Bank fears mother of all binges

Australians are looking forward to a swag of tax cuts in their pay packets this month, but analysts worry that the windfall could trigger a rise in interest rates if they spend rather than save it.

Personal tax cuts worth A$8.9 billion ($11 billion) come into effect in July, amounting to around 1 per cent of gross domestic product or about A$1000 per taxpayer.

In all, the Government plans to return around A$36.7 billion to taxpayers in the four financial years ending in June 2010.

"Extra cash in the pocket should mean extra spending," said Rory Robertson, interest rate strategist at Macquarie Bank.

Yet that was exactly what Australia's central bank does not want at a time when it is tightening monetary policy in an attempt to restrain demand and inflationary pressures.

So, while the Reserve Bank of Australia kept rates at 5.75 per cent at its July policy meeting this week, analysts see the fiscal largesse as a major reason it might still have to tighten in months to come.

"There's no getting round the fact that this expansionary policy means upward pressure on demand, inflation and interest rates will be greater than it otherwise would have been," said Robertson.

"Monetary and fiscal policy are pulling in opposite directions."

Whether people chose to spend or save is an open question.

Some analysts argued that, with record petrol prices taking a bigger share of the household budget, people might use the money freed by the tax cuts to maintain their spending habits.

Indeed, it could be argued that, by raising borrowing costs, the central bank's last rate hike in May actually increased the chances of people spending their tax gains.

There was even a hint of that in figures for debit card activity in June. The Cashcard retail index showed a seasonally adjusted 0.4 per cent gain in spending on top of a hefty 0.9 per cent rise in May.

Greg Nash, managing director of Cashcard's parent company First Data International, said it looked like consumers were spending the tax relief even before they got it.

The full effect of the cuts could show up in the official July retail sales report due at the end of August.

"This will be the first retail data to include the impact of the generous tax cuts and probably will show that households were inclined to spend rather than save their fiscal windfall because of the squeeze from higher interest rates and energy prices," said Stephen Walters, chief economist at JPMorgan.

He estimates the windfall will boost economic growth by around 0.5 percentage points of GDP in 2006-07 alone.

The economy grew by 3.1 per cent in the year to the first quarter and analysts fret that anything faster would stoke inflation in an economy already fully stretched by 15 years of uninterrupted expansion.

Still, not everyone was convinced that taxpayers would automatically spend all their new-found income. After all, taxes were also cut in 2005/06 and most of the money was used to trim debt or build savings.

"Although the potential boost from the tax cuts is large, the past two rounds of tax cuts barely had any impact on growth as households ended up saving rather than spending them," said Kieran Davies, chief economist at ABN Amro.

Even Macquarie's Robertson said that the tax cuts favoured high-income earners who might be more inclined to save the extra cash.

"The main thing limiting the inflationary risks of the tax cuts is the fact that a good chunk of the cash is headed towards the well-off who have a lower marginal propensity to consume than the less-well-off."

Analysts also noted that a portion of any extra spending would go on imports - which account for about 10 per cent of consumption - and thus subtract from economic growth.

In fact, after mapping the average level of taxes against GDP, ABN's Davies actually found it was economic growth that led to lower taxes, and not the other way around.

- REUTERS