The economic outlook and taxation Part 1

Aug 18, 2020

The Covid-induced recession has turned out to be worse than we initially hoped writes Michael Keating. Part 1 of this article discusses the additional fiscal stimulus that will be necessary and why it should not include bringing forward the Government’s legislated tax cuts. Part 2, tomorrow, will discuss the key requirements for revenue raising.

Credit – Unsplash

The Economic Outlook

The recent Reserve Bank Statement on Monetary Policy finds that:

The contraction [in the Australian economy] over the first half of 2020 was smaller than anticipated three months ago, though it was still very large. … However, the pace of recovery is expected to be slower than previously forecast. Generalised uncertainty and deficiency in demand have turned out to be more of a drag on growth than previously thought. The measures taken to address the current outbreak in Victoria will further delay the recovery.

The initial success in dampening the impact of the pandemic on the economy largely reflects the support offered by the Government’s JobKeeper and JobSeeker programs. Thanks to these two programs, plus the access to early withdrawals of superannuation, the Reserve Bank finds that “In aggregate, household disposable income has been maintained through this period, even as many people lost their jobs or worked fewer hours”. Indeed, some low-income households have even had more money than usual, and their savings have increased, while other, mostly higher-income, households have had to draw down on their savings or increase their debt.”

But this support for household incomes and demand was intentionally temporary and time-limited, on the assumption that business trading conditions would be returning to normal by the end of September. However, this assumption looks increasingly doubtful. Furthermore, the latest official thinking is that full economic recovery will be much slower than previously anticipated, even if there are no further setbacks in suppressing the virus.

For example, the Reserve Bank considers that

Even prior to the most recent set of restrictions applied in Victoria, the outlook for much of the economy was very uncertain, and forward indicators of activity and the labour market were weak. It will take a considerable period of time to recover the lost output and employment resulting from the COVID-19 outbreak.

In recognition of this deterioration in the economic outlook, the Government recently announced that the life of the JobKeeper and JobSeeker programs would be extended six and three months respectively beyond the end of September, albeit at reduced rates and with tightened eligibility conditions. It seems extremely unlikely, however, that this extra spending will be sufficient to adequately support aggregate demand in the next year or more.

Indeed, notwithstanding this extension of the two major programs – JobKeeper and JobSeeker – the Reserve Bank expects that the unemployment rate will rise further over the current half-year. Thus, in its baseline scenario, the Bank expects that the unemployment rate will average as much as 10 per cent in the December quarter, and will still average 8½ per cent in December 2021 and 7 per cent in December 2022. Furthermore, if there were a second wave of infection, peaking early next year, then by the end of that year the Reserve Bank thinks that Australian unemployment rate could be as high as 11 per cent rather than 8½ per cent.

What further fiscal stimulus is needed?

Given this prospect of continuing economic stagnation and high unemployment, not surprisingly most pundits are calling for additional government fiscal support to counteract the prospective shortfall in aggregate demand. And at the top of many pundits’ wish-list is that the second and third stages of the legislated tax cuts should be brought forward from 1 July in 2022 and 2024 respectively.

However, these tax cuts will only affect high-income earners. No-one with a taxable income under $90,000 will gain any benefit at all from the second tranche, and the third tranche will only benefit people with a taxable income in excess of $120,000 – that is less than 10 per cent of taxpayers will get any benefit from this quite unnecessary third tranche of tax cuts.

More generally, the taxable income of half the tax-paying population is less than $50,000, so the vast majority of taxpayers will gain no benefit from either of these second and third round of tax cuts. Furthermore, the only beneficiaries tend to have high savings rates, and so these tax cuts will do relatively little to support aggregate demand, which is the ostensible reason for bringing them forward.

Clearly, if these tax cuts are brought forward in the October Budget, they will not provide adequate support for the economy and substantial other spending measures will be necessary as well.

Second, any fiscal stimulus should have regard to the nation’s longer-term fiscal requirements. At present, there are good reasons for running budget deficits in response to the low levels of private demand – a situation that is likely to persist for some years. Nevertheless, policy also needs to have regard for the future revenue demands when the economy has returned to full employment and these deficits are no longer appropriate.

Ideally, therefore, the fiscal measures introduced in response to the recession should, as much as possible, only continue for a limited time, ending as the economy recovers, and thus not damaging the longer-term fiscal position. That in itself is another problem with these tax cuts – they are permanent and come at a continuing cost to the Budget.

In short, at best accelerating these tax cuts is a second-best option, compared to other ways of stimulating aggregate demand. Most importantly these second and third round of tax cuts will make no difference to most household incomes and consumer demand, and they are likely to be inconsistent with longer-run fiscal requirements (which will be further explored in Part 2 of this article tomorrow).

Thus, for all these reasons it would be better if the legislated Stage 2 and Stage 3 tax cuts did not go ahead, and therefore they should not be brought forward. Instead, there are other more effective ways to provide fiscal stimulus, which are more consistent with Australia’s long-term expectations of government.

Part 2 tomorrow

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