KEY POINTS:
The size, timing and allocation of tax cuts won't be decided until close to the May Budget, Finance Minister Michael Cullen says.
In the meantime we have to make what we can of the four tests for tax cuts that he has spelled out.
TESTS 1 AND 2
The first conditions that must be met - that the Government will not borrow, or cut services, to pay for tax cuts - bear on the issue of how much money will be on the table.
At one level it is a reminder that $1 less tax revenue is $1 less for the Government to spend or, if it does not want to adjust its spending plans, it means that Government debt will be $1 higher.
But to speak of borrowing "for" any particular thing is misleading. Any increase or fall in Government debt is the bottom-line impact of changes to its income and spending.
A literal-minded interpretation - that there will be no tax cuts if the Government has to increase its debt, so that tax cuts can only be funded from cash surpluses - is unlikely to be right.
More likely "not borrowing for tax cuts" means living with the Government's longstanding, self-imposed definition of fiscal prudence. That is to keep gross debt, relative to the size of the economy, around the 20 per cent mark.
It is certainly less of a mouthful than "keeping gross sovereign issued debt (excluding Reserve Bank settlement cash) below 20 per cent of gross domestic product".
The Treasury forecasts gross debt to be $32.6 billion or 18.7 per cent of GDP by the end of the fiscal year in June. If the Government was willing to see that rise by 1 percentage point to 19.7 per cent of GDP that would give it $1.75 billion to play with.
And there might be some more, out of the $2 billion allowance for new operating initiatives which is a routine feature of recent Budgets.
The Treasury's forecasts for next year and subsequent years includes $1.5 billion of tax cuts, but they still project gross debt to fall to 17 per cent of GDP by 2011.
Every $1 billion increase in debt adds about $60 million a year to the Government's costs.
Cullen has been determined to keep the lid on debt, and therefore interest costs, for demographic reasons.
When the babyboomers start moving from the workforce into retirement, health and superannuation costs will climb. To bequeath a hefty interest bill as well is seen as irresponsible.
New Zealand also has to live with the consequences of Roger Douglas' changes to the tax treatment of retirement savings, which front-loaded the tax take from them while making the final payouts exempt. The US Government stands to receive about $5 trillion in tax as babyboomers cash in their retirement savings.
The New Zealand Government instead has had to rely on running surpluses and strengthening its balance sheet.
TEST 3
The third condition is that tax cuts should not exacerbate inflationary pressures.
This bears on the issue of timing.
Looser fiscal policy inevitably puts upward pressure on inflation.
The Reserve Bank is already outside its target band and has to contend with strong wage growth, the best terms of trade in a generation and an international environment in which inflation is more and more of an issue.
On the other hand, what has been an overheated domestic economy is showing signs of cooling, the global growth outlook is increasingly weak and drought will take the cream, so to speak, off the stimulus from sky-high dairy prices.
Those developments will tend to reduce inflation pressures and bring forward the point which a tax cut stimulus would be timely.
TEST 4
That leaves the fourth of the Government's tests: that tax cuts must not to lead to greater inequality.
"It depends how you define inequality," says PricewaterhouseCoopers chairman John Shewan.
"If you define it as meaning it must not increase the gap between the net take-home pay of people at the bottom [of the income scale] and people at the top, then that is a severe impediment to reducing tax rates."
The combination of a steeply progressive tax scale, a relatively broad base in which few expenses are deductible, and the targeting of Working for Families tax credits means many taxpayers are facing very high effective marginal tax rates - how much of the next dollar you earn you get to keep.
"It's the people in the $55,000 to $100,000 band who are getting absolutely hammered and that's where the relief ought to be," Shewan said.
The top tax rate of 39c in the dollar which kicks in at $60,000, now catches 14 per cent of taxpayers, who collectively pay 53 per cent of the income tax take.
That is risky in a globalised world where labour is mobile, says ANZ National Bank chief economist Cameron Bagrie.
People in the top tax bracket are also probably those who would find it easiest to take their skills and their drive to countries whose tax systems they see as less onerous.
Shewan said the abatement of entitlement to family tax credits provided further distortions that could colour perceptions of fairness.
"Compare a single-earner family on $45,000 with two young children and an identical family, in terms of the age of the children, but with an income of $80,000.
"Most people I think would say it was fair enough for the better-off family to pay 2 1/2 or maybe three times as much tax as the other one," Shewan said.
"But the current system has them paying 14 times more tax."
That was because Working for Families was quite generous at the $45,000 level but then it started to abate, he said.
Patrick Nolan at the Institute of Economic Research has modelled the complex interaction of the income tax scale, Working for Families, unemployment and domestic purposes benefits, ACC levies and the accommodation supplement.
People on lower incomes are taxed less but are more likely to be caught in poverty traps arising from the abatement of the main benefits, facing effective marginal tax rates of 90c in the dollar or higher.
For those on middle or higher incomes, roughly speaking, Nolan's results suggest that if you don't want to pay a lot more than 40c tax in the next dollar you earn, you have to be either childless or in the top 5 per cent of the population by income.
Rob McLeod of Ernst & Young, who chaired the last major review of the tax system in 2001, sees the personal income tax scale as the area most in need of renovation.
McLeod would start by cutting the top rate, in the interests of economic efficiency and growth.
"It's at the margin that most damage is done. It is the cutting edge where action and decision-making take place.
"That is not something that economists argue about," he said.
McLeod and Shewan both deplore the increasing retreat from the principle of tax neutrality, the notion that all forms of income should be taxed at the same marginal rate and tax should not be used to encourage or discourage particular behaviour.
Those distortions are about to become worse. From April 1 company profits and the earnings of approved (PIE) savings vehicles will be taxed at 30c in the dollar.
But an unincorporated business, or the income from investments held directly, may well be taxed at 39c in the dollar.
"Politicians of all persuasions downplay the importance of these distortions and point to the social advantages of their particular hobby-horses," Shewan said.
"But the distortions are enormous and officials are increasingly worried about them."
FOUR COMMANDMENTS
1"We will not borrow to pay for tax cuts."
2"We will not cut services to pay
for tax cuts."
3 "We will not exacerbate inflationary
pressures when we deliver personal tax cuts."
4 "We will not allow tax cuts to lead
to greater inequality in our society."
