tax cuts and borrowing don’t always fuel inflation – but Nicola Willis has to get the balance right

On the eve of the first budget from the National-ACT-New Zealand First coalition government, there is ongoing debate over whether borrowing while offering tax cuts^[1] could trigger a rise in inflation.

Finance minister Nicola Willis has confirmed the budget will introduce “meaningful but modest^[2]” tax relief. But what impact will these cuts have on New Zealand’s economy?

During the election campaign, National promised^[3] up to $250 fortnightly in tax cuts for families with children, and up to $100 for childless households. Similarly, ACT pledged^[4] approximately $100 monthly to the average New Zealander. NZ First did not promise any tax cuts^[5].

But definitive figures have been vague. This uncertainty has triggered heated debate. During the first leader’s debate last year^[6], former prime minister Chris Hipkins argued^[7] “National’s tax cuts would exacerbate inflation”.

Echoing these concerns, the OECD’s biennial report^[8] on the New Zealand economy emphasised the necessity for tax cuts to be fully funded, whether through spending reductions or boosted revenue streams.

The OECD also cautioned against new debt creation, arguing the New Zealand government should first focus on bolstering debt sustainability and curbing inflation.

The core critique coming from those opposed to the government’s tax cuts is that debt-financed tax cuts tend to fuel inflation. So, what does economic research – and recent history – reveal about the ramifications of debt-financed tax cuts? Turns out, quite a bit.

Debt and inflation

The fiscal theory of the price level^[10]) argues inflation is determined by government debt, and present and future tax and spending plans, and not monetary policy. So, debt per se is not inherently inflationary.

Instead, inflationary risks arise when there is no clearly defined and credible policy on how fiscal surpluses will be reinstated in the future.

Even if spending programmes or tax cuts rely entirely on debt financing, they would not necessarily cause inflation – provided there is a credible commitment and pathway to restoring surpluses in the future.

In contrast, spending by the preceding Labour government – some of which was an appropriate response to the pandemic – significantly contributed to the persistent inflation we are now witnessing. This is largely due to the absence of a clear strategy for restoring fiscal surpluses.

Labour’s NZ$1 billion debt-financed spend on cost-of-living payments, for example, was almost certainly inflationary^[11]. It violated the basic economic principles of adjusting fiscal and monetary policy as needed to control abrupt changes in demand or supply (also known as business cycle stabilisation).

Similar tax rebate programmes in the United States in 2001 and 2008 led to demand surges of up to 2.3% in the quarter of their introduction.

This heightened demand occurred within an already overheating economy with substantial supply shortages, and no credible plan was introduced to restore fiscal balance. This combination inevitably fuelled inflationary pressures.

Overall, the impact of income tax changes on inflation depends on the complex relationship between demand and supply side effects, exchange rate effects, and expectations. And there is no clear answer in existing theoretical economic models as to whether income tax changes alone will increase or decrease inflation.

Adding tax cuts to the mix

A recent study^[12] using data from the US investigated the effects of tax cuts at the top and the bottom of the income distribution.

The study found cutting taxes at the bottom had a positive effect on the economy, but cutting at the top did not. Cutting income taxes at the bottom increased consumption, GDP, real wages, employment, hours worked and labour force participation.

These results reveal how income tax cuts can be beneficial for the economy, strongly affecting both the demand and supply sides of the economy. Willis has said National’s tax cuts will be targeted to middle and lower-income workers.

The most interesting insight from this study is that the effect of tax cuts on prices is insignificant. Price levels do not significantly change when taxes are cut. Furthermore, the largest (yet still insignificant) effect occurs about three years after the tax cut.

Therefore, even if the government’s proposed tax cuts pushed inflation up, it would not occur before 2027-2028, when the Reserve Bank predicts inflation will be back to its target level of around 2%^[13].

Overall, and based on the latest available research, there is no evidence the proposed tax cuts would make inflation worse.

References

1. ^{^} borrowing while offering tax cuts (www.newshub.co.nz)
2. ^{^} meaningful but modest (www.1news.co.nz)
3. ^{^} National promised (www.thepost.co.nz)
4. ^{^} ACT pledged (www.act.org.nz)
5. ^{^} not promise any tax cuts (www.wk.co.nz)
6. ^{^} first leader’s debate last year (www.1news.co.nz)
7. ^{^} Chris Hipkins argued (www.1news.co.nz)
8. ^{^} OECD’s biennial report (www.nzherald.co.nz)
9. ^{^} Hagen Hopkins/Getty Images (www.gettyimages.com.au)
10. ^{^} price level (press.princeton.edu)
11. ^{^} almost certainly inflationary (www.stuff.co.nz)
12. ^{^} recent study (www.journals.uchicago.edu)
13. ^{^} target level of around 2% (www.rbnz.govt.nz)