Brian Gaynor: Tax cuts? Not when we owe the world

Finance Minister Michael Cullen is the envy of every chief executive. He has reported an operating surplus of $11.5 billion for the year to June, an 83.7 per cent increase over the previous year, yet he is not recommending a higher dividend in the form of personal tax cuts.

Is this decision justified, or are Cullen's tax policies far too conservative?

Government tax revenue rose by 11.3 per cent to $52.4 billion last financial year. This figure clearly demonstrates that the Government swamps the private sector, as the combined revenue of Fonterra and Telecom, the country's two largest companies, is only $18.8 billion.

The Crown's tax revenue is made up of personal income tax (44.8 per cent), GST (19.8 per cent), company tax (16.9 per cent) and other taxes such as ACC levies, customs duty, and petrol and tobacco excise (18.5 per cent).

The main item under "other revenue" in the Government's financial statements is investment income. This rose 36 per cent last year because of higher NZ Superfund contributions and interest income.

The main expenditure cost is social security and welfare, which was up 6.2 per cent on the previous year. National superannuation, which cost $6.4 billion last year, was by far the biggest item in this area followed by domestic purposes benefits ($1.5 billion), family support ($1.3 billion), invalids benefits ($1.1 billion), accommodation supplements ($0.8 billion) and unemployment benefits ($0.7 billion).

The cost of unemployment fell 14.3 per cent last year because of the strong labour market.

Health and education spending also increased in real terms although a large part of the boost in the education figure was from the write-down in the value of student loans.

The other major item was the net surplus attributable to state-owned enterprises and Crown entities. This increased from just $400 million to $2.2 billion.

This resulted in an operating surplus of $11.5 billion, the figure that grabbed the headlines this week.

But we can't stop at this point because the operating balance is an accounting rather than a cash figure.

A $2.6 billion adjustment has to be made for non-cash items including the revaluation of assets, accounting changes (mainly in relation to provisional tax recognition) and the non-distribution of surpluses reported by state-owned enterprises and Crown entities.

As well, there was a $2 billion-plus contribution to the New Zealand Superannuation Fund, $1.8 billion for the purchase of assets and $1.7 billion of advances and capital injections.

The bottom line was a cash balance of nearly $3 billion compared with $3.1 billion for the June 2005 year.

Although the cash residual was far less than the accounting surplus, it could be argued that tax cuts are warranted because the Crown is in an extremely strong financial position with total assets of $158.3 billion, liabilities of $86.9 billion and a net worth of $71.4 billion.

Over the past 10 years, the Government's net worth has risen from $7.5 billion to $71.4 billion. Investment bankers would say Cullen oversees a lazy balance sheet and should be making bigger distributions to stakeholders in the form of tax cuts.

But looking at the issue from a strictly non-political perspective, the huge current account deficit severely restricts Cullen's ability to cut personal taxes.

The current account deficit, which is the difference between the country's income and spending with the outside world, is due to two main factors.

Demand in New Zealand is far greater than output. In other words, the amount we spend on things such as imported cars, oil and electronics and overseas holidays is significantly greater than the amount we earn from agriculture, horticulture and other exports and spending by foreign tourists in this country.

And we are poor savers, relying heavily on overseas equity capital and lenders. The lenders come into the picture because our demand for borrowed money is greater than the domestic supply.

As a result we give far more dividends and interest to foreign parties than we receive.

With demand substantially exceeding output, the last thing the New Zealand economy needs is personal tax cuts. The extra income would stimulate demand, boost imports and add to the current account deficit. Personal tax cuts at this stage would be appropriate only if individuals saved most of the additional income, which is highly unlikely.

Recent developments in Iceland are worth noting.

The country, which has a population of 300,000, has had one of the highest OECD growth rates in recent years and the largest current account deficit.

The Icelandic krona nosedived this year after Fitch Ratings downgraded the outlook for long-term Icelandic treasury securities from stable to negative.

The credit rating agency's main argument was that proposed personal income tax cuts would stimulate demand, which was already well in excess of output, as indicated by the large current account deficit.

The OECD's August survey on Iceland also criticised the tax reductions.

It said the tax cuts provided a considerable stimulus to the Icelandic economy at a time when tighter monetary policy, in the form of higher interest rates, was being used to dampen demand and inflation.

The OECD believes that the Government's budget strategy should be trying to achieve the same objective as monetary policy, rather than pulling in the opposite direction.

The widely held view is that Iceland's tax reductions were introduced too soon, and the Government should have waited until the central bank's high interest policy had been effective.

The same arguments apply to New Zealand.

The beauty of the Government's strong budget position is that tax cuts can be introduced once the Reserve Bank's high interest rates policies are effective.

That is the reason personal income tax cuts from April 1, 2008, are a near certainty, particularly as there will be a general election six months later.

But our current account deficit is also an issue of too few exports and not enough savings, and this can be addressed by tax changes.

Company taxes could be cut immediately if the Government was convinced this would lead to more investment in export businesses and other foreign exchange earning areas.

The KiwiSaver scheme is a start as far as savings are concerned but it doesn't go far enough to address the huge imbalance between our overseas receipts and payments in the form of dividends and interest.

The investment deficit is by far the biggest contributor to the current account deficit and will be seriously addressed only if there is more encouragement to save through tax incentives or some form of compulsory superannuation.

The final conclusions from an economic point of view are that Cullen is correct as far as immediate personal tax cuts are concerned, but he could reduce company tax at this stage, particularly if it stimulates investment in exporting.

As far as savings are concerned Cullen is too cautious.

He needs to introduce further tax incentives, or some form of compulsory superannuation, to reduce our heavy dependence on overseas equity and borrowings.