And it’s relevant to current debates about our Coalition Government’s proposed tax cuts.

The American government ran substantial deficits in the early 2000s, spending more money every year than they were taking in tax revenue. President Bush proposed a tax cut despite the deficit.

Some supply-side conservatives lauded the move. They knew that government spending was not constrained by any kind of rigorous assessment of spending programmes. Every dollar the government collected would be spent, and more taxes collected generally meant more spending boondoggles.

They were not wrong about that.

But they concluded that ‘starving the beast’ was a good idea. On that theory, cutting taxes would force spending cuts in the future.

Some fiscal conservatives disagreed. George Mason University’s Professor Alex Tabarrok warned that President Bush had not proposed a tax cut but rather a tax shift.

Cutting taxes while in deficit simply shifts the burden to later taxpayers - a terrible idea when an aging population means larger future government outlays on Medicare and Social Security. If government is a ravenous beast with access to a nearly unlimited credit card, tax cuts will hardly constrain it.

Tabarrok warned that America had two political parties: “the Tax and Spenders and the No-Tax and Spenders”, and neither was fiscally conservative. In the two decades after Tabarrok’s warning, the federal government never achieved a balanced budget. America’s federal deficit ranged from 1.1% of GDP to over 14% of GDP and gross federal debt doubled, rising from 60% of GDP to 120% of GDP.

New Zealand’s Public Finance Act aims to avoid those kinds of outcomes.

The fiscal architecture is neutral about whether core government spending should be about 27% of GDP, as it was in 2018, or over 33% of GDP, which is forecast for 2024.

The six-percentage point difference in Core Crown expenditure, as a proportion of GDP, might not sound like much. But in a $405 billion economy, it amounts to almost $25 billion in increased core government spending per year across a population of just over five million people. Or over $18,000 for a family of four.

Some of that substantial increase in spending has been funded by a higher tax take. Core Crown tax revenue increased from just over 27% of GDP in 2018 to over 29% in 2024. The rest, after accounting for other bits of government spending and revenue, is funded by what is now a substantial structural deficit.

Taking on debt during the depths of lockdown to deal with the crisis was one thing. Now, that crisis has long since passed – but the structural deficit remains. The One Big Task for the coming budget is providing a credible path out.

It is not just a test for the current government. It is also a test of the Public Finance Act.

The Public Finance Act requires the government to follow defined ‘principles of responsible fiscal management.’ Those principles include reducing total debt to prudent levels and, once those levels have been achieved, maintaining prudent debt levels by avoiding operating deficits.

In other words, it tells governments that they cannot use debt to finance normal operations.

The current National-led government inherited a mess. The prior Labour government did not just defensibly use debt to fund the response to Covid. It also deficit-funded a substantial increase in structural expenditure: an increase that was arguably inconsistent with the Public Finance Act.

And, as economist Michael Reddell points out, the United States is the only advanced economy currently with a worse structural deficit than New Zealand, in the most recent World Economic Outlook report.

The National Party and the Taxpayers Union are right that taxpayers deserve a tax break. Government tax revenues are up considerably as a fraction of GDP, partly because inflation pushes more people’s incomes into higher tax brackets.

But expenditure growth has outpaced revenue growth. Cutting taxes while delaying a return to surplus isn’t a tax cut. The bill for a longer period of larger deficits will come due. The only real tax cut, when government is in substantial deficit, is a spending cut.

The Budget Policy Statement claims that any tax reduction would not add to debt because reprioritisation, savings, and new revenue measures would fund it. But debt would be lower and the path to surplus would be faster if tax reductions were deferred until spending cuts provided room for them.

Professor Tabarrok’s warnings remain on-point. If National wants to be the party of lower taxes, setting a more ambitious expenditure reduction target and abolishing the structural deficit is the only credible way of getting there.

If you want to put the beast on a diet, you can’t keep using the credit card to feed it.

To read the article on The Post website, click here.

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