Tax cut issues

Posted by: Matt Nolan on: May 20, 2008

• In: Government Policy | Macroeconomics | New Zealand Economics
• 6 Comments

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.

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