Debt and deficit, levies and taxes: let the real debate begin

Tony Abbott is preparing the electorate for his government’s first budget. Julian Smith/AAP

The prospect of a “debt” tax or some sort of “deficit levy” to assist with the budget bottom line should prompt a clearer debate about the virtues of raising taxes versus cutting expenditure as a means of dealing with budget problems.

Reports have suggested a short-term tax on high incomes is being considered by the government, as a means of reducing the budget deficit.

In the debt and deficit discussion there’s a domineering but intellectually bereft notion which sees any public debt and any structural budget deficit as inherently problematic. This idea has for a long time been like a dead hand weighing on any enlightened debate on this subject.

So too the idea that expenditure cutting must be preferred to tax increases, to the extent that one or other is deemed unavoidable.

How levies work

But if we are to give it serious thought, a good place to start is by thinking about how a levy which raises, let’s say one billion dollars, would compare with an expenditure cut of one billion dollars. On paper, in the first instance, the impact on the budget bottom line is the same.

The tax would mean less disposable income and less expenditure by households. But because households do not spend all of their income in the aggregate, spending by households does not fall by the same amount as the levy.

Indeed, to the extent that the levy is targeted more towards middle and upper income groups, which might be assumed to save a higher proportion of their disposable income, the fall off in household spending from the levy will be smaller.

Government spending cuts are different

The same proposition however does not apply to an equivalent cut in government expenditure. If we’re talking about expenditure by government on goods and services, then spending on goods and services in the first instance falls by exactly that amount – one billion.

In other words, the effect on demand for goods and services in the economy is different between the two cases. The levy would have less negative impact on that demand than an equivalent expenditure cut.

One qualification here is if the cut to government outlays is not wholly in terms of government spending on goods and services but in terms of cuts to unemployment benefits, pensions or other welfare payments. These are income payments (which an economist would refer to as negative taxes). Cutting these would work similar to a levy or tax since it affects household spending via a change to household disposable income.

If all of the cuts to outlays were in this form then it would have an impact on spending much more in line with that resulting from the imposition of a levy. However, the impact on spending would likely be greater than for a levy, if the levy is targeted away from lower income households whereas welfare payments are concentrated in the low income groups, which spend a higher proportion of their income.

But a cutting of outlays to lower income groups in preference to imposing a targeted levy targeted at higher incomes is a proposition presumably no one in their right mind would support, at least one would expect.

This leaves the choice of imposing a levy to raise one billion or cutting government expenditure on goods and services by one billion.

If it is the case that the latter means a greater negative impact on household expenditure this means that the multiplier effect is larger. In other words, the negative impact of this cut in household spending through the economy will be greater.

Everything else being constant, growth in the economy will be slower for a time with the expenditure cut than it would be with the levy. But this means slower growth in tax receipts for a time and hence less benefit to the budget bottom line with the expenditure cut compared with the levy.

As I said above, this is where we should start in considering the pros and cons of a debt tax or debt levy or whatever you wish to call it.

Instead we have predictable shouting about broken promises of no new taxes, and two political parties captive to fear mongering about public finances. I live in hope that at the very least a discussion of a debt/deficit levy might provide the opportunity for both sides to rethink the predilection for lower taxes at the expense of the social wage.

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