The case against hand-outs; The rescue plan

In Australia's great Keynesian giveaway debate, much pontificating turns on whether it is better to provide hand-outs or tax cuts.

Though tax cuts have certain superiorities (and are marvellous in combination with spending cuts), the short answer is neither of the above.

Assuming increased spending is to be funded in some way -- that is other than having the Reserve Bank simply print money -- increasing the deficit either by tax cuts or hand-outs means tapping funds from overseas or from domestic savers.

Whether debt is covered from domestic or overseas funders, it has to be repaid, and if it is simply spent on consumption, future real income levels will be reduced.

Tapping overseas savers is hardly the correct solution for Australia since, as Kevin Rudd pointed out in his infamous global financial crisis essay, foreign debt has increased rapidly since the Hawke-Keating governments.  And unlike classically described foreign borrowings, Australians' increased overseas indebtedness has not been used to augment domestic savings but has, in fact, replaced those savings.

Our increased debt has, in short, simply been spent on consumption.

Government borrowing from domestic resources cannibalises the funds available for productivity-enhancing private investments.  It therefore disadvantages firms hoping to tap into savings to shore up their finances or to expand.

The rationale for raiding savings for tax cuts or hand-outs is that this will shift expenditure patterns to those who are more likely to consume and that the increased consumption will ignite a new cycle of investment and growth.

But shifting money between different classes of people is less likely to resurrect growth than leaving things as they are.  After all, it is not as though savings are simply being hoarded and not finding their way into the economy at large.  Savings are held in financial institutions and attract interest rates.  The financial institutions have to re-lend those savings, thereby re-injecting them into the economy.

Those advocating deficit financing are punting on the money assuming greater power if it is given to those it hopes are spendthrifts.  Aside from undermining the incentive to prudence, there is no evidence that this will work.  Indeed, Rudd's first $10.4 billion hand-out totally failed to restart the economic locomotive.

These considerations overshadow the debate about hand-outs versus tax cuts.

Hand-outs are particularly noxious, however, because they give people something for doing nothing.  Income tax cuts have the merit of reducing the fiscal burden on working men and women.  They bring a diminished siphoning-off of the money that people have earned and, as Wayne Swan pointed out in last May's budget, in lightening the load, tax cuts provide incentives for people to work harder.  But hand-outs are likely to discourage work.

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