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December 30, 2007

Taxes, Money and Surpluses: Fact and Fiction
by Gerard Jackson

John Stone's somewhat harsh criticism of the Howard government's fiscal policy was fully justified. (Mr Costello's repeated budget failure, National Observer No. 73 - Winter 2007). However, Stone's comments on government revenues and budget surpluses missed a very important question: what generated such huge government revenues and massive surpluses? There was a time when the answer would have been self-evident to any economist worth his salt.

From March 1996 -- when Howard won his first general election -- to October 2008 currency increased by 111 per cent, bank deposits by 180 per cent and M1 (currency plus deposits) expanded by 164 per cent. This is an astonishing and unprecedented monetary expansion. Yet it is totally ignored by our commentariat, including those who are supposed to have some economic training. It has become increasingly clear that for these people -- and I include Treasury and Reserve Bank officials -- money does not matter with respect to economic activity. I would go even further and say that they do not even have a working definition of money let alone any concept of its nature.

It's as if the great debate on monetary policy that is known as the "bullion controversy" never took place. One thing is for sure, the wisdom that flowed from that debate has long since been lost to the vast majority of the economics profession. The result has been the inability of economists to link Australia's current account deficits and mounting foreign debt to the Reserve's reckless monetary policy. This has led economic illiterates like Simon Crean, Federal Trade Minister, to declare that the current account deficit is a structural problem that requires -- you guessed it -- more government interference and increased spending.

(If our self-appointed guardians of the free market were in truly acquainted with economic history and the history of economic thought they would have no problem dealing with Crean's economic nonsense).

Stone called for tax cuts and a reduction in the number of tax scales. Sticking strictly to the economics of the proposals -- worthy as they are -- we will find any number of commentators, particularly in the media, arguing that cutting taxes, including capital gains taxes, will increase spending which in turn will worsen the current account deficit and fuel inflation, forcing the reserve to raise interest rates. Complete and utter tripe.

Let us make this so simple that even a journalist can understand it. If tax cuts are offset by cuts in government spending aggregate spending remains unchanged. If the cuts are offset by increased borrowing from the public aggregate spending still remains unchanged. However, if the government inflates the money supply to pay for the cuts then -- and only then -- will we get inflation.

But note: it is not the cuts that generate the inflation but monetary expansion. Expanding the money supply stimulate economic activity and raises nominal incomes. This increases the government's revenue stream. So long as government expenditure lags behind the growth in revenue surpluses will continue to emerge. This is how the Howard government accumulated massive surpluses. Good economic management had nothing to do with it.

It follows from the above reasoning that if surpluses have been kept by the Reserve as idle balances then using them to fund tax cuts would have the same consequences as a monetary expansion. As for investing these surpluses, as some people suggest, this could act as a form of "forced savings" which would probably result in the funding of unsustainable projects. The best thing the Labor Government could do would be to pulp these dollars.

It is to be deeply regretted that some of the issues that I raised will not be publicly debated.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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