Australia Govt Tax Cut Promise Carries Rate Risks

Australia's government, desperately seeking re-election in a November poll, on Monday promised A$34 billion ($30 billion) in sweeping tax cuts if returned by voters.

With polls pointing to an opposition Labor landslide, Treasurer Peter Costello also upgraded forecasts for economic growth, predicting a brisk 4.25% in the year to end June 2008 compared with 3.5% just a few months ago.

But analysts warned the largesse could come back to haunt the government if it added to upward pressure on inflation, and so interest rates.

"That's an unbelievably large amount of money," said John Edwards, chief economist at HSBC. "For an economy that's already operating at the very perimeter of its capacity, it's going to see a government that just deliberately adds very significantly to demand pressures."

"It's a direct challenge to the Reserve Bank and I do think it puts Australia's inflation experience and the durability of the expansion at risk," said Edwards.

The economy grew at a surprisingly rapid 4.2% pace in the year to June, while inflation jumped in the second quarter leading the Reserve Bank of Australia (RBA) to raise interest rates to a decade high of 6.5% in August.

The central bank has since cautioned that the economy showed no signs of slowing and might need to be restrained further. Financial markets are pricing in around a 50:50 chance it may tighten as early as its November board meeting, depending on what  inflation figures for the third quarter show.

"The question is: do you really want to be adding stimulus when the economy is already near its speed limit?," said Daniel Blake, an economist at Merrill Lynch. "They should let fiscal policy tighten to take something out of domestic demand." 

Spread Out and Affordable

Others, however, noted the tax cuts were spread over three years starting from 2008/09 and even after the giveaway, the government's budget was still expected to be in surplus to the tune of 1 percent of gross domestic product (GDP).

"The first cuts don't start until mid-2008, and who knows how the global economy will be faring by then, so it's hard to argue that this demands an immediate response from the RBA," said Stephen Roberts, research director at Grange Securities, the local arm of Lehman Brothers.

"In any case, running a surplus at all is super-tight compared to most other industrialised countries," he added.

Tony Meer, chief economist at Deutsche Bank, noted the budget surplus for 2006/07 turned out to be A$17.2 billion, about 1.6% of GDP and far above initial estimates of A$10.8 billion.

"That means fiscal settings were tighter than intended, so by cutting taxes all they are really doing is returning some of that extra money to keep the surplus steady," said Meer. "It's not as stimulative as the headline numbers would suggest."

Still, analysts of all stripes were well aware that this was just the second day of an election campaign which has a long way to run to voting day on Nov. 24.

"In isolation they look affordable," said Tony Pearson, senior economist at ANZ, of the tax cuts. "But we need to remember this is only the first shot in the election war and you really need to see the totality of all the other election promises that are likely to come over the next six weeks."