Are tax cuts a good idea?

Before John Key resigned as Prime Minister there were plenty of hints he favoured income tax cuts this year, while Finance Minister Bill English was rumoured to be less keen. So how will the partnership of English as Prime Minister and Steven Joyce as Finance Minister approach tax cuts and will they be a good idea?

Most voters probably now recognise that the economists’ adage 'There is no such thing as a free lunch’ definitely applies to tax cuts. There are only three options if a government cuts taxes: it eats into its budget surplus — if it has one; it spends less on things it presumably thinks we need or want; or it borrows more now but raises tax later when the borrowing has to be repaid with interest. (Cutting tax rates but managing to raise more revenue is sometimes possible, but it’s pretty rare.)

So are tax cuts a good idea? Before answering that question, it is worth recalling that if the Government does nothing it will generally end up each year with more tax revenue than the year before. That is because, whenever wages and salaries go up (whether to compensate for price rises since the last wage increase or because real wages rise), the income tax we pay goes up more rapidly, due to the progressive nature of the tax schedule and some taxpayers shifting into higher tax brackets.

This ‘fiscal drag’ is a bit of a stealth tax because it happens quietly in the background without the Government announcing any change. As a result, it is easy for taxpayers to forget about it.

If income tax brackets had been adjusted over the last seven years (since tax thresholds were last increased in 2009) purely to compensate for the effects of inflation, they should have gone up by about 11 percent; for example, the $48,000 threshold would have risen to around $53,000. If the Government did that now, it would cost around $1b in foregone tax revenue.

So, arguably, a tax cut of $1b would not be a tax cut at all — in real terms. That seems like a fair and worthwhile cut to make. In fact, I have argued for some time that Finance Ministers should commit to indexing income tax thresholds to prices, if not annually, then at least regularly. That way it stops them getting used to spending extra tax revenue that only comes from higher wages that were meant to compensate us for higher prices.

What about a bigger tax cut? Whether you think this would be fair and reasonable ultimately depends on what you prefer to do with your money. More and better public services from the extra tax revenue? Or more money in your pocket to spend?

If taxes are cut, which taxes? That question raises the thorny issue of who should pay any additional tax or benefit from cuts. Most government tax advisers will tell you taxes aim to do three things: raise revenue required for public services with minimum disincentives that distort the choices people make; redistribute income when we don’t like the outcomes delivered by private markets; and discourage people from doing socially harmful things like smoking or polluting rivers.

Obviously, people’s preference across these three options will differ. Perhaps I favour more school or health spending, especially if I have several children or health issues. Higher taxes can seem more justifiable then. Interestingly, though, evidence suggests in this case people tend to favour increases in taxes that others will pay! Low earners prefer top rates of income tax to rise, while high earners prefer higher GST rates.

And on disincentives, the evidence points to quite different effects for different types of taxpayer, depending on such things as gender and family circumstances. For example, ‘secondary earners’ (mainly partnered women) and sole parents tend to be more responsive to changes in taxes and benefits. A tax cut affecting these people might therefore encourage them to earn more.

If so, then conventional statistics would indicate a healthier New Zealand economy — more employment, more hours worked, higher earnings. But, of course, that ignores the value people put on their leisure time or home and childcare activities that have been squeezed out by the greater work commitments. So, once again, it is hard to escape the fact that what different people think is fair and reasonable — and vote for — may legitimately be quite different.

But how much redistribution we favour is often the most emotive and contentious aspect of tax cut proposals. And who should be targeted the most by any cuts? Of course, politicians love to promote their tax cuts with phrases that emphasise help for “honest hard-working families” — four words surely no one could find unpalatable, and that allow almost everyone, whatever their circumstances, to think they include them!

With a current top income tax rate of 33 percent — one of the lowest in the OECD — there doesn’t seem to be a good case, in my view at least, for lowering taxes for top earners. But the 30 percent marginal tax rate applying to incomes between $48,000 and $70,000 is relatively high for these middle income earners.

So let me make a prediction: if the current Government offers tax cuts, it will mostly target those on middle incomes. This could take the form of pushing up the tax thresholds so the 30 percent rate kicks in at a higher income or cutting the rate itself. For example, the Government could ‘give away’ $1b in revenue (out of around $76b in 2016) by cutting the 17.5 percent and 30 percent rates to 17 percent and 25 percent. For another $1b, it could also raise the thresholds to $57,000 and $77,000. Good for honest hard-working families, surely? It won’t be long before we know if that is how the new Prime Minister and Finance Minister are thinking.

If you want to try out your own tax cuts, you can. Just download Treasury's income tax calculator.

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