This has been achieved by lowering the lowest tax rate and moving the thresholds for higher tax rates. In reality, all this has done is to reverse what is called 'fiscal drag' which comes about through inflation.

To illustrate how fiscal drag works, let's assume that five years ago you were earning $35,000 a year and your marginal tax rate was 19.5%. Let's assume also that you had a pay rise of 3% a year, just to keep up with inflation. You would now be earning just over $40,000 a year, but because inflation has been 3% a year the purchasing power of your income is unchanged. However, you have now crossed over the $38,000 threshold which puts you into the 33% marginal tax bracket. You are now paying a higher percentage of your income in tax even though the purchasing power of your income hasn't changed. In effect, you are earning less after allowing for tax and inflation than you were five years ago. By not changing the income tax thresholds each year to take account of inflation, the Government is automatically increasing their tax revenue.

Raising the thresholds this year simply reverses the fiscal drag that we have been experiencing for some time. Thresholds will be progressively raised over the next three years. Spreading the tax cuts in this way means that we will be less likely to go on a spending spree, which would only add to inflationary pressures.

However, the size of the immediate cuts will not be sufficient to bring relief to families struggling with high mortgage interest rates and increased petrol and food prices. A 1% drop in mortgage interest rates would have a much greater impact for the average family than the proposed tax cuts. For example, on a mortgage of $200,000, a 1% interest cut would mean a saving of somewhere around $30 a week. Interest rates have been kept high to try and reduce inflation by halting the increase in property prices and reducing the amount of consumer spending. That goal has now been achieved, and the inflationary pressures that still exist are coming from imported products such as oil and high export prices for dairy products.

With the economy heading for recession, surely interest rate cuts are not far away, and no doubt the Government would welcome a lowering of the Official Cash Rate just prior to the next election. It won't be until October that the first of the tax cuts are implemented. The challenge for most families will be to make sure that the benefit of extra money in pay packets doesn't dissolve into thin air through poor money management. After all, we are only talking about the value of a big block of cheese, or a couple of lunches in town. It would be easy to just let expenses increase to match the extra income. Good money managers will use the extra net pay to get rid of debt faster or to set aside for unexpected bills. This can easily be done by setting up automatic payments of an equivalent amount to the tax cut into debt or savings accounts.

Article by Liz Koh

Liz Koh is a financial adviser. Her disclosure statement can be obtained free of charge by calling 0800 273 847.

Ph: 0800 273 847

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www.moneymax.co.nz

Author of the book Your Money Personality; Unlock the Secret to a Rich and Happy Life, Awa Press, March 2008

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