What if tax cuts don’t get people spending?

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Economic theory states: tax cuts are stimulatory. They will boost aggregate demand and support economic growth. But what if they don’t?

Let’s rewind a step. In terms of people’s incomes, there are three things that happen with their money. They can spend their money, they can save it and they have to pay tax. Sigh. This relationship is neatly summarised by:

Y=C+S+T

(Where Y is income, C is consumption, S is saving and T is tax.)

After Saturday’s election in Australia, the Morrison Government has been re-elected and it’s now figuring out how to implement its proposed tax cuts. Under the tax cuts, people earning up to $126,000 will get $1,080 back at tax time. This potential economic stimulus is so large that it could be equivalent to TWO Reserve Bank of Australia rate cuts, each of 25 basis points (according to the Commonwealth Bank of Australia’s economics team).

"The RBA [may] refrain from taking the cash rate lower because they know that household consumption will pick up in the second half of 2019 courtesy of the tax relief,” says CBA senior economist Gareth Aird.

But what if consumer don’t spend their extra income? What if they save?

In recent years, the size of the average Australian mortgage has been rising (mortgage payments now make up 34% of household incomes). At the same time, Australia has relatively low household savings rates (see graph below). If households are given a bunch of extra money, they could save it, depending on their marginal propensity to save or spend.

The marginal propensity to save (MPS) or spend (MPC, C for consumption) is what proportion of every extra dollar in income will be spent or saved.

Australia’s household savings ratio — peep that decline!

Australia’s household savings ratio — peep that decline!

My point here is that, as economists, we need to factor in the possibility that the government’s policies may not have their intended impact. Or they may not have as large an impact as the government would like.

How can you use this information?

  • When you’re talking about fiscal policy for 2019-20, mention the Morrison Government’s tax cuts and their impact according to economic theory. But also include the possibility that households will save, not spend.

  • Mention the potential impact of these tax cuts: equivalent to an RBA rate cut of 25 basis points. So, very stimulatory.