Cullen’s conditions and GST rates
Posted April 15, 2008on:
One way in which the government may try to satisfy its “four conditions” for tax cuts is through a cut to the GST rate. However, any belief that a GST cut would be more likely to satisfy these four conditions than a cut in personal income tax rates is folly – something we aim to discuss below.
The four conditions are:
- government services must not be cut,
- no borrowing to fund tax cuts,
- no additional inflationary pressure,
- no increase in inequality.
Lets start our discussion by looking at the first two conditions:
Note: We will assume for now that there is no supply side effect from tax cuts – a very steep assumption. However, any supply side impact from tax cuts would help either of these policies satisfy the first three conditions.
We can look at the first two conditions in the same light as they require the same thing – that the cost of the policy falls in some range. According to Treasury costings, the cost of a 1% cut in personal income tax rates (including withholding tax) would cost $915m while a cut in GST rates would cost $935m. These costs are sufficiently close (well within a reasonable margin of error) that if one policy satisfies the first two conditions the other will as well.
Next is inflationary pressure. A income tax cut gives people extra income, which drives up demand for resources, causing inflation (especially when capacity pressures are tight). A GST rate cut will reduce the “price level” (not inflation), giving households an effective real income boost, driving up demand for resources, causing inflation.
Inflation, and the costs associated with it, come from the rate of growth in the price level (and the volatility associated with it), not the actual price level itself (note that the wage is also a price). As a result, as long as GST rate cuts don’t lower inflation expectations (which they shouldn’t as everyone will know that GST has been cut – its not a secret move), the GST rate cut will be just as inflationary.
In fact, a GST rate cut may be more inflationary, as income taxes are also placed on interest income. A cut in income taxes will increase the implicit interest rate that savers receive, leading to a greater level of savings. A GST rate cut will not do this, and as a result the inflationary impact will be greater!
The final condition is inequality. This is a condition that any proponent of a GST rate cut will think is sewn up. However, as we have discussed earlier, goods and services taxes may not be as regressive as they first appear.
I agree that it is true that those on low incomes borrow a larger proportion of their income than those on high incomes, however we need to think about why people borrow. The purpose of borrowing is to smooth lifetime consumption – you borrow when your income is low relative to your expected lifetime wealth. As a result, the people that will borrow the most will be people with high future income expectations (eg students).
When looking at equality we should be interested in lifetime equality measures, not static equality measures. As savings is deferred consumption, and borrowing is consumption brought forward, all that income will get taxed at some point over a lifetime (or two) – implying that goods and services taxes will hit all the income in the end.
Viewing it this way, the equality impact of a cut in income tax rates and GST rates is likely to be equal – except for the fact that it benefits current savers and punishes current borrowers (by lowering the price level).
As a result of all these factors, I do not think that a cut in GST rates will provide a solution to solving these four conditions Dr Cullen wants solved. Given economic efficiency issues (namely the fact that income tax cuts will reduce more deadweight loss and create a greater incentive to save without hitting economic activity by increasing the effective interest rate for savers only), I think that changes to the income tax schedule would be preferable.