The visible hand in economics

Tax cut issues

Posted on: May 20, 2008

No right turn and the Standard are concerned about Nationals mention of a $50 a week tax cut, that mainly goes to the well off.

The fundamental concern seems to be redistribution. I/S expresses it succinctly by stating that he sees the elections choice as between:

a party who distributes wealth for the benefit of the many, or a party which distributes wealth for the benefit of the few

However, if the concern relates to redistribution it is important to ask two questions: What is the trade-off between redistribution and economic growth? Are tax cuts the appropriate mechanism for redistribution?

Redistribution – economic growth trade-off?

Although Dr Cullen has been quoted as saying that “there is no trade-off between growth and fairness” (Speech to NZICA 7-05-08), such a trade-off does exist (depending on your definition of fairness I guess 🙂 ). Lets assume that fairness requires some re-distribution from the rich to the poor. In this case, what are some channels this trade-off works through?

First we have the human capital channel. If we target people with higher income, then we lower the incentive to invest in skills. The lower peoples skills are, the less we can produce.

Secondly we have the effort channel. If we tax people more highly they have a lower return from working. As leisure is untaxed, the incentive to work hard will be diminished.

Thirdly we have the savings channel. During “high income” periods people will save to “smooth” consumption over time. As a result, higher taxes on high income people will severely diminish savings incentives – especially if they realise that the government will give them money in low income periods (eg retirement). This will lead to a higher level of cost to capital and inflation (although I think this channel depends on the population distribution more than the income distribution). More importantly, the higher tax brackets in a progressive system create a wedge between the interest rate a saver receives and a borrower pays – leading to dead-weight loss in the savings industry and definitely to higher cost of capital, reducing productivity and increasing inflation.

Fourthly, it increases the relative price of skilled labour, forcing firms to use an inefficient combination of skilled labour to other inputs.

Notice that all these factors work through the supply side of the economy – and they all point to a redistribution – growth trade-off.

However, if we value the redistribution as a society more than the additional production there is no problem here – we should put in place redistribution. If this is the case, Nationals scheme may increase “output” but it would reduce welfare (social surplus) – which is what we care about.

Is tax the right way to redistribute?

However, even if we believe in redistribution, we have to ask – is tax the right mechanism.

Although benefits are just negative taxes they are easier to target. This implies that there is some trade-off between the cost of running a benefit system vs a tax system and the benefits of more appropriate targeting.

As I stated here, I’m not a huge proponent of the “churn” argument. As a result, I think there is plenty of scope to have redistribution through the benefit system. However, this has to be met with a tax system that is less progressive.

The current governments goal of increasing redistribution through the benefit system and the tax system (which is what is happening when the government does not adjust for fiscal drag) presupposes that we still have a suboptimal level of redistribution. Maybe we will get an idea of what New Zealander’s actually believe about our level of redistribution come the next election.


6 Responses to "Tax cut issues"

Of course tax cuts aren’t a redistribution to the “wealthy” as such at all. A redistribution implies taking and then passing it back. Tax cuts stop the distribution in the first place.

Standard sort of redefinition language intended to frame the debate where the money all belongs to those in power who then parcel it back out. No thoughts of actually earning money comes into it.

“Standard sort of redefinition language intended to frame the debate where the money all belongs to those in power who then parcel it back out. No thoughts of actually earning money comes into it.”

I agree with that point of view to a degree – after if a flat tax cut gives more back to those on higher incomes it is because they pay more tax in the first place.

However, fundamentally tax isn’t necessarily paid for by the person supplying labour – it is also partially funded by the firm. As a result, I don’t really agree that the gross wage a firm offers an individual is truly “the money they earn” – it depends on the elasticity of supply and demand for labour.

I touched on this here:

just wondering whats the rate 16 yr olds get taxed with the minimum wage?
need this a.s.a.p please

“just wondering whats the rate 16 yr olds get taxed with the minimum wage?”

That depends how many hours they are working, and whether they are a new entrant to the firm or not (having worked 300 hours puts them on parity with adult employees for their wage).

If we assume they get the adult minimum wage then that is $12 an hour. Furthermore, assume that they work 2080 hours a year (40 hours a week times 52 weeks in a year), then their gross wage is $24,960.

From October we get taxed at 12.5% on our first $14,000 of income and in this case 21% on the result. As a result, the tax they have to pay is $1,750+$2301.6=$4051.6. This implies that the average tax rate will be approximately 16.2%.

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[…] is an issue we have discussed before in this post. In the post we asked “what is the equality-efficiency trade-off” and “is the tax […]

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