The Nightmare Shadowing Key's Dream Run

By James, Colin | New Zealand Management, May 2008 | Go to article overview

The Nightmare Shadowing Key's Dream Run


James, Colin, New Zealand Management


In Budget after Budget during Michael Cullen's time the Treasury has been wrong. It has projected less revenue than the economy dished up. This time, if the Treasury is wrong again, chances are revenue will be lower, not higher.

Just whose problem will that be?

In an economic upswing companies do well, profits rise, individuals' incomes rise and taxes deliver a chunk of all that to the Treasury, with a lag--and with a built-in bonus: fiscal drag siphons a higher proportion of individuals' incomes in taxes as their incomes rise through the thresholds at which higher rates cut in.

So the Budget's operating surplus climbs, siphoning off cash and helping avoid overheating. This is the "automatic stabiliser" in action. The "fiscal impulse" on the economy is contractionary.

When the economic cycle turns down, as it always does, revenue falls, the operating balance falls, the automatic stabiliser reverses and the "fiscal impulse" turns expansionary. That helps avoid overcooling.

The job of a prudent treasurer is to ensure that in the upswing the surplus is not frittered away in spending and tax cuts so that in the downswing the Budget does not go into serious deficit.

That is, the treasurer must be sure before doling out the surplus that it is "structural"--the result of a step-change in economic activity--not just cyclical. The risk is a return to the structural deficits of the 1970s, which necessitated painful reforms in the 1980s.

Cullen and Helen Clark were determined not to risk structural deficits. The surpluses grew. Cullen was besieged by demands for social and other spending, and for tax cuts.

In 2005, facing a tough re-election fight, they spent heavily--as if the surplus had become structural. Don Brash and John Key also campaigned as if it was structural, promising lavish personal and company tax cuts (though some of that was to be covered by spending curbs).

There was some reason to think in 2005 that the surplus had become structural. The economy kept growing strongly, in part because of an upturn in the terms of trade, in part because the international economy (particularly China) was growing strongly, in part because jobs were plentiful and in part because consumers were cheerily piling up debt and spending it.

Cullen's difficulty in 2005 was distilling which bits of that mix were structural and which were either cyclical or illusory. …

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