Tax Cuts Don’t Cause Higher Interest Rates: Part II
Updating the numbers from the previous post, the 1988-89 and 1989-90 underlying cash surpluses are now both put at 1.7% of GDP, compared to an estimated 1.5% of GDP for 2005-06. The high interest rates of the late 1980s were thus associated with the strongest budget surpluses as a share of GDP since 1973-74 and still stronger than any Peter Costello has delivered.
The budget surplus falls to 1.1% of GDP in 2006-07 and is essentially unchanged after that, yielding a fiscal impulse from the budget of 0.4% of GDP.
Alan Wood gets it:
wouldn’t all this tax cutting and spending force the Reserve Bank to put up interest rates again?
The answer is an unequivocal no. Why not? Because what matters to our central bankers, as Governor Ian Macfarlane has explained ad nauseam, is the budget bottom line…
As a per cent of GDP the size of the surplus is forecast to be 1.5 per cent in 2005/06 and 1.1 per cent in 2006/07.
This implies a stimulatory change, using the Macfarlane rule of thumb, of 0.4 per cent of GDP—too small to be even a blip on the RBA’s radar screen.
And, if the experience of Costello budgets is a guide, the forecast surplus of $10.8 billion for 2006-07 will turn out to be a substantial underestimate.
In other words, the actual swing in the surplus is more likely to be mildly contractionary, rather than mildly expansionary.
Ross the Wowser doesn’t:
it’s by spending our tax cuts that we risk adding to inflation pressure and making the Reserve Bank want to raise rates further.
It’s likely that part of the reason for last week’s increase was the Reserve’s knowledge that a tax cut was coming, but I doubt it was expecting anything half as big as what we got. We now have budgetary policy and interest-rate policy pulling in opposite directions - not a recipe calculated to minimise the risk of further rate rises.
Somehow, I don’t think Peter Costello is too worried on that score. And since Ross thinks money makes you unhappy anyway, why would he care?
posted on 10 May 2006 by skirchner
in Economics
(8) Comments | Permalink | Main
|
Comments
Two points (for you to shoot down in flames):
1. At a time when the RBA is on a hair trigger, it would have been prudent to have delivered the superannuation tax cuts on the contributions side rather than the benefits side. I can see a lot of retirees taking their super as a tax-free lump sum and going on a spending binge, only to fall back on the pension when the money runs out.
2. On July 1 there will be a lot more money sloshing around the economy than there was the day before. Why is that not inflationary? On our recent track record I can’t see Australians saving or investing that money.
Posted by .(JavaScript must be enabled to view this email address) on 05/10 at 01:58 PM
1. People do that now of course. The bigger problem is one of time-inconsistency. As the pool of superannuation grows, the greater the incentive for the government to use it as a captive tax base. Those who put money in today hoping for a tax free benefit on withdrawal may be in for a surprise in years hence.
2. Retail trade has not benefited much from previous tax cuts, so the implication is that they were saved. Indeed, since the tax cuts are just a temporary reversal of bracket creep, a rational expectations model would predict the tax cuts will be entirely saved, since there is no change in life-time income and government spending remains the same.
Posted by skirchner on 05/10 at 05:15 PM
Costello did actually reduce tax rates a tad this time (how brave!) so it won’t all be recovered by bracket creep, and tax on super benefits has been abolished which adds further stimulus.
ASIDE: Being a Gen Xer, I fully expect the baby boomers to enjoy tax free super payouts for the next 20 years, which will almost certainly need to be reintroduced by the time I retire.
Ok, here are some economists/commentators who think the budget is inflationary and adds to the risk of an interest rate rise:
http://www.smh.com.au/news/national/fears-rate-rise-to-wipe-tax-cuts/2006/05/10/1146940613216.html?page=fullpage
“This is a budget that is incendiary,” the chief economist at Goldman Sachs JBWere, Tim Toohey, told clients in a research note. “This is a highly provocative and potentially dangerous political strategy.”
Another analyst, Scott Haslem, of UBS, said the budget “puts upwards pressure on interest rates”.
The Commonwealth Bank’s chief economist, Michael Blythe, said: “Certainly, as things stand, it’s added to these upside inflation risks that have the Reserve Bank moving towards putting rates up.”
An economist at National Australia Bank, Jeff Oughton, said: “The Treasurer has used the strong economy to implement some useful longer-term reforms, but in the near term has added to the inflation risks - and that may be enough to push the RBA into further action.”
http://www.theage.com.au/news/business/smart-money-is-betting-on-rate-rise/2006/05/10/1146940613850.html?page=fullpage
THE market’s verdict on the budget is clear: the $11.6 billion splurge of government spending and tax cuts increases the likelihood of another interest rate rise.
“If you pump more money into an economy which is close to full employment, you add to the risk of inflation, you add to demand,” said Colonial First State head of investment markets research Hans Kunnen.
Deutsche Asset Management head of fixed income Bill Bovingdon said yield rises show that investors were pricing in further rises, adding that Treasury might underestimate the strength of the domestic economy in the wake of the tax cuts.
Economists agree that dangers the economy may overheat exist. “At the margin, the budget will boost domestic spending, and add to pressure on interest rates”, said ANZ Bank chief economist Saul Eslake.
NAB chief economist Alan Oster, who predicted last week’s RBA rate rise, estimates the tax cuts and new spending in the budget would lift economic activity by 1-1.25 per cent on on ongoing basis.
“The budget may be a touch too stimulatory and hence inflationary in the environment of an accelerating domestic economy,” he said. “That in turn could trigger RBA action. Insurance is always cheaper in good times, and we would have liked to see more.
I’m sure I can find more…
Posted by .(JavaScript must be enabled to view this email address) on 05/11 at 09:50 AM
I’m sure you could. The market is not buying it though. The front end bill futures contract is barely changed compared to pre-Budget.
Posted by skirchner on 05/11 at 11:05 AM
Do you have some charts covering the pre and post budget period to back that up? The media are reporting stuff like this:
“Thirty-day interbank futures were pricing in an 80 percent chance of a tightening by November, while 90-day bank bill futures were implying a cash yield above 6 percent by the end of the third quarter.
BTW, I think its time for another post on the weakening U.S. dollar and the price of gold. You have to admit there’s been some significant action since you last blogged on this topic.
Posted by .(JavaScript must be enabled to view this email address) on 05/11 at 04:00 PM
You can check futures prices at the SFE web site.
Posted by skirchner on 05/11 at 04:42 PM
Hey, how about something on gold? It was up $16 again last night. (Wow!) At this rate it will be above $800 by the end of the month.
The gold bugs and US dollar bears are starting to look pretty smart!
Posted by .(JavaScript must be enabled to view this email address) on 05/12 at 10:31 AM
Since the gold price is USD-denominated, we would expect some correlation.
In the past week, I have had a taxi driver and one of my post-grad students tell me they have bought gold.
Will have more to say on this due course.
Posted by skirchner on 05/12 at 12:49 PM