Tuesday, March 21, 2006

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.


Timothy Bradley said...

(Welcome back to the blogosphere)

This statement: "income tax revenue has increased by 25 per cent despite three income tax cut" is in absolute terms yes?

Its a moot point (that I'm making), but the feds are keeping taxes constant as a per cent of income, just spreading who pays. And thats been point of the last three "cuts." (See the table at the end of http://vibewire.net/2/index.php?option=com_content&task=view&id=9249&Itemid=90)

PErsonally I think the feds are going about this the wrong way. Rather than think of more efficient ways to collect revenue, they should be looking at more efficient expenditures. Go through the budget line by line, cut out the pork, the waste and the rot.

Significantly decreasing the overall budget size will do more for efficieny and welfare then will a flat tax or equating the top threshold with company tax rates. Raising small revenues with relatively high distorionary taxes will have a lower impact than large revenues with relatively efficeint taxes.

Matt Canavan said...

The income tax increase is in real, absolute terms. Agree with you that the Libs are happy to keep tax as a ratio of GDP constant. (Even the cuts to company tax were sold as revenue neutral). However, tax/gdp is not all that relevant when you are trying to see if tax cuts increase GDP.

I also agree that expenditure cutting is needed too. But surely we can walk and chew gum at the same time. Indeed, tax cuts are probably essential if pork cuts are to be successful.

Timothy Bradley said...

Sure its relevant- consider the effect of reducing Tax/GDP if it were 100%. But that wasn't my point.

My point was, that the last three sets of tax cuts were just burden sharing. This tax review is about raising more tax $ from a larger pie. I'm not that excited.

If you want a sure fire way to increase the efficiency of the tax system- easy raise less taxes. Walk first, chew later.

Matt Canavan said...

My point is that you can't use tax/gdp to calculate whether a tax increase has paid for itself. You need the absolute tax figures. But sure the higher the ratio is, the more likely a tax cut will raise revenue.

I agree with both your latter two points. Previously it has been burden sharing, and I'm also not that exicted about the current review (as I think I said in the post). I am excited about tax cuts though.

Matt Canavan said...

My previous comment should say 'tax decrease'. Damn, no editing!

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