The Octopus and the Big Picture on Tax
When policy changes are announced, focus on the big picture. Tax relief from July was already factored into the outlook. Changes at the margin do not change the overall story.
If you (or your predecessors) decide a course of action years in advance, it might not feel like the right choice when the time comes. Circumstances can change, and so can incentives.
This issue is well-known to students of monetary policy, where it is called the “time-inconsistency problem”. The inflation-targeting regime followed by the RBA and most other advanced-economy central banks was designed in part to address that issue.
When it comes to fiscal policy, there is a similar issue. If tax brackets are not indexed, the tax take from households will necessarily rise over time. This creates an imperative to give back some of that fiscal drag periodically. But the shape of that adjustment then becomes a choice. As the current government has found, pre-specifying the distribution of the tax relief can lead to time-inconsistency issues. The distributional choices you made based on past information might not be the choices you would make based on what you know now. This would have been an issue even if the government had not changed.
Some countries deal with this issue by indexing tax brackets automatically to inflation. As we have discussed previously, though, this reduces the role of fiscal policy as an automatic stabiliser that leans against periods of strong growth. Flattening tax system brackets also reduces bracket creep, but it too results in the automatic stabiliser properties being lost. Even more of the burden of macroeconomic management would fall on monetary policy. This would have its own distributional implications. It is also the reason why we have previously advocated for the tax brackets to be indexed by the mid-point of the RBA’s inflation target, 2.5%, each year.
First-order versus second-order
Over coming days, many analysts will release detailed analyses of the impact of the announced changes. Our own colleague, Westpac Senior Economist Pat Bustamante, will likewise release a note today. It will show our assessment that the changes do not materially affect the macroeconomic outlook.
Relative to the originally legislated Stage 3 package, the changes redistribute the benefits to lower-income and middle-income taxpayers. Past research suggests that, on average, these households tend to spend more out of every dollar of extra income than higher-income households do; economists call this the “marginal propensity to consume”. The changes therefore redistribute more of the tax relief to people who are more likely to spend more of it.
So yes, this can be construed to imply that the adjusted package is a bit more stimulatory than the original version.
But no, lower-income households have seen stronger income growth on average than higher-income households lately, according to RBA analysis. So they might be less constrained to begin with, and those marginal propensities to consume, which are generally estimated using a long run of data, might not be a good guide to current behaviour.
But yes, spending could be higher than expected because middle-income households (along with higher-income ones) spend proportionately more on discretionary goods and services than low-income households. Hence, they had more scope to pull back spending in the face of cost-of-living pressures. In the current circumstances, their spending might bounce back more than assumed, offsetting the smaller bounce from higher-income households.
But no, by retaining the 37% bracket, the system is not flattened out as much as originally planned. This means that more households will still face some fiscal drag, and fiscal policy retains more of its automatic stabilising properties. The RBA would therefore not need to do as much in the face of strong income growth, should that emerge.
If you think the issue all the way through to the end in this way, you end up with so many “on the other hand” arguments that you feel like a bit of an octopus. As with many of these analyses of whether the effect of a policy change is different than before, the factors discussed are offsetting, and in any case each of them is at the margin. (Similar issues arise when discussing whether the effects of interest rate moves has changed recently.) It is far better to focus on the big picture.
The big-picture issue is that households have been squeezed in recent times by a rapidly rising tax take. Real household incomes have been falling. Tax relief in the second half of the year goes some way to reducing the tax drag on household incomes. The original package was already factored into our forecasts, and everyone else’s. While the changes this week alter the distribution of the benefits, the macroeconomic impact of this – relative to the package as originally announced – is marginal. We do not expect that this will affect the RBA’s view of the inflation outlook or the future path of the cash rate.
It is also important to remember that these tax cuts will not take place until 1 July. By that stage, inflation is likely to be within striking distance of the RBA’s 2–3% target. Any surprises around the effect of the tax package on household spending will only emerge after that. What matters for near-term monetary policy decisions is whether the RBA currently thinks that the outlook has changed, not whether things turn out differently once we get to that point. Media reports suggest that the RBA has already confirmed with the government that the tax changes do not affect the outlook.
Actual (monthly) inflation has surprised a little on the downside since the RBA’s last forecast round. Much of the data on real spending has also been softer in recent weeks. For the announced changes to the tax package to push the RBA in the direction of raising the cash rate again, the changes would have to offset these downside risks and signals. It would be hard to make a case that a second-order distributional change to a known large tax package more than offsets these other factors. This would still be the case even if the RBA were only focusing on the differences in marginal propensities to consume, rather than channelling their inner octopus and considering all the offsetting factors noted above.
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