Should we dump the tax cuts?

I find it weird when people tell me that we should not cut taxes because a slowdown in the economy means we are going to run a fiscal deficit. Now you might think I’m weird for thinking its weird – after all many people see it as equivalent to this: think of it like a household, when your income falls you should cut back on spending so that you have more to spend in the future.

However, thats the question – has our countries ‘lifetime’ tax take fallen (which would imply that we need higher tax rates to fund current spending), or is this budget deficit just the result of a cyclical movements in our countries income. As it seems like we are moving into a cyclical slowdown, there is no reason to take tax cuts off the table.

Ultimately, we want to set our taxes at a level where they fund government spending over the long-run. In the short-run the budget deficit runs around with the state of the economy. But in the long-run, under-taxing will imply we need to borrow in the future, while overtaxing will imply we should put money back into the economy in the future (and in the case of New Zealand has lead to more private borrowing).

Treasury and the government have decided that we have been over-taxing, so that we have been running a “structural surplus”. In this case the best thing to do is to lower-taxes, and then leave it like that.

Some people may say that we should change taxes to be fiscally prudent (lift them when the economy slows) while others say we should change them to stabilise the economy (lower them when the the economy slows). Personally, I think we should leave them as is. Fiscal policy has ‘automatic stabilisers’ that deal with a slowing and accelerating economy, these are the tax take (as the economy slows, less people work and therefore less tax is paid) and benefits (as the economy slows, people lose their jobs and get the unemployment benefit). Outside of this, fiscal policy should not be focused on smoothing economic growth as it takes too long to be implemented (given the legislative issues involved) and can be subject to regulatory failure. Note: I would have no problem with other fiscal stabilisers being introduced – I think that could be a novel way to deal with the economic cycle.

The best way to smooth the economic cycle is through monetary policy (as it influences economic variable more quickly, and can be implemented quickly) – sadly we are in a position where inflation is rising and output growth is slowing, implying that some economic downturn will have to be accepted.

Still, back to the point. We shouldn’t dump the tax cuts, even if we go into an annual budget deficit, as long as we believe that in the long run tax rates are too high for the bundle of government spending we want to fund.