No, Virginia, Tax Cuts Don’t Cause Higher Interest Rates

The Federal government will hand down its 2007-08 Budget next Tuesday facing an all too familiar embarrassment of riches.  On a no policy change basis, the 2006-07 underlying cash surplus could easily exceed $16 billion compared to a MYEFO estimate of $11.8 billion, with the 2007-08 surplus likely to be in excess of $10 billion. 

The actual surplus will then depend on how the government allocates the surplus among new spending, tax cuts and the Future Fund.  The challenge for the government in recent budgets has been to hold the fiscal impulse neutral, by keeping the change in the budget balance broadly steady as a share of GDP, in the face of what would otherwise have been a sharp fiscal contraction brought about by revenue growth that has consistently exceeded previous estimates.  This is consistent with the view that fiscal policy should be focused on microeconomic objectives and not demand management, with the latter task being best left to monetary policy. 

Among financial market economists, there is nonetheless a widely held view that the government should somehow assist the RBA in its demand management task, by favouring the accumulation of surpluses in the Future Fund over tax cuts to avoid putting upward pressure on inflation and interest rates.  The same argument is rarely made against new spending measures, even though ‘crowding out’ is a much more serious problem in relation to new spending than tax cuts.

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posted on 04 May 2007 by skirchner in Economics, Financial Markets

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