WEEKEND ECONOMIST: Bring on the tax cuts

Labour force participation is rising thanks to tax cuts and welfare-to-work measures. The Rudd government is right to proceed with another round of cuts in Tuesday's budget.

This week’s labour market data showed that the labour force participation rate and the employment-to-population ratio both made new record highs in April. Increased labour force participation has been one of the objectives of the tax cuts and welfare-to-work measures introduced in previous budgets and the data have now confirmed the supply-enhancing value of these measures. The data also vindicate the Rudd government’s decision to proceed with the delivery of its promised tax cuts in order to further increase labour supply.

Far from adding to inflationary pressures, tax cuts have helped prevent the labour market from becoming an even more binding constraint on economic growth. The notion that the government can purchase decreases in the official cash rate through revenue hoarding is absurd, because it ignores the supply-side of the equation. The assumption that tax cuts fully flow through to aggregate demand is also mistaken. Unless tax cuts are received as a permanent change in life-time income, it is more likely that they will be saved rather than spent. Tax cuts likely add more to aggregate supply than to aggregate demand, easing pressure on inflation and interest rates.

The main threat the tight labour market poses to inflation outcomes is via wages growth. Next week’s March quarter labour price index will likely see the strongest growth on record for this series at 1.2 per cent over the quarter and 4.4 per cent over the year. Trend productivity growth rose a miserly 0.7 per cent in calendar 2007. Add the upper-end of the RBA’s 2-3 per cent inflation target to this figure and you get an estimate of sustainable nominal wages growth of around 3.7 per cent. Aggregates wages growth is thus running at unsustainably high rates in the absence of increased productivity growth, but the situation would potentially be much worse without supply-enhancing tax cuts.

The RBA’s quarterly Statement on Monetary Policy contained an inflation forecast consistent with the 2-3 per cent medium-term target range, assuming you don’t mind waiting until Christmas 2010 to get it. This was achieved largely by way of a dramatically lower economic growth forecast. Non-farm GDP is now expected to slow to 1.75 per cent by the end of this year, compared to the 2.75 per cent forecast in the February Statement and 4 per cent at the end of 2007. This is an annual growth rate not seen since 2001 in the wake of the recession in domestic final demand that followed the introduction of the GST in the second half of 2000. The RBA has dramatically raised the bar on the weakness we will have to see in the activity data this year for the RBA not to further raise interest rates. The RBA’s forecasts highlight the growth sacrifice that will need to be made to tame inflation. Even then, inflation will still be sitting at the upper-end of the target range.

We got the first bottom-up look at June quarter inflation this week, with the release of the TD-MI inflation gauge for April. It was a shocker at 0.5 per cent over the month and 4.3 per cent over the year, the strongest annual growth rate on record for this series. Core inflation (ex-volatile items) rose 0.5 per cent over the month and 3.9 per cent over the year compared to 3.3 per cent in March. The trimmed mean, which proxies for the RBA’s preferred measures of underlying inflation, rose 0.6 per cent over the month and 4.3 per cent over the year compared to 3.8 per cent in March. If May and June look anything like this, then we are set for another increase in official interest rates in August following the release of the Q2 CPI at the end of July.

The ABS confirmed a steady double-digit annual growth rate of 13.8 per cent for the weighted average of capital city established house prices over the March quarter, a reflection of the chronic national shortage of housing stock that will maintain pressure on housing affordability, rents and inflation. The April AIG performance of construction index showed that both the apartment and house building sectors were experiencing outright contractions in activity. Next week, we expect housing finance for March to decline 2.2 per cent, extending the sharp 5.9 per cent drop seen in February and pointing to a continuation of tight housing supply.

Next week’s federal budget will likely see underlying cash surpluses of around 1.7 per cent of GDP over the forward estimates, a trivial fiscal contraction relative to recent budget outcomes of 1.5-1.6 per cent of GDP and only a minor tightening on the forward estimates in the previous government’s Mid-Year Economic & Fiscal Outlook. Consequently, the fiscal impulse will be broadly neutral for economic activity and have no implications for inflation or interest rates. Fiscal policy is an inferior tool for demand management relative to monetary policy and should not be used in a fruitless effort to buy reductions in official interest rates. The proper focus for the budget is micro-economic measures that will enhance the supply-side of the economy. Unfortunately, such measures are likely to be thin on the ground based on pre-budget leaks, but we are happy to be surprised on that score.

RBA Governor Stevens will give the Inaugural Annual Dinner speech to the Sydney University Faculty of Economics and Business on Thursday, on the subject of ‘The Australian Economy, Then and Now.’ When Australian central bankers don’t want to say anything new, they often take refuge in an economic history lesson and this speech is likely to be no exception.

Across the Tasman, we saw a sharp fall in March quarter employment announced this week. Together with a decline in hours worked and what we expect will be a contraction in quarterly retail trade volumes released next week, there is a strong chance the New Zealand economy contracted in the March quarter. This has seen a dramatic turnaround in the monetary policy outlook, with most analysts now looking for a new RBNZ easing cycle to commence with the release of the September Monetary Policy Statement. However, it remains to be seen whether inflation outcomes will cooperate with this scenario, with the risk being that inflation remains elevated even as activity weakens, keeping the RBNZ on hold for longer than the market is currently pricing.

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com


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