ABC News: Alistair Kroie/John Gunn
Would you prefer to give an additional $300 each month to your bank or the federal government? Most individuals would likely respond with a resounding “neither.” However, if you had to choose between the two, which option would you select?
On one hand, the bank would distribute your money to savers, shareholders, and bondholders. On the other hand, the government could utilize those funds to lessen national debt, provide public services, and invest in infrastructure development.
At present, governments have opted to direct funds to banks and their investors, as they have largely delegated the responsibility of managing inflation to the Reserve Bank of Australia (RBA).
During a press briefing this week, RBA Governor Michele Bullock emphasized that interest rates are the sole instrument available to the bank for controlling demand and managing inflation. “The interest rate is the tool we’ve got,” she stated in response to a query from ABC journalist Emilia Terzon. “It’s blunt, and it affects individuals in various ways, but it’s the most effective method we have for controlling inflation.”
For instance, with a typical $700,000 mortgage, borrowers have seen their monthly interest payments increase by $317 due to three rate hikes this year. But could there be alternative solutions?
Historically, interest rates have not always been the primary means of combating inflation. During the previous surge in inflation following COVID-19, prominent independent economist Saul Eslake addressed audience inquiries on potential non-rate strategies to tackle elevated inflation levels. He referenced historical practices, noting that altering tax rates was a prevalent method in the more regulated economies of the 1950s and 1960s.
“In 1951, in reaction to the double-digit inflation brought on by the Korean War wool boom, the Menzies Government instituted a 10 percent surcharge on personal income tax, raised company tax rates, mandated that companies prepay 10 percent of their estimated tax liabilities, and increased the sales tax from 8.5 percent to 12.5 percent,” he explained. However, Eslake cautioned that these measures had similar downsides to increasing interest rates.
“These strategies were effective; inflation decreased from a peak of 23.9 percent at the end of 1951—the highest rate recorded in Australia—to a low of 1.6 percent two years later,” he noted. “Yet, this came at the cost of plunging Australia into its first post-war recession, with real GDP contracting by 0.8 percent in 1952-53, corresponding to a 2.8 percent drop in real per capita GDP, and pushing unemployment from 1.1 percent to 2.9 percent, which was considered alarmingly high at the time.”
Eslake further highlighted that the drastic actions were partly due to the Menzies government delaying action against inflation until after the April 1951 elections, despite inflation already reaching 12 percent.
Another noted Australian economist, Nicholas Gruen, articulated in a late 1990s publication that “the central issue is that fiscal expansion is typically more politically appealing than contraction, leading to a bias toward expansion.” Essentially, it is often easier for governments to increase spending on public services and reduce taxes than to reverse such actions, even when the economy would benefit from such measures, particularly when elections are approaching.
This presents a significant argument against employing fiscal policies, such as modifying tax rates, for economic management, as politicians may prioritize their political gains over the national interest. Additionally, altering tax rates can be a lengthy process, as such changes necessitate parliamentary approval.
As Bullock pointed out, “It’s not a very nimble way to address inflation.”
Could a ‘Central Fiscal Authority’ provide a solution? In his 1990s paper, Gruen proposed a potential remedy supported by another esteemed Australian economist, Ross Garnaut. This proposal entails the establishment of a “Central Fiscal Authority” (CFA), an independent body akin to the Reserve Bank, but endowed with the authority to adjust government tax policies within a predefined range.
For instance, Parliament might amend income tax laws to allow the CFA to adjust “base rates” by up to 2 percentage points in either direction. This authority could extend to company taxes and potentially the Goods and Services Tax (GST), although any GST modifications would require state agreement.
This proposed body would not replace the RBA or eliminate the necessity for adjusting interest rates entirely; rather, it would function alongside the central bank to stimulate demand during economic downturns or temper demand when inflation runs high. This collaboration could enable the RBA to adopt a more measured approach to rate adjustments, leading to reduced fluctuations in repayments for borrowers and interest returns for savers.
The increased stability in interest rates could also enhance confidence in investment decisions for both individuals and households. In his paper, Gruen argued that such a framework would offer several advantages over reliance solely on the central bank. Firstly, he posited that altering tax rates could impact the economy more swiftly and uniformly than monetary policy, which often has uneven effects.
With Australia’s PAYE (pay as you earn) system, temporary adjustments to income tax rates could be implemented within two weeks for most workers, which is significantly faster than the months required for interest rate changes to influence mortgage payments, with full economic effects taking 12 to 18 months to materialize. Unlike interest rate adjustments, changes in tax rates would affect all taxpayers, not just those with outstanding debts. Additionally, many savers could see their benefits from higher interest rates diminished due to increased taxation.
