Tax cuts DO stimulate economic growth

Mon, 22 Jan 2018  |  

This article first appeared on the Yahoo7 Finance website at this link: https://au.finance.yahoo.com/news/2307140-040859645.html 

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Get ready for election economics

Let’s get a bit of basic economics and budget analysis sorted out as 2018, a likely year for the next Federal election, starts to unfold.

Tax cuts do stimulate economic growth.

Be it company or income taxes that are cut, the impact on economic growth will be positive, at least in the short run. When the government decides to cut taxes by, say, $1 billion a year, there is a simple transfer of $1 billion cash from the government sector with its saving level reduced by that amount, to the private sector. That $1 billion will be available to be spent, invested or even saved by the private sector. Whatever the end mix, there is a boost to the economy.

And yes, it is as simple as that.

But what if the government decides to spend $1 billion extra on educational, roads, consultants, health care, or any other purpose for that matter?

Well, that would stimulate the economy too. The effect would be different to a tax cut because the money would be directed to a specific area (consultants for example) and not as broadly based as a tax cut. But in the end, $1 billion of cash is simply transferred from the government into the bank accounts of those receiving the money via the extra spending.

Again, it is that simple.

The issue is that tax cuts and spending increases do undoubtedly stimulate the economy when the cash flows to the private sector.

An important question is whether lower taxes and extra spending are sustainable, especially if, as is inevitable, they funded by the government borrowing money or they mean a larger budget deficit or smaller budget surplus. Is it wise or indeed sustainable over the longer run to have higher government debt locked in because taxes are too low or government spending is too high?

These are the issues that are important considerations when it comes to working out whether company taxes should be cut or indeed, as appears to be set for the budget in May, income tax cuts should be on the agenda.

They will stimulate the economy, but are they affordable?

Is it worth having tax cuts when it means the money to fund them will need to be borrowed and at the same time will keep the level of government debt higher for longer? And here, note that Commonwealth government debt is already around $515 billion and is on track to exceed $700 billion by the mid-2020s.

Economic theory shows that stimulatory policies from the government are best implemented when the economy is weak and unemployment is rising. That way, the government distribution of cash into the economy helps the private sector pick up the slack and makes sure employment is more robust and economic activity can continue to run along at a healthy pace.

The other side of that theoretical economic coin is that when the economy is doing well, and especially when there are signs of a boom and economic overheating, more restrictive policies are better. That means tax increases and spending cuts are prudent to ensure inflation risks don’t build. It also allows the government to accumulate a proverbial war-chest of money via budget surpluses so that it can fight the next negative economic shock when it inevitably comes along.

In this election year we, the electorate, will hear a lot about company and income tax cuts. We will also hear about changes to negative gearing tax rules and capital gains tax concessions. There will be good and bad parts with each of these policy proposals in terms of costs, benefits and whether the policy changes are sustainable.

The electorate will be wise to consider whether the policy changes are occurring at the right time of the business cycle, whether they are affordable and also, whether they are fair in a society that is increasingly unequal in terms of income and wealth.

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