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Phil Rennie is a Policy Analyst working in the Centre's New Zealand Policy Unit. Previously he has worked as a Researcher and Press Secretary for National MPs in the New Zealand Parliament, and as a Researcher / Writer for the NZ Institution of Professional Engineers. He has a law degree and a BA in Politics & Public Policy from Victoria University in Wellington .

His full paper on this topic, “Why tax cuts are good for growth”, may be viewed at CIS >>>

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Phil Rennie
10 December 06
Do Tax Cuts Make a Difference?

With a budget surplus of over $11 billion the government is fast running out of excuses not to cut tax.

Intuitively we might think the answer is obvious: of course they do. That is, if you believe that individuals can spend their money more efficiently and effectively than politicians and the bureaucracy.

However, proving a direct relationship between the level of tax and economic growth is not cut and dried. The problem is that the economy is such a complicated beast, and there are so many different influences that can overshadow the effects of tax cuts. It is almost impossible to isolate the effect of just one input, however important it might be, and to prove causality, and the direction of causality.

This is why Michael Cullen can say with a straight face that tax cuts will do nothing for economic growth. Likewise, the New Zealand Institute is dismissive of the impact of tax and rarely, if ever, mentions it in their publications. This is surprising. When total government revenue is $76 billion, or 48.8% of the entire economy, it seems like you are ignoring the elephant in the room somewhat.

The traditional view of government spending has been that at certain low levels it actually helps growth by providing basic infrastructure (such as roads, a legal system and schools). However, if it rises too high it can become a handbrake on the economy.

With the size of the government in New Zealand at such high levels it’s clear the private sector is being crowded out. This is why the Treasury has been urging the government to cut taxes to boost growth.

There are three main ways lowering the tax burden can help growth. For a start, imposing tax changes people’s behaviour. This is why governments tax cigarettes and fine speeding drivers – to discourage those activities. The same holds true for taxing work and employment. By lowering the rate of return, a high tax rate (both personal and corporate) makes risk-taking and entrepreneurial activity less rewarding.

What this means is that the true cost of tax is never 1:1. Instead, it will always have a higher cost because of the potential wealth that money could have created had it been left in private hands. These ‘deadweight’ losses are recognised by the Treasury, who now recommend that every new spending initiative should generate a return of at least $1.20 for every $1 spent.

Tax also discourages people from working. This is not a big issue for people on a set wage or salary, but it is for those who have control over their hours, such as the self-employed and those considering a return to work.

This is very important, because while New Zealand has low unemployment, there are still many groups in society who are shut out of the labour market. In particular, moving off a benefit into part-time work is tough. With the combination of tax and benefit reduction many people will only get to keep a few cents of every dollar they earn, which hardly makes it worthwhile.

Taxes are not the only answer to this problem, but they can help by increasing the gap further between work and welfare.

Finally, the effect tax has on our international competitiveness should not be underestimated. If nothing else, it serves as a marketing function. Lowering taxes shows that as a nation we celebrate achievement and hard work, rather than penalising it. This is important because average tax rates around the world are falling, especially in Australia .

Governments can’t do much to improve the weather, or to lift wages (in the short term at least) but tax is one area they do have direct control over. It is one important way they can make it more attractive to work and invest in New Zealand .

The massive budget surplus means the government has the chance to kill another myth – that tax cuts mean cuts to public spending. While there are strong arguments for tighter quality control on spending, in the short term at least the government has a rare opportunity to cut taxes painlessly.

Even using the conservative cash surplus of $3 billion would allow for significant cuts. For example, the top personal and corporate tax rates could all be dropped to 30% and the middle rate could be lowered to 18%, without even touching current spending or debt repayment.

The movement for lower taxes is not an ideological exercise, or a way for the rich to make more money. It is a key tool in sparking the economy and helping us compete on the world stage.