How costly are tax cuts?

Peter Costello's recently announced tax inquiry is now 4 weeks in. By my calculations they would have just finished downloading the relevant OECD reports and now have a week to reformat the tables and graphs so they look like original work.

All in all the whole exercise is a waste of time and effort. Instead of looking at what other countries are doing we should instead examine our own recent history, applying Milton Friedman's dictum that, "if a tax cut increases government revenues, you haven't cut taxes enough."

Surely there is no better initial question to ask. If we can cut taxes without hurting revenue why don't we do it. Unless one believes there is something beneficial in paying taxes in and of itself, or there is something wrong with economic growth, then it's a no-brainer.

Looking at the Howard Government's record it appears that we haven't cut taxes enough: income tax revenue has increased by 25 per cent despite three income tax cuts:

• The biggest cut came with the introduction of the GST (according to Costello the biggest income tax cut in history). Treasury estimated that income tax revenues would fall by $12 billion. They only fell by $4 million and by the next year income tax revenues were back to their level before the cuts.
• In 2003-04, the Government delivered the 'sandwich and milkshake' tax cuts forecast to cost $2.4 billion. Revenues rose by $4.5 billion.
  
• Last year the thresholds rose and are to be lifted again in July. The cost was forecast at $1.9 billion this year and $3.4 billion next year. Data is not yet out on the true 'cost' of these cuts but given reports of another bumper surplus, revenues will probably rise again.
  

Quite simply, then recent tax cuts have not actually cut revenue. Although there are no doubt other effects I'm not controlling for (population growth, bracket creep and economic growth not itself caused by the tax cuts) there is a clear cut case on the relatively costless nature of the recent tax cuts.

This is important since many of the agitators against large tax cuts claim that it would cost too much, the good times won't last forever and we should put money away now for a rainy day. There are two things wrong with this argument.

First, the cost estimates that it is based on are flawed (as shown above). In the US they are making an effort to calculate the effect that cuts have on stimulating growth and simultaneously boosting revenues. This is not a simplistic Laffer argument (that all cuts raise revenue) it's just recognition that multiplying the size of the rate reduction by the size of the existing tax base is not a very accurate estimation of cost.

Second, you should never overfeed pigs at the trough. There is no need to shore up government future claims on our money since if we do they'll just spend the sinking fund and ask for more anyway. Plus if we do cut now and things turn really pear shaped, we can always raise taxes later. Or, even better, if there is a squeeze on then this will put pressure on government spending. Hardly such a bad outcome when government spending has been rising just as fast as its revenues.

In sum, let's stop navel gazing at our bulging tax revenues and start slashing away, at least until government revenues actually start falling.