Working Papers

Tax Cuts Don’t Cause Higher Interest Rates: Round-Up the Usual Suspects

Tonight’s federal budget has the usual suspects (that means you, Chris Richardson) lining-up to tell us that any fiscal stimulus, whether in the form of tax cuts or new spending, will put upward pressure on interest rates.  This would come as news to RBA Governor Macfarlane, who has told the House Economics Committee on at least two occasions that fiscal policy has not been a significant influence on monetary policy in recent years.

What made the government’s claims about interest rates during the last federal election campaign so silly was that the 17% mortgage interest rates of the late 1980s were in fact associated with much larger federal budget surpluses as a share of GDP than we have now.  The 1988-89 underlying cash surplus was 1.8% of GDP.  The best Peter Costello has engineered to date is an estimated 1.1%.

If anything, we would expect strong budget surpluses to be associated with higher interest rates, because both are a reflection of the strength of the economy.  This is correlation, not causation.  As a general rule, the budget balance is a very poor guide to interest rates, both over time and across countries.  The industrialised country with the lowest interest rates in recent years has been Japan, which has also seen the worst fiscal deficits.

Readers are invited to submit entries for the silliest or most overwrought comment and analysis on the budget, either in comments or via email.  A small prize may ensue for the best entry.

posted on 09 May 2006 by skirchner in Economics

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Even if you believe in Keynesian macroeconomics, you would not expect a fiscal stimulus to have much effect in a small open economy with a floating exchange rate and a high degree of capital mobility. A fiscal stimulus would tend to increase net capital inflow, appreciate the exchange rate and reduce net exports, offsetting the effects on interest rates and aggregate demand.

It is monetary policy that is powerful in such a world, although the pre-tax real interest rate is still determined mainly by world capital markets.

Apart from not being on top of open economy macroeconomics, Chris Richardson also seems to believe (in the face of all evidence to the contrary) that

1.A large surplus will not encourage extra government spending (which would stimulate the economy as much, if not more, than tax cuts)

2. That tax cuts are somehow irreversible.

I didn’t have to look far for an entry to your competition (the silliest). The front page of the Sydney Morning Herald has this headline (in very large print): “Spend: Tax rates slashed (sic)”. Apart from thinking tax cuts are government spending, it reveals the mindset of the staff at the Herald: letting us keep some more of our hard-earned income is the Government spending ‘its’ money on us.

Posted by .(JavaScript must be enabled to view this email address)  on  05/10  at  04:53 PM

As I argue in comments above, from a permanent income perspective, we would expect a temporary reversal of bracket creep to be entirely saved rather than spent.  Government spending is rising, so the private sector’s expected income should be unchanged.

Posted by skirchner  on  05/10  at  05:26 PM

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