Inflation threat poised to kill pre-election tax cut sweetener

Ten million low and middle-income earners face a tax increase as the federal government debates whether to extend its $1080-a-year tax offset in next month’s pre-election budget or risk adding to growing inflation pressures that could force the Reserve Bank to lift official interest rates.

There are increasing concerns within the government, which faces budget deficits for the rest of the decade and gross debt surpassing $1 trillion by 2024-25, that while extending the offset for another year may be vital to the Coalition’s re-election chances, it could come at a huge economic cost.

Treasurer Josh Frydenberg debates the 2021-22 budget, which extended the income tax offset for a year as a COVID stimulus measure. Credit:Dominic Lorrimer

The offset, worth up to $1080 and available to people earning less than $126,000 a year, has been extended by Treasurer Josh Frydenberg in his past two budgets. On both occasions, he said the offset would be important to supporting the economy through the COVID-19 recession, describing it as a stimulus measure.

The measure, which costs more than $7 billion, had been widely expected to be extended to the 2022-23 financial year as an election sweetener in the March 29 budget.

But the economy has rebounded much more strongly than expected. Unemployment is at 4.2 per cent and on track to hit a near-50-year low in months. Inflation, at 3.5 per cent, is growing locally and around the globe.

That has led the Reserve Bank, which has official interest rates at 0.1 per cent, to walk back expectations it could hold rates steady until 2024. On Friday, Reserve governor Philip Lowe signalled interest rates could start rising from August, with the bank expecting inflation to outpace wage growth well into next year.

The Sydney Morning Herald and The Age have been told by several sources, all on condition of anonymity, that while the political importance of the tax cuts has not changed, the turnaround in the economy and the rise in inflation is forcing the government to examine closely the dangers of another one-off tax cut.

The budget is forecast to show a deficit of $84.5 billion in the 2022-23 financial year. The stronger economy is expected to reduce that, but there are already signs that the cost of government debt is growing because of inflation pressures.

Another issue is the large amount of cash sitting in the bank accounts of ordinary Australians. Savings have swelled by $245 billion through the pandemic and the government and Reserve Bank expect households will tap into that money as recession-era measures end.

Financial markets are already pricing in four interest rate rises by year’s end, taking the cash rate beyond 1 per cent. If passed on by banks, that would increase monthly repayments on a $500,000 mortgage by almost $300.

Grattan Institute economic policy program director Brendan Coates said there was a real inflation risk from a new round of tax cuts.

“Tax cuts at this point would be like putting more fuel on the fire,” he said. “It would be a hard case to make that the economy needs more support.”

The Grattan Institute’s Brendan Coates says a new round of tax cuts would be adding fuel to the inflation fire.Credit:

EY chief economist Jo Masters said monetary and fiscal policy would be working in opposite directions if the government delivered tax cuts while the Reserve Bank was increasing interest rates.

“Tax cuts are clearly stimulatory given the boost to disposable income. And any new initiatives will come alongside high household savings, the wealth boost from the housing market, expectation of faster wage growth and the third stage of the income tax cuts,” she said.

Respected independent economist Saul Eslake said another round of tax cuts risked repeating mistakes made between 2004 and 2008, when tax cuts put upward pressure on inflation that resulted in the Reserve Bank increasing interest rates.

He said the government’s budget papers, its recent intergenerational report and the Parliamentary Budget Office’s own projections showed whoever won this year’s election faced budget deficits for decades without changed policy settings.

Government spending was on a higher plane than before COVID-19 due to extra expenditure on aged care, the National Disability Insurance Scheme and on defence.

“Ideally, we should be having a conversation during the forthcoming election campaign, between the electorate and our would-be leaders, as to how that additional spending is going to be paid for – not about whether or by how much, or whose taxes should be reduced,” he said.

Treasury analysis made public by Mr Frydenberg on Sunday night showed the government’s range of tax cuts since 2018-19 had delivered 5.2 million women an average tax cut of $3130.

The analysis, based on unpublished ATO data, shows 1.8 million women under the age of 35 have collectively garnered $5 billion in tax relief. Among women under the age of 24, the amount of tax paid has fallen by 20 per cent.

Treasury analysis shows many women have enjoyed tax relief worth more than $3000 since 2018-19.Credit:Dominic Lorrimer.

It also shows the impact of the government’s changes to the childcare subsidy. A single mother on $60,000 a year with two children in childcare will have a $3680 increase in disposable income next year because of childcare and tax changes.

For a dual income, two children-in-care household with both partners on $90,000, the increase in disposable income next year will be $10,230.

“Lower taxes, record investments in childcare and skills and training has seen female participation reach record levels, with more women now in work than ever before despite the largest economic shock since the Great Depression,” Mr Frydenberg said.

“New ATO data shows that those women have benefited the most from the government’s tax cuts, especially younger women early in their careers.”

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