Will Costello’s tax cuts push up rates?

It would be no surprise if yesterday’s election promise of a $34 billion, three year package of tax cuts by Treasurer Peter Costello set the cat among the economic pigeons.

After all, for the past year we have heard about how the Australian economy is positively bursting at the seams, with an interest rate hike likely to be necessary in order to keep inflation under control.

So surely the injection of a new $34 billion in tax cuts threatens to send our economy over the edge?

According to several leading economists, this is not necessarily the case – in the short term, anyway.

Why? First, the tax cuts are staggered over three years, with the bigger cut to taxes for higher income earners unlikely to bite until 2010.

As JP Morgan senior economist Stephen Walters points out, it is these cuts, rather than the earlier moves to tax payments by lower income earners, which will most strongly into consumer spending.

“We know low income earners don’t do the bulk of the spending, so it is money in the pockets of those with higher wages that will flow more quickly into consumer spending,” Walters says.

Second, according to Walters, the Reserve Bank of Australia expects a bit of extra spending by the pollies in election time, and has factored this into its calculations about inflation and interest rates.

“The RBA governor has made it clear he expects some loosening in fiscal policy, so for an inflation surprise you would need to go over and above what they were expecting and this promise doesn’t do that,” Walters says.

The third reason the package won’t necessarily force up rates is that government spending is just one factor among many that can have an impact.

NAB chief markets economist Rob Henderson says a slowdown or recession in the US, something that is still a distinct possibility, would more than cancel out spending stimulus from the tax cuts.

But both Walters and Henderson agree that interest rate rises, both this year and in the medium term, could still be on the horizon.

“You can expect the cuts to eventually flow into stronger household consumption, and combined with the forecast economic growth of 4.15%, which is little bit faster than the economy’s speed limit, that sort of rate of growth is not sustainable in the medium term,” Henderson says.

As for this year, the markets are still pricing in a strong chance of a rate rise before the end of this year, and quite possibly at the November meeting of the RBA if CPI figures to be released next week are stronger than expected.

“We think the case for rates to go up is strong anyway, so even if the effect of these cuts is down the track we could well see the RBA move in the short term,” Walters says.