Many are questioning the fairness of using rising interest rates as the primary tool to cool down the economy, especially when it seems to primarily affect mortgage holders, leaving cash-rich baby boomers untouched. In this article, we delve into the alternative strategies for economic cooling, particularly the idea of using the Goods and Services Tax (GST) as a more inclusive approach.

The Role of Monetary and Fiscal Policies: Traditionally, macroeconomic policy has relied on monetary policy, such as adjusting interest rates, to manage regular economic fluctuations. Fiscal policy, on the other hand, is reserved for addressing major crises like the Global Financial Crisis (GFC) or the onset of a pandemic like COVID-19. 

Professor Jeff Borland, a Truby Williams Professor of Economics at the University of Melbourne, sheds light on this division. According to Prof. Borland, fiscal policy revolves around balancing government spending with tax revenue, with a focus on priorities like healthcare, welfare, and infrastructure. “Using interest rates as the main policy to try to deal with inflation - as is happening at present - is out of this playbook,” he says.

(Professor Jeff Borland pictured above)

“I think that the government would argue that, in this case it is also assisting to reduce aggregate demand* through fiscal policy (at least for the financial year past) by having a relatively large budget surplus (that is, taxes are bigger than spending, which reduces aggregate demand),” says Prof. Borland.

*Aggregate demand is a measurement of the total amount of demand for all finished goods and services produced in an economy. Aggregate demand is commonly expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.

The RBA's role and government's objective: The Reserve Bank of Australia (RBA), as an institution, is legislatively bound to utilise interest rates for stabilising the economy. However, the government contends that it's also employing fiscal policy to reduce aggregate demand through significant budget surpluses.

Challenges in using the GST: Why isn't the GST used as an alternative to reduce spending? Prof. Borland highlights a few critical factors. Firstly, tax changes, especially increases, often trigger opposition campaigns and political controversy. Secondly, the practicality of frequently adjusting the GST rate raises administrative concerns. There is also a political issue relating to tax changes. Unfortunately increasing taxes has become an issue where you can count on the opposition party to mount a knee-jerk campaign against it, which would make the government hesitant about using taxes to reduce aggregate demand.

Regressive nature of the GST: One key drawback of using the GST is its regressive nature. Low-income households bear a proportionally greater burden because they spend a larger share of their income on goods and services. Prof. Borland acknowledges this issue and suggests that the government could consider short-term taxes on high-income earners to achieve a more equitable distribution of the burden.

To illustrate the regressive impact of the GST, consider two households: one with a weekly income of $500 (low income) and another with $2000 (high income). When a 10 per cent GST increase affects all their expenses, the low-income household is hit harder, as $40 represents 8 per cent of their income, compared to only 5 per cent for the high-income household.

To counter the regressive impact of the GST, measures like increasing income support payments and lowering income tax rates for low-income individuals were implemented when the GST was introduced.

Equity considerations in interest rate policies: Prof. Borland raises a crucial point that increasing interest rates can have adverse equity effects, particularly impacting those with variable-rate mortgages. As inflation begins to slow, it becomes imperative to strike a balance between economic stability and equity.

While interest rates remain the primary tool for controlling inflation, exploring alternatives like GST adjustments should not be dismissed. Achieving both economic stability and equity is a complex challenge, and policymakers must carefully consider the trade-offs as they chart the path forward.

This is how macro policy has operated since the early 1990s. As an organisation, the RBA's legislation and letter of instruction from the government basically requires it to use interest rates to stabilise the Australian economy.

“I think that the government would argue that, in this case it is also assisting to reduce aggregate demand* through fiscal policy (at least for the financial year past) by having a relatively large budget surplus (that is, taxes are bigger than spending, which reduces aggregate demand),” he adds.

Secondly, there is also a political issue relating to tax changes. Unfortunately increasing taxes has become an issue where you can count on the opposition party to mount a knee-jerk campaign against it, which would make the government hesitant about using taxes to reduce aggregate demand. There is also the issue of not wanting to be adjusting GST up and down all the time, which is an important consideration since it would require a great deal of administration. 

Prof. Borland also offers, “An issue about using the GST to reduce aggregate demand is that it is a regressive tax; that is, in relative terms it has a bigger negative impact on low income than high income households, which is because low-income households spend a larger proportion of their incomes on goods and services.”

“So, as well as not wanting to be adjusting it up and down all the time, its regressive impact is another reason why the government wouldn’t use the GST to try to reduce aggregate demand. At the same time, the general idea of using taxes as a mechanism to reduce aggregate demand is certainly sensible. For example, if there is seen to be a need to reduce aggregate demand, the government could consider a short-term extra tax on high income earners, and it could then be argued that (together with the interest rate increases) the burden of reducing the rate of price inflation was being more evenly shared.”

The bigger negative impact of the GST increase is in relative terms, as a proportion of household's income. As an example, a low-income household that earns $500 a week and a high-income household that earns $2000 a week. It's known that the low-income household will spend a bigger proportion of its income than the high-income household. In this example, the low-income household spends 80 percent of its income ($400) and the high-income household 50 percent of its income ($1000). 

Supposing there is a GST rise that increases the cost of the goods and services to which it applies (by 10 percent) and suppose that GSP applies to everything that both households buy. The cost of buying the same set of goods and services will rise by $40 for the low-income household and by $100 for the high-income household. (That is 10 per cent of the original amounts of spending of $400 and $1000 respectively.)

The important thing is that $40 is eight per cent of the income of low-income household, but $100 is only five per cent of the income of high-income household. Consider also that the absolute amount of tax paid by high-income households is greater; but in relative terms they are less affected because it's a smaller share of the income they have available. Also, it's in relative terms that economists usually think of, in terms of how the well-being of households is affected.

Due to the regressive impact of the GST, when it was originally introduced there was a lot of attention to increasing income support payments and lowering income tax rates for low incomes - to offset that regressive impact.

Prof. Borland agrees that increasing interest rates is having negative effects on equity and suggests that needs to be more taken into account when considering what the overall policy response to reduce price inflation should be.

“The good news is that inflation does seem to be slowing, and the faster that happens the quicker the rate increases can be reversed, which will remove the adverse equity effects, and also minimise the extent to which the rate of unemployment rises,” says Prof. Borland.