Inflation v Tax Cuts

I want to say something about the statement 'tax cuts increases inflation' that is being thrown around a lot lately. This is being used, particularly by Cullen in New Zealand, to justify not cutting taxes (and criticising National's not yet promised tax cuts - something I will touch on below).

Inflation is caused by general demand exceeding supply. According to those using inflation as the spectre to justify not cutting taxes, demand increases as the supply of money increases and the supply of money in the economy increases when taxes are cut as the amount of money that taxpayers has increases.

Thus the statement 'tax cuts increase inflation' rests on the assumption that tax cuts will increase demand, presumably because all the tax cut money will be spent where as it would not have been if it was not cut. This is what I have an issue with... the fact that it is assumed (by Cullen, the media and those that just accept what they are told) that not only will all money returned to taxpayers be spent, but that money that is not returned in tax cuts will not be spent.

From financial year end 2006 to financial year end 2007, New Zealand government expenditure increased by 5%, from $65,422,000,000 to $69,017,000,000. Year on Year inflation in March 2007 was 2.5%. This means that government expenditure increased by 2.5% in real terms (i.e. negating the effect of inflation. The effect in real terms will be the real effect of growing government expenditure on demand and inflation) over the same period of time.

Therefore not cutting taxes is not demand nor inflation neutral, unless government expenditure grows at the same rate as inflation, inflation will be influenced. If expenditure grows slower, demand caused by the government decreases; if expenditure grows faster, demand caused by the government increases.

Growing government surpluses can reduce demand by taking money out of the economy, but such growth in surpluses has to outweigh the increase in government expenditure. Also the only place a growth in surplus in real terms can come from is by taking money out of the non government economy. The non-government economy will have to have decreased by 2.5% in real terms between 2006 and 2007 to offset the growth in government expenditure with regards to increasing inflationary pressures.

I also have issue with the assumption that all money returned through tax cuts will be spent increasing demand. Much may be said about (New Zealand's in particular) woeful savings rates, but it is unlikely that every cent will be spent. Some will be saved for those that can afford to save and some will be used to retire debt, which does not increase demand. All increases in government expenditure are spent, increasing demand.

The statement 'tax cuts increase inflation' also ignores the supply side of the inflation equation, as if supply increases relative to demand then inflation should decrease. As government expenditure is unlikely to be efficient or productive expenditure (feel free to let me know if you disagree, I have not yet examined the numbers for this) but rather redistributive, it is unlikely to influence supply. Tax cuts, and especially tax cuts for business or aimed at higher income earners, on the other hand at least have the opportunity of being put to productive use through investment in productive business, increasing supply and lowering inflationary pressure. I say tax cuts aimed at higher income earners, as it is higher income earners who can afford to, and are more likely to, invest in shares and business rather then just pay off a little bit more of the mortgage

Cullen has used the inflation spectre to criticise Key's Freudian slip that National's tax cuts will be around $50 a week. Cullen said:

"Mr Key has not yet seen up-to-date inflation forecasts, he has no idea
what Treasury is predicting by way of economic or revenue growth in the year
ahead and no idea if his $50 a week or more in tax cuts would result in higher
interest rates for New Zealanders."

Even $50 a week tax cuts will apparently cost only $5 billion, only slightly more then the increase in government expenditure from 2006 to 2007. The increases in government expenditure has had more of an influence on inflation and raising interest rates then even National's not yet promised tax cuts.

Finally, it annoys me that a rise in interest rates for those who hold mortgages becomes a burden every tax payer has to bear. But that is a blog topic for another time.