Paying for cyclones

Step back in time with me. Six months ago or thereabouts, there was a lot of discussion about the size of the tax cut in the coming budget. Or, rather, the long-overdue inflation adjustment to the tax brackets. Tax bracket creep has been enormous since the brackets were last adjusted over a decade ago. It would be a cut in taxes relative to the large inflation tax increases that otherwise would continue to bake in.

What seemed most likely, at least to me, was that Labour would undo some of the bracket creep in the lower bands, perhaps taking things back to where they were in 2020 before the Big Inflation. But they would hold the 39% rate at $180k. And I expected that National would criticise them for not taking it all the way back to 2017 (ignoring the more minor bracket creep that they allowed to happen after 2011). And I hoped very much that National would pressure for indexing the bands going forward so that this sort of thing wouldn't keep happening. And in some best of all possible worlds, there'd be agreement to index the tax thresholds so the adjustments happen automatically (5% chance?).

Remember that the forecast path for tax revenues was based on no adjustment. It always has to take current policy as being the forward policy. That path continued to have a lot of inflation-driven tax increases built into it. Remember that this isn't just "well, everyone pays 7% more in tax but everything costs the government more". It's that people get pushed into higher marginal tax brackets, resulting in tax increases that outpace inflation - and considerably if you let them accumulate.

This substantial tax increase since 2011 was not voted for by anyone. It was not legislated. It had no democratic deliberation. It just happened, and especially from 2020 when RBNZ went off the hook.

And it will keep happening in the absence of changes.

Flip to the spending side.

As of six months ago, government was only slowly retrenching from continued ludicrous levels of 'Covid' spend. Government issued tons of debt to deal with Covid, and spent it very liberally on non-Covid things. It added to inflationary pressures that the Reserve Bank has to lean against. 

So where did that leave us? A Labour-led government seemed most likely to want to entrench a higher ongoing government-spend proportion of GDP. They'd package a minor inflation adjustment to the indices as a tax cut but maintain things at a level well beyond 2017. They'd cut some of the more ridiculous Covid spend and present a reasonable path back to surpluses but at a higher level of government spend and tax relative to the overall economy. And that's fair enough so long as there's long-term balanced budgets. 

Now what does this have to do with cyclones?

Let's remember standard drill. Here's what I said after the Christchurch earthquakes. And it's the same thing that Paul Krugman said about other similar spend. This is mainline econ stuff. I'll pull-quote Krugman again:

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters. [emphasis added]

This is the case against temporary levies and surcharges. Unless a government is debt constrained, you want to spread the cost over time. And you want to cover that cost through a combination of higher taxes than you otherwise would have had and lower spending on other stuff than you otherwise would have had. 

So if it had been the case that Labour was going to inflation-adjust brackets back to 2020, indexing them only going forward would be a tax increase relative to the path we would have had. If it had been the case that Labour was going to have locked in a permanent increase in the relative size of government on non-cyclone stuff, then a reallocation from whatever that stuff would have been toward cyclone is a spending cut. 

The case for an actual tax increase looks awfully weak given the massive increase in real government takings in the leadup to the cyclone. Thomas Coughlan pointed to the numbers yesterday. Core Crown revenues increased from 27.5% of GDP in 2017 to 30.2% of GDP in 2022. 

Core Crown revenues will have to be above the levels we'd had in the mid-2010s for a while - there's Covid debt to pay off. 

But the forecast expenditure track in HYFU had core crown expenses rising from $126 billion in 2022 to $150 billion in 2027. Surely there's room for greater reprioritisation in there, combined with slightly smaller inflation adjustments to tax bands than we otherwise might have had. 

We're still using borrowed money to fund over a billion dollars in discounted road user charges - when there are piles of roads to fix. It's nuts to consider a deadweight-cost-ridden income tax increase when government is using general tax revenue (in the end - it's what pays off debt) to avoid charging road-users for the use of the roads. That subsidy induces a deadweight loss! You're putting thorns in the heart of Baby Pareto! Can't you hear him crying?

Anyway - bottom line:

1. You spread the cost of this kind of thing over time with higher taxes than you otherwise would have had and less spending on other stuff than you would have had. You don't try to do it with a large temporary tax increase. Unless you're debt constrained. Maintaining low steady-state debt levels matters so that there's room to use debt for these kinds of shocks. 
2. Views on counterfactual taxation and spending paths will really matter in deciding what's here appropriate. If you think that it is right and proper that government take 30% of GDP as Core Crown revenue forever for regular spend or some amount higher than that, then you'd want a higher tax path to accommodate this spend. But everyone was expecting that government was going to be reversing at least some of the inflation bracket creep. Have views on appropriate size of government changed, or is this opportunistic? Or we all just crazy to expect that there'd have been an inflation adjustment to the tax brackets in May?
3. A smaller inflation adjustment to the tax thresholds really ought to be able to get the job done. Core crown revenue is about 2.5 percentage points higher, as fraction of GDP, than it was in 2017. If they can't use that increase to get this job done, you've gotta wonder how much work they're actually putting into reprioritising spend.