Global monetary policy tightens

In short, the Australian economy is again picking momentum with growth likely to be above trend in 2006. With the mother of all resource booms and the recent sell-off of the Aussie dollar, the big issue for the second half of 2006 is likely to be overheating and, dare we whisper, inflation. And we advise, following Basil Faulty: "Don't mention the CAD!"

The budget is in surplus, and pressure is building on Treasurer Peter Costello to start the hard grind of another round of tax reform. So far he is resisting this pressure manfully, and one can only admire his fortitude as virtually every galah in the pet-shop, including Henry, believes he should give in gracefully. One recognises, of course that the Treasurer wishes to avoid adding fuel to an already buoyant economy which the latest data says is already picking up speed.

The answer here is to announce some goalposts for real tax reform, including a 30 per cent top marginal rate of income tax and the number of years in which it will responsibly be achieved - such as 5 to 8 years. Simple arithmetic suggests that the annual reduction in the top rate should be manageable in a buoyant economy.

Suppose for a moment the Treasurer does as most economists believe he should and grasps the nettle of serious tax reform.

The knee-jerk reaction of some to such a graduated, pre-announced program of tax cuts might be to say interest rates would be higher. Of course the net effect on aggregate demand in the economy would depend on other budgetary changes and the Reserve Bank would hope those other changes made the overall reform package approximately neutral in its effect on aggregate demand. But there is a far more profound issue to consider. The effect on the supply side of the economy would be to encourage work, household saving and entrepreneurial effort.

In Henry’s judgment, these favourable supply side effects might well outweigh the effect of tax cuts in raising aggregate demand even if the effect of the tax cuts on demand were not offset by other budgetary changes. But the main point is that a gradual, pre-arranged program would allow plenty of time and expertise to be brought to bear to ensure the overall economy remained in balance. Perhaps monetary policy would need to be a touch tighter, but there is no way there would need to be a dramatic tightening of monetary policy to “undo” the effects of cuts to income tax.

Whether (or when) cash rates again begin to rise in 2006 lies in the lap of the gods. As we have said for some time, RBA Governor Ian Macfarlane will do everything he can to sit on his hands at least until his choice of successor is signed on for the traditional seven-year term. Recent economic news, however, strengthens the case that the next move in rates is far more likely to be up than down.

But the big question for Australian economic policy remains as it has been for some time. When will the Treasurer grasp the nettle of serious tax reform?