Roger Kerr Op-Ed: Are Tax Cuts Inflationary?

Are Tax Cuts Inflationary?
By Roger L Kerr
Op-Ed In Otago Daily Times 15 July.

In arguing against tax cuts, one point that finance minister Michael Cullen asserts is that they would push up prices, and that the Reserve Bank would have to raise interest rates to curb inflation.

To any serious economist, this argument is an embarrassment. Even at a superficial level, tax increases are more likely to push up prices and reductions in tax are likely to lower them.

This is easy to see with GST. When the Goods and Services Tax was introduced there was a relatively brief spike in prices. Increases in excise tax on petrol push up the CPI.

Changes in income taxes have similar effects. When the Muldoon government imposed a wage-price freeze in the early 1980s, it cut income taxes to encourage wage earners to be more moderate in their wage demands. The idea of a wage-tax trade-off was to reduce pressure on wage costs and prices.

Conversely, when the government lifted the top tax rate from 33 to 39 cents in the dollar in 2000, some firms had to increase wages so that the post-tax incomes of their workers did not fall, in order to retain them. This added to their costs and price pressures.

Where, then, does the idea that tax cuts push up prices come from?

The answer is that it is a hangover from the heyday of Keynesian economics. Dr Cullen has described himself as "an old-fashioned Keynesian".

Economists then were taught that the causes of inflation were 'cost push' or 'demand pull'. Increased taxes were an example of 'cost push' inflation.

'Demand-pull' inflation was said to derive from a surge in the demand for goods and services in general ('aggregate demand'), especially when 'aggregate supply' (the production of goods and services) was held back by capacity limitations. Tax cuts in Dr Cullen's Keynesian economic model would work this way.

But how realistic is this model? The answer is, not very.

First, if tax cuts replaced government spending of the same amount, a Keynesian model would predict a fall in demand, as some of the tax cuts would be saved rather than spent.

Second, the Keynesian model essentially represents a closed economy - ignoring capital flows and exchange rate responses. New Zealand is a small, open economy and producers in the rest of the world can easily respond to increased demand by New Zealand consumers without affecting the prices of tradable goods.

Third, tax cuts would ease capacity constraints and increase supply in New Zealand over time by improving the incentives to work and invest.

Fourth, and most important, Dr Cullen's analysis is static. Inflation is a sustained increase in the general price level, not a one-off change in prices. Even if there were a one-off effect of tax cuts on prices, why would that matter?

Inflation is a monetary phenomenon, as Milton Friedman demonstrated in his attack on Keynesian economics. Only central banks can generate inflation by printing money. The widespread acceptance of Friedman's argument has led the main central banks of the world to target inflation and reduce it to low levels since the 1980s.

Non-monetary theories of inflation based on 'demand-pull' ideas have fallen by the wayside. They were discredited by the stagflation of the 1970s.

The empirical evidence on tax cuts is consistent with this analysis.

Opponents of President Reagan's tax cuts argued that they would be inflationary, but inflation in the United States fell steeply in the 1980s.

The Bush administration has cut taxes twice and is proposing further cuts (while also hiking government spending and sending the budget into deficit). The spending and deficit budgeting can rightly be criticised, but the tax cuts have not triggered inflation and US interest rates are at historical lows.

The reality is that there is scarcely any relationship between the state of the government's budget and inflation in an open economy with a floating exchange rate. This conclusion is well established in the economic literature.

There is no evidence that low-tax economies are more prone to inflation than high-tax economies. In fact, the opposite is likely to be the case, as well-run low-tax economies tend to be more flexible. Inflation was not a problem in New Zealand when taxes were below 10% of GDP.

With public debt down to low levels, New Zealand should now strive to improve its international competitiveness and attractiveness to investment by moving to a lower-tax regime, more in line with other countries in the Asia-Pacific region.

Tax cuts, preferably accompanied by cuts in the high rates of growth of projected government spending (much of which is of poor quality) and reductions in the excessive operating surplus, would improve incentives and boost economic performance.

A sound medium-term programme of tax reductions could be implemented without any threat to macroeconomic stability. Let's have a sensible debate about taxes and spending rather than red herrings about inflation.

Roger Kerr is the executive director of the New Zealand Business Roundtable.

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