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Tax Cuts Aren't Going To Grow Our Economy

It doesn't work like that.

04/01/2017 12:05 PM AEDT | Updated 04/01/2017 12:06 PM AEDT
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"The Government's decision to increase infrastructure spending is laudable. But its belief that spending on social sector, such as health, education, childcare, etc. is growth inhibiting is mistaken."

At the joint press conference to announce the mid-year budget outlook in December 2016, the Treasurer explicitly acknowledged: "Our debt remains less than a third of what the average of advanced economies are experiencing on both net and gross terms and is less than all G7 economies." Yet, being a hostage to the unaccountable credit-rating agencies, so-called budget repair and returning the budget to surplus remain the main focus of the Government.

The Government sees the issue more as a spending problem, despite the fact that overall government expenditure over the current forward estimates is now $18.5 billion lower than anticipated at budget time. The Government intends to cut spending in some areas (mainly in social sectors) to offset promised increased in other areas, e.g. infrastructure investment.

The Government's decision to increase infrastructure spending is laudable. But its belief that spending on social sector, such as health, education, childcare, etc. is growth inhibiting is mistaken. There is overwhelming evidence in support of a positive relationship between, say public social spending and growth as shown in the figure below.

OECD

A recently commissioned study by the DFAT concluded: "Evidence is overwhelming of the positive impacts of social protection on household productivity and labour market participation in developing countries."

The cornerstone of government policies aimed at "growth and jobs" is tax cuts, specifically for companies -- at least for businesses with a turnover of up to $10 million. In the words of the Treasurer: "You've got to grow the economy and you don't grow the economy by taxing it more."

This is from the discredited so-called supply-side economics promoted by conservative economists, and which got oxygen during the Reagan-Thatcher era of the 1980s. The experiment with tax cuts during the Reagan administration on high-income households and businesses failed to boost growth at the federal or state level in the US. Interesting research by Martin Feldstein, President Reagan's former chief economist, and Douglas Elmendorf, the former Democrat-appointed Congressional Budget Office Director, concluded that the 1981 tax cuts had virtually no net impact on growth.

The 2001 and 2003 Bush tax cuts on ordinary income, capital gains, dividends, and estates also failed to stimulate much growth, if any. In both cases, whatever growth was noticeable came from expansionary monetary policies.

The experience is not much different elsewhere. Both the OECD and the IMF doubted whether tax cuts attract investment in any significant way.

Cross-country research has found no relationship between changes in top marginal tax rates and growth between 1960 and 2010. For example, during this period, the US cut its top rate by over 40 percentage points and grew just over 2 percent annually. Germany and Denmark, which barely changed their top rates at all, experienced about the same growth rate.

Thus, tax cuts will not magically improve economic growth. Instead, the government should focus on building economic capacity with new investments in infrastructure, research and development (R&D), education, and anti-poverty programs. As the IMF has recently observed, the impacts of public investment are greatest during periods of low growth. This view has also been endorsed by recently outgoing Reserve Bank Governor, Glenn Stevens.

The experience is not much different elsewhere. Both the OECD and the IMF doubted whether tax cuts attract investment in any significant way.

Investments in education produce a more skilled workforce, raising earnings and spurring innovation. A worker with only a high school education is twice as likely be unemployed as one with at least a bachelor's degree. An extra year of school is correlated with a significant increase in per capita income.

There are also gains associated with investments in early childhood education. The earlier the intervention, the more cost-effective, which is why policymakers have focused on preschool. Children who attend early high-quality care and education programs are less likely to engage in criminal behaviour later in life and more likely to graduate from high school and university. Reducing the cost of preschool also effectively increases a mother's net wage, making it more likely she will return to the labour market.

Spending on effective social programs provides immediate benefits to low-income families and can enhance long-term economic growth. The increased income security contributes to better health and increased university enrolment, leading to higher productivity and earnings. Similarly, nutrition assistance programs improve beneficiaries' health and cognitive capacity. Research shows similar positive impacts of housing assistance programs.

Nevertheless, the revenue boost from growth and productivity impacts of such social programs may not be enough to prevent rising deficits or debt. However, there are plenty of tools to deal with this problem, including a carbon tax or a wider GST tax base, an improvement in tax laws to stem tax evasion and reduce tax expenditures, a judicious social welfare and Medicare reform that does not affect equity and access adversely.

These need courage and political will. The current Government has shown none.

This is not the time for debt reduction by damaging cuts in social programs when the economy is nose-diving and the world economy is still struggling to recover. Instead, our current priority should be to ignite more robust and inclusive growth.

The evidence on supply-side tax cuts is simply not supportive. It is time for a pragmatic inclusive growth agenda, not fairytale thinking.

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