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Australia needs income tax cuts to spur economy

Australia needs income tax cuts to spur economy

SYDNEY: At the start of each year, it is customary for economists to offer up predictions for the coming 12 months. For economists in financial markets, chief among those predictions is the likely course of official interest rates. Yet the more interesting policy moves in 2018 might not be interest rates. Indeed, Deutsche Bank doesn’t have the Reserve Bank increasing interest rates until the second half of 2019.

So, does that mean 2018 will turn out to be a boring year? Not likely. Rather, it means that the action might be more on the budgetary front – namely income tax cuts.

For all the focus on the mining/non‑mining split, that’s not where the real fault line lies in Australia’s economy. Instead, it is the split between difficult conditions facing households versus those reported by businesses.

At the heart of that split is the weakness in wages growth; it has kept household incomes and consumption very soft. In fact looking back to the mid‑1980s, there has only been a handful of episodes where growth in household spending has been weaker.

While wages growth probably won’t slow any further, global experience suggests a real turnaround is unlikely until the unemployment rate moves through old estimates of full employment (about 5 per cent in Australia). We also draw a similar conclusion by looking at NSW, where the unemployment rate has averaged less than 5 per cent for a year while wages growth remains stuck around record lows.

Against a backdrop of near-record low wages growth, weakness in consumer spending, and growth in household incomes over the past few years not far above recessionary levels, the household sector could probably do with a bit of a hand up in the form of income tax cuts, rather than a hit from higher interest rates.

Additionally, part of the reason for the weakness in household spending and softness in consumer sentiment evident over much of 2017 might be the pernicious impact of bracket creep.

The share of household sector income devoted to paying taxes has risen back to levels last seen in 2006. In other words, households have been – in aggregate – progressively handing back the Howard/Costello and early Rudd tax cuts in the form of bracket creep for quite some time.

Factoring in bracket creep also helps explain why progressive reductions in interest rates have failed to stimulate consumer spending.

If we combine tax payments as a share of household income with interest payments as a share of household income (to construct a measure of household financial obligations), we find that the last few rounds of interest rate cuts were largely offset by the steady increase in the share of income going to pay taxes.

Sitting behind bracket creep has been the need to restore the federal budget to surplus. It was Australia’s stellar budget position that enabled us to dodge the global financial crisis, so returning the budget to surplus must take priority.