New Zealand needs to cut tax, if the Government wants to avoid a recession

Friday, 9 August 2019

What does the official cash rate mean?

OPINION: If New Zealand wants to make sure to stave off a recession, the answer isn't with the official cash rate. It's with tax cuts.

The official cash rate was cut this week to 1 per cent. The drop wasn't a surprise – economists had almost unanimously been predicting it would fall.

But the depth of the cut was a shock to some.

Reserve Bank Governor Adrian Orr pointed to slowing gross domestic product growth and weakness in global economic activity.

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Giving poorer households money would create more of a spending boost than cutting the official cash rate.

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There's an international race-to-the-bottom to devalue currencies and support exporters, and New Zealand can't afford to be left behind.

The problem is, the lower the official cash rate, the less impact any cuts have.

Banks' floating mortgage rates have moved in line with the official cash rate, but hardly any of us have loans that are floating (about 17 per cent of all home lending). Their fixed-rate offers have moved only marginally.

Reserve Bank Governor Adrian Orr delivering the bank's Official Cash Rate decision in August 2018.

This means the theory that a lower official cash rate prompts more spending doesn't work so well. The more the Reserve Bank cuts, the more it uses up its economic ammunition but the less impact any of it has.

But if the Government really wants to pump up the economy and avoid the downturn that some predict is on the horizon, it does have options.

One of them would be to reduce taxes. The other would be to spend up large, and stimulate the economy through big projects.

The recent Tax Working Group report floated tax cuts, mostly focused on the lower end of the tax table and specifically a tax-free threshold. This was understood to be up to $7000.

Currently, if you earn up to $14,000 a year, you'll pay 10.5 per cent in tax.

Income between $14,000 and $48,000 is taxed at a rate of 17.5 per cent. Between $48,000 and $70,000 it's 30 per cent and over $70,000 it's 33 per cent. But you don't pay 33 per cent on that entire $70,000 - its only the bit $70,00 and above. We've got what's called a progressive tax system.

The Tax Working Group also recommended the Government consider increases in the bottom threshold of personal tax, and recommended that the Government consider combining increases in the bottom threshold with an increase in the second marginal tax rate.

But, it also suggested that if those tax thresholds were lowered, the abatement rate of Working for Families tax credits to offset the impact of the increase be reduced.

The Government is reportedly heading for a much bigger-than-expected surplus this year, and its self-imposed debt target of 20 per cent by the 2021/2022 is low by international standards.

It has room to give a bit back to the population. Wouldn't it be nice for the Government to return some of our hard-earned cash rather than spend it? Governments don't tend to do this, but let's dream for a minute.

Tax cuts can be more effective than the OCR in several ways.

Lower-income people tend to spend the extra money they get, which then boosts businesses around them.

They're more likely, as economist Brad Olsen says, to choose to get pizza for dinner once every so often or to buy a present for the kids if they have a little more in their pay each week.

Much of their debt isn't affected by the OCR at all. New Zealand is a nation of credit card-users – the cash rate has very little influence on the rates charged on those.

Tweaking the OCR, by contrast, benefits those households and businesses who have large amounts of debt with a bank. These people, generally, are better off and less likely to spend the extra they receive.

Borrowers are told time and again that they should make the most of low interest rates to pay off debt more quickly. This might be good for the individual household but it's terrible for the wider economy to have people doubling down in this way.

In 2009, Australian Prime Minister Kevin Rudd announced a stimulus package, which gave $950 dollars to many Australian workers and families. It worked. Australia avoided recession, unlike New Zealand, where the economy contracted 3.3 per cent between the December 2007 quarter and the March 2008.

Treasury has suggested New Zealand might need to do something similar.

Economists can roll out a lot of jargon and intricate predictions to show what they expect to happen but, broadly, it's a sentiment game.

If people feel good about the economy, it generally performs better. When they start to feel a bit shakier, it can become a self-fulfilling cycle of bad news leading to worse.

What's going to make people happier than a bit more money in their bank accounts each week? Compared to that, slightly lower interest rates for some of us just don't cut it.

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