This article first appeared on The Guardian web site at this link: https://www.theguardian.com/australia-news/2018/may/09/australia-budget-2018-whats-the-point-of-scott-morrisons-policy-speed-limit
What’s the point of Scott Morrison’s ‘policy speed limit’?
The budget confirmed a deluge of tax revenue for the government that will see the tax-to-GDP ratio rise over the next few years to a peak of 23.9% in 2021-22.
The treasurer, Scott Morrison, has decided to use that peak as a self-imposed “policy speed limit”: in other words, he will put a cap on the tax-to-GDP ratio at this arbitrary level to 2028-29. This cap is effectively how the income tax cuts have been funded, as excess tax revenue is recycled back into lower tax rates.
It is an odd speed limit for a treasurer to embrace and it means there is either an economic timebomb in the budget for a future government or Morrison has no intention of sticking to the cap.
It is important to note, in this context, that the budget is framed on a series of realistic and reasonably conservative economic forecasts for economic growth, wages and company profits, while it makes the usual technical assumption of broadly flat or even lower commodity prices than recently seen.
But in the world of budgets, where even the best medium-term economic projections are inevitably wrong, there needs to be some thought given to scenarios and contingencies as unforeseen events unfold.
Suffice to say, the business cycle is alive and well, which means that over a period of a few years there will be the usual ups and downs in the economy.
Over the bulk of the past decade since the global crisis was unleashed, the biases on the economy have generally been down. That is, the economy has experienced subtrend growth, with inflation remaining below the bottom of the Reserve Bank target band and wages growth hovering near record lows. No one can accurately anticipate when the next economic upswing will be but one day it will happen.
This means that Morrison’s 23.9% tax cap will be tested when the economy experiences an unexpected lift, manifest in a surge in economic growth.
It will happen one day, perhaps soon, and when it does the strong economy will lift employment, wages, company profits and consumer spending to well above the level projected in the budget papers.
A torrent of tax will flow to the government, which could easily see the tax-to-GDP ratio exceed 25%, more than a full percentage point above the Morrison cap. History suggests that when an economy booms and overheats, it tends to do so for several years, so it would be realistic to expect a scenario that sees the tax-to-GDP ratio hold around the higher level for a few years when the upswing comes along.
When this happens, what will Morrison and the Coalition do?
Cuts in taxes, either personal or company, to meet the tax cap would be grossly irresponsible.
Throwing extra cash into an overheated economy via tax cuts in the clamour to meet the 23.9% cap would fuel inflation and there would no doubt be interest rate hikes to offset the inflationary effects.
There was a similar episode in the period around 2004 to 2007 when the budget surplus massively exceeded forecasts year after year on the back of the mining and commodity price boom. While the Howard government did not have an arbitrary tax cap, it nonetheless chose to use the bulk of these windfall tax gains slash tax rates and boost spending. As a result, inflation spiked, peaking at a stunning 5% and official interest rates were hiked, as a result, to an unthinkable 7.25%.
With the Morrison tax cap, when the next economic upswing unfolds, either history will repeat or the tax cap will be breached and the extra revenue allowed to accrue as a fiscal war chest to be deployed when the next economic downturn unfolds. It is obvious what the prudent policy response would be.
Which comes back to the original point.
Because of the tax cap, either Morrison will blow up the economy with excessive tax cuts when the economy is strong and overheating, or the “policy speed limit” is a glib soundbite that he has no intention of sticking to if the economy turns out to be stronger than expected.