Tax Cuts in a Near-Capacity Economy

The economy is near capacity: unemployment of 5.2% is close to estimates of the natural rate, and core inflation of 5.1% with expectations at 4.2% shows inflation is persistent.

A $2.4bn tax cut (1.3% of GDP) with a multiplier of 0.9 raises aggregate demand by about 1.2% of GDP, consistent with the estimated 1.1% rise in consumption. On an AD/AS diagram, AD shifts right. Because the economy is near the vertical section of the AS curve, most of the effect is on the price level, with little on real output.

• Short run: output may rise slightly, but capacity constraints and a tight labour market mean firms respond mainly by raising prices and wages.
• Medium run: inflation expectations rise further, workers bargain for higher nominal wages, SRAS shifts left, and output returns to the natural rate at a higher price level.
• Policy reaction: the central bank's 75bp of OCR increases shift AD back left, so the net output effect may be close to zero while the composition shifts from private consumption towards reduced investment and a higher exchange rate.

The tax cut is therefore largely ineffective at raising real output; it mainly redistributes income and raises the price level.

The claim conflates nominal and real income. A tax cut raises nominal disposable income, but if prices rise faster, real incomes may not improve. With inflation at 5.9% and expectations at 4.2%, a demand stimulus risks embedding inflation.

The policy mix is contradictory: fiscal expansion while monetary policy is tightening forces the central bank to raise the OCR further. Higher mortgage rates could offset the cash benefit for indebted households, and the distributional effect favours those with jobs and higher incomes, not beneficiaries or renters.

The multiplier of 0.9 is estimated near capacity; if the central bank fully offsets the stimulus, the effective multiplier is close to zero. Credibility is also at stake: if expectations become unanchored, the later cost of disinflation - higher unemployment - rises.

With net debt at 48% of GDP and a 3.1% deficit, the cut is debt-financed, shifting the burden to future taxpayers and increasing vulnerability to interest rate rises.

Judgement: the claim is valid only in nominal, short-term terms, and only for households that keep their jobs. As a cost-of-living policy it is poorly targeted compared with direct transfers or supply-side measures.

A more coherent package would combine four elements:

• Targeted transfers to low-income households, time-limited and indexed. These have a high marginal propensity to consume for necessities but a smaller aggregate demand impulse than a broad tax cut, protecting the vulnerable without adding as much to inflation.
• Supply-side investment in energy, transport and housing infrastructure, plus consenting reform. These shift AS right over time, reducing inflation while raising real output - the only sustainable way to improve living standards.
• Fiscal consolidation: offset the transfers with savings elsewhere, or let the deficit fall as the economy grows, keeping debt on a downward path and avoiding adding to demand.
• Coordination with the central bank: publish a fiscal strategy consistent with the inflation target so expectations fall, reducing the OCR increase required.

Justification: the binding constraint is supply, not demand, so a demand stimulus at near capacity is inflationary. The package addresses equity and efficiency together. The trade-off is that supply measures take time, so short-term transfers bridge the gap. Overall, this package is more likely to reduce the real cost of living while preserving macroeconomic credibility than a debt-financed tax cut.