Josh Reviews... Tax Cuts

The Australian federal budget is coming up, and along with it comes the perennial debate over what to do with the surplus. Not long ago, AC Nielsen published a survey that indicated that nearly three-quarters of the population would prefer the surplus to be directed to increased government spending on services, rather than tax cuts. This provoked a debate in my house about which was the preferable option; somewhere along the way, I realized that my arguments probably weren’t as well thought out as they could have been. This, then, is my counterargument to 75% of the Nielsen sample: why not tax cuts? My position is that this is simple stuff – it really is Macroeconomics 101. If you give the money back to the private sector, they will spend it more efficiently than the public sector possibly could. And not only will tax cuts increase spending and thus stimulate the economy, they’ll also make you more attractive, improve your car’s gas mileage, and whiten your teeth while you sleep. (I think my economics lecturer might have been a bit overenthusiastic.) That’s all well and good. But why take this position? What evidence do I have to support my position that tax cuts are preferable to increased spending on services?

There are two main arguments that you can make in favour of tax cuts. The first one concerns the nature of government spending – for the purpose of this argument, you have to assume that the economy knows what’s good for it, and that it tends to produce whichever goods are the most profitable. This is a pretty reasonable assumption, and it generally holds true in practice. If the private sector (businesses and households) is working away, and is suddenly given an injection of extra cash via tax cuts, they’ll tend to put it to good use. Businesses will invest it in more jobs, and more capital expenditure. The household sector will spend it – or, in higher income brackets, they’ll tend to save it or invest it, in a similar way to businesses. Whatever happens, the private sector tends to have its own interests in mind, and they put their money to good use. If we take back those tax cuts and let the government spend the money instead, another scenario emerges. Now, for better or for worse, governments do not tend to invest in profitable projects (if they do, they start to crowd out private capital, which is a whole other problem in itself). Governments tend to invest in goods that the private sector won’t supply. The problem is that because a government isn’t encouraged to turn a profit (businesses do) and doesn’t really have an incentive to spend its money wisely (households do), governments tend to funnel money toward unprofitable projects. One of the most common examples of this is “pork-barreling” – anyone who lives in a marginal seat will be pleasantly acquainted with this. Businesses don’t have to win elections – they’ll build their facilities and invest their money wherever the returns are good. Governments, on the other hand, can be driven to make bad spending decisions by the demands of winning the next election. (Japan’s infrastructure system is an extreme example; you may have heard of the empty superhighways that run all across Japan, funded entirely by government money, with only a handful of cars using them each day.) The point of this example is that governments tend not to make good decisions when they’re spending, even if they’re spending on essential services. On the whole, it’s more efficient to return the money to the private sector, and let them do what they want with it – as likely as not, they’ll provide the same services that the government would, but on time and at half the cost. The second strong argument in favour of tax cuts is focused more on the household sector – individuals rather than businesses. You’ll probably have heard of the “marginal tax rate” – the rate you pay on every extra dollar of income above what you’re earning. If you’re earning an average income in Australia these days, your marginal tax rate will be about 30 cents in the dollar – possibly 42 cents if you’re just slightly above average. Think about this for a moment. It deserves italics. Of every extra dollar you earn, the government will take 42 cents. Your $2.50 coffee requires $4.30 worth of work to earn it. 20-gigabyte iPod, list price $600? Over a thousand dollars worth of work. An inner-city apartment, around the $400,000 mark? Nearly seven hundred thousand dollars worth of work. The government takes a very large bite out of any extra work you do, or any extra money you earn from a raise – and that’s where the problem lies. High tax rates are a disincentive to earning more money. This affects people right across the social scale – down around the $20,000 mark, where social security payments cut out and tax cuts in, the effective marginal tax rate can be as high as 60 cents in the dollar. Ask yourself for a moment – if you were earning $19,500 a year, would you bother asking for a raise if 60% of it went in tax? More importantly, would you bother doing any training in order to win a higher-paying job? It wouldn’t be worth it. Whether down the bottom of the scale or up the top, where tax takes 47 cents in every dollar, high marginal tax rates discourage people from doing more work and from improving themselves – ‘upskilling’, if you like your buzzwords. It also discourages people from investing and earning more money, but the disincentive to work is the danger. The solution is tax cuts – carefully crafting tax cuts around the lower-to-middle income levels reduces the impact of the high effective marginal tax rates where social security cuts out. Tax cuts for the rich, while politically unpopular, are effective as well – no matter where they fall, tax cuts will encourage people to work harder, invest more, and improve their skills, with the single goal of making more money. Whether looking at the business sector or the private sector, the thrust of these arguments is that any extra money sloshing around in the federal budget to be handed down in a week’s time should be given back to the people who paid it in. Those people who made fun of the $4-a-week “sandwich and a milkshake” tax cut in last year’s Australian federal budget should stop for a moment and consider that over a whole year, that’s two hundred dollars. Now, hands up anyone who would rather let the government choose how to spend that two hundred dollars? I didn’t think so. Tax cuts: 55. Very enjoyable, and highly recommended.