Australia | Oct 16 2007
By Chris Shaw
The Howard Government has come out swinging in the election campaign, announcing on the back of stronger than expected revenues it will look to implement tax cuts worth as much as $34 billion in coming years.
The proposal was revealed to coincide with the release of the Mid-Year Economic and Fiscal Outlook (MYEFO) document, which showed the Australian economy continues to perform well despite the capacity constraints that have been experienced for some time.
As part of the MYEFO Australia’s growth estimates were increased, with Treasury now expecting the economy will expand by 4.25% in FY08, up from 3.75% previously. Inflation should not be affected unduly, with the latest assessment being it will remain within the Reserve Bank of Australia’s target band through FY09.
Westpac chief economist Bill Evans suggests the revised growth forecasts in the MYEFO are if anything likely to prove conservative, as he sees scope for employment and private demand growth to be even faster than currently expected.
The government’s tax cuts are aimed primarily at lower income earnings, GSJB Were estimating 2/3 of the cut benefit this group compared to 1/3 for higher income earnings in FY09. However, in later years the broker suggests it will be upper income earnings that derive the most benefit from the changes.
According to Westpac’s Evans the proposed tax cuts are the government’s attempt to deal with the inflation issue from the supply side, as lower taxes should stimulate labour supply and so increase the level of spare labour resources, meaning more people are likely to enter the workforce.
Merrill Lynch doesn’t agree with the decision, arguing the current capacity constraints in the economy mean the more prudent move would be to maintain rather than take advantage of the fiscal windfall of stronger revenues by returning the funds to taxpayers.
But as Evans notes, the tax cuts effectively offset the stronger revenues and should help to stimulate the labour side of the economy, so easing one of the capacity constraints.
There is a flip side to the move however, as ANZ Bank economist Saul Eslake points out the tax cuts for lower income earners in particular are more likely to be spent, which will mean an increase in demand. This in turn would put additional upward pressure on inflation, which may result in higher interest rates.
GSJB Were agrees, suggesting the tax proposal is likely to contribute to interest rates moving higher in the early part of next year. The broker also suggests the proposed tax changes are not the fairest proposal as the stronger than expected revenue environment is generated by improvements to Australia’s terms of trade, so it should be those contributing the most to this that should receive the greatest benefits.
This would imply less in the way of tax cuts for individual taxpayers and more incentives for companies, as such an approach would likely result in a better balance to future economic growth.
According to Merrill Lynch the tax cuts should boost growth in later years, estimating a 0.5% boost in FY09 and around 1% annually in later years. It takes the view the RBA is unlikely to be happy with such a boost given the economy’s current capacity constraints as it will put upward pressure on inflation.
ANZ Bank industry economist Wain Yuen agrees and suggests the projected decline in inflation back to middle of target band next year may prove to be ambitious, so putting the RBA on alert for greater rather than reduced price pressures.
Commonwealth Bank economist Joseph Capurso makes the same point but also highlights the inflation outlook has deteriorated recently because of higher food prices, which has a lot to do with the drought.
He also points out the tax cuts have been back-end loaded so inflation is still expected to be within the RBA’s target band of 2-3% in underlying terms in the year to June 2009.