The visible hand in economics

Fiscal responsibility in taxes

Posted on: June 12, 2008

With the actions of the finance minister and the RBNZ both contradicting what I have learned about sound economic management it is time for me to take to task some of the more aggressive issues I have avoided up until now.

Today, my aim is to discuss the (lack) fiscal responsibility associated with Dr Cullen’s nine years in charge of taxes.

Now, there are two ways people have stated that his tax policy is a success:

  1. Through Keynesian economic management,
  2. By increasing progressiveness.

However, if either of these were his goals – the means he has used to achieve them has not be satisfactory. Let me explain.

First let us begin with the Keynesian claim. Brian Fallow is a strong proponent of that, and feels that Dr Cullen was true to his word in this sense.

Now I do believe that Dr Cullen views himself as a Keynesian, and his willingness to run surpluses and spend money now is partially based on a belief in this view of Keynesianism. However, Keynesian economics does not necessarily support increases in the real level of tax rates over boom times – which is what we have experienced.

In fact, Keynes hated the idea that “fiscal tinkering” would come from his description of the demand side of the economy – which is exactly what Dr Cullen has done.

You may ask – when did the finance minister increase taxes? Well, instead of thinking about the number of dollars, we should be thinking about peoples claim on resources. As the target bands in our tax system is not inflation adjusted, and as inflation is positive, then as the gross cost of an employee rose the proportion of that employees wage going to the government also increased – effectively implying that the government was increasing its claim on resources in New Zealand. This is a tax increase (fiscal drag infact).

You may also ask – how can we have Keynesian stabilisation policy without tax increases and cuts? Well taxes on income, corporate profit, and goods along with the benefit system are also called “fiscal stabilisers”. When the economy booms tax incomes increase, and benefit payments fall – implying that with the appropriate tax system we will have a surplus. When the economy slumps tax incomes fall and benefit payments rise – leading to a deficit. These facilities help to smooth fluctuations in the economic cycle – this is the sort of stabilisation Keynes was into.

You have to remember that during the Great Depression there was a short term balance budget stigma – so when tax revenues fell they CUT benefit payments – making the whole cycle head deeper. Keynes was arguing against this and for “medium term” balanced budgets, he wasn’t saying “lets fiddle the tax system constantly”.

Other types of fiscal stabilisation (such as slashes in the tax rate) usually take too long to come into effect – which implies that trying to directly control the cycle may just make things worse (tax cuts come in when growth is picking up while the increases come while growth is slowing). That is why the concept of stabilising monetary policy is prefered – something that can be used when the monetary authority has been responsible in the past.

A further benefit to not actually changing real tax rates is that it gives people certainty as to what their claim on resources is. Certainty helps promote investment and economic activity – uncertainty almost always leads to suboptimal economic choices.

Furthermore in this case if a government authority tells you it is going to cut taxes it is directly saying it will also cut resources as well – and it is asking you to vote for it you will know that you are voting for a society with less public and more private spending. Making sure that taxes are a STRUCTURAL variable (which is what setting the tax bands to rise with inflation would do) is transparent – and as a result is a widely accepted part of sound economic management.

What about progressiveness – that is why people voted for Labour!

So we have determined that the tax target bands should be pinned to inflation, and tax should be treated as a structural variable – even if you’re a Keynesian. In this sense, Dr Cullen has been deceptive, and economists in New Zealand have done nothing to correct it 😛

However, Labour did come in on a mandate to increase the progressiveness of the tax scale. Now this is a structural issue – the tax scale must be changed such that social desires for progressiveness match the cost.

If I remember correctly, Labour said they would introduce at 39c band – they did that. However, was their mandate to also increase taxes by not adjusting for fiscal drag – I think not. If their goal was to increase progressiveness further, they should have told the public what they wanted to do, and changed the tax scales immediately – then pinned them to inflation. Increasing progressiveness by stealth only leads to uncertainty and is akin to manipulation.

Conclusion

Letting taxes rise with fiscal drag cannot be defended by Keynesians, and is not a good way to achieve social goals with your tax system.

Such actions were neither transparent or fair. Furthermore, he used the name of one of the great economists (Keynes) in vain to defend these policies – something I cannot let slide

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9 Responses to "Fiscal responsibility in taxes"

I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you down the road!

[…] Original post by The visible hand in economics […]

[…] number of supply shocks force us to move.  In a sense this is what Dr Cullen did (although he was effectively increasing taxes by not indexing the them to inflation – thereby breaking this rule!), given the level of expenditure that he wanted to put into […]

[…] policy and tax (diminishing marginal utility), (Flat taxes and fairness), (fiscal responsibilities), (tax free threshold), (income splitting), (tax cuts and […]

[…] is excitement in the air.  First tax cut after a decade of effective tax rate increases (through fiscal drag).  And what an interesting time for it, as we go through the largest financial crisis since the […]

[…] is excitement in the air. First tax cut after a decade of effective tax rate increases (through fiscal drag). And what an interesting time for it, as we go through the largest financial crisis since the […]

[…] have said it before and I will say it again, Dr Cullen has been fiscally irresponsible (this post also goes into more detail around tax policy and cycles).  He has gone past the […]

[…] The first way doesn’t make sense (as tax rates should be independent of the economic cycle, they are “structural”).  We have discussed this before here. […]

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