POLITICS : The Nightmare Shadowing Key’s Dream Run

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 chunk of all that to the Treasury, with lag – and with built-in bonus: fiscal drag siphons 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 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 step-change in economic activity – not just cyclical. The risk is 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 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. Some of the international strength came from the United States Federal Reserve Board’s low interest rates, which expanded the money supply, jacked up asset prices and encouraged consumers to take on debt and spend.
At home, demands for tax cuts spread from the mansions of Remuera to the units of South Auckland. Last year Clark and Cullen concluded there was no alternative to tax cuts this year.
In any case, equity demanded they return some of the fiscal drag. That essentially was what Peter Costello was doing in Australia and growing numbers of New Zealanders took note.
The debt-fuelled economic party ended last year in the United States. Now it has ended here.
Still, in this month’s Budget Cullen should be able to project firm revenues. The received wisdom is that the Treasury has been systematically, not just cyclically, underestimating revenue.
So Cullen should be able to bid high for re-election, on spending and tax. Key and Bill English should, too.
But what if their estimates of what is structural and what is cyclical are over-optimistic?
There are two dimensions.
A government can look through short-term contraction, even sharp or severe one, which rebalancing this seriously unbalanced economy will at some point require. The automatic stabiliser will inject an expansionary offset to such contraction and post-election treasurer could ride it out.
But if we have to some extent fooled ourselves these past few years, thinking that piling up debt and spending it was real and sustainable – that is, that more of the boom was structural than was actually the case – things will be tougher for longer.
The public reaction to longer and tougher adjustment would kill fourth-term Labour-led government. Cullen would be remembered less for his early careful stewardship than his later relaxing the reins.
And for new government, tax cuts followed by tough times for households could, if the worst came to the worst, turn out to be recipe for single term.
That is the nightmare shadowing Key’s dream run.

Colin James is New Zealand’s leading political commentator and Management’s regular political columnist.

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