Treasury advised Nicola Willis her tax package would reduce inflation and interest rates but should be trimmed by $500 million to help balance the budget faster

Treasury officials advised Finance Minister Nicola Willis that fully-funded tax cuts would put some downward pressure on inflation and interest rates, although the impact would be small.

This backs-up the claims she has made since getting into Government, even though the Reserve Bank assessed the impact of income tax cuts as being neutral or uncertain.

Advice released as part of the budget process showed the Treasury told Willis it expected any increase in private spending to be smaller than the decrease in government spending.

This may be because households choose to save some of that extra income, but it was true even if the full amount was spent — as GST would return 15% to the Crown. 

Another scenario showed that lower tax rates would encourage more people into the labour force, but that effect would be more than offset by the reduction in demand and employment from government spending cuts.

While Treasury officials didn’t entertain any possibility of the income tax cuts being inflationary, they did warn these estimates were purely “illustrative”.

“None of these assumptions will necessarily be accurate, but serve to approximate the range of results and allow readers to interpolate any intermediate policy responses,” they wrote. 

The tax package would reduce interest rates by about four basis points over the next two years if the extra money were fully spent by workers. Or, rates could be 14 basis points lower if they saved 70% of the money.

Interestingly, even if the tax cuts had been entirely debt-funded it wouldn’t have impacted interest rates very much. That scenario showed interest rates lifting just 16 basis points. 

On the other hand, cutting spending without also lowering taxes could have lowered interest rates by 20 basis points — a little less than one rate cut. 

“While the scenario modelling shows some impact on macroeconomic variables such as nominal interest rates, the absolute magnitude of these impacts is relatively small,” Treasury officials said. 

They also warned the policy would result in an increase in unemployment, as net demand would decrease. However, it was not confident enough to give a specific estimate.

“We are confident though in the direction of the impact, which is the flip side of the easing of inflationary pressures due to the reduction in demand,” they said.

Operating allowances 

The Treasury also advised the Finance Minister to lower annual operating allowances, but not by as much as she did. It said the annual operating allowances in Budget 2023 would mean being in deficit for nine years and suggested cutting them by up to $300 million. 

Willis went further than this and hacked them by $600 million to just $2.4 billion in each of the coming years. Treasury documents did not recommend this and warned it was the smallest possible operating allowance on the table. 

“We do not recommend this option at this time as it increases the relative risk that allowances would need to be increased in future,” they said. 

Treasury said it would take support from all ministers in Cabinet, ongoing reprioritisation, and minimal out-of-cycle funding, to stay within such small allowances. 

It is notable that there are already examples of two of these guidelines being crossed. 

Foreign Minister Winston Peters successfully negotiated to be excluded from the public sector spending cuts, and a big out-of-cycle funding package for cancer drugs was announced shortly after the budget.

Officials said there was not a “clear rationale for exempting MFAT” from the savings process and advised using savings from Foreign Affairs to help fund a boost in the defence budget.

Now or later

While Willis cut her future allowances aggressively, she didn’t trim the 2024 allowances as much as recommended by Treasury. Worsening economic forecasts prompted officials to advise Willis to cut the upcoming budget by “as much as possible, ideally by at least $500 million on average per annum”. 

This was because the first operating allowance was the largest, originally set at $3.5 billion, and cutting it would have the biggest impact on the deficit and inflation. 

However, it would involve decisions at “the upper bounds” of available options and/or scaling back the tax package by about $500 million a year — to help the return to surplus. 

“From a macroeconomic perspective, a smaller operating allowance at Budget 2024 would likely help deliver interest rate relief sooner,” Treasury added.

But this was politically unpalatable to Willis, and she ultimately set the allowance at $3.2 billion and kept her tax plan intact. This contributed to the lower allowances in future budgets, which are smaller than Treasury’s estimates of cost pressures.