Tax reform requires hard choices

ScreenHunter_1944 Apr. 04 08.12

By Leith van Onselen

As noted by Houses and Holes earlier, the University of Canberra National Centre for Social and Economic Modelling has released new analysis showing that in the absence of tax cuts, the effect of people being pushed into higher tax brackets because of inflation (“bracket creep”) would increase total personal ­income taxes by 21% or $32.5 billion within a decade.

While such ‘taxation by stealth’ would go a long way to restoring the Federal Budget back to balance, it poses great risks for the Australian economy and the social fabric.

First, as argued by Professor John Freebairn today, the collection of each dollar of personal ­income tax costs the economy between 30 cents and 40 cents, making it a relatively inefficient tax. An escalation in personal tax collections would, therefore, be a major drag on productivity, reducing Australia’s growth potential and living standards.

Second, allowing personal taxes to rise ahead of other forms of taxation risks creating a nation of working tax slaves, as today’s generation Xers, Ys and Zs are forced to pay more tax (and consume less) in order to fund the growing army of retired Australians, many of whom also enjoy generous taxpayer entitlements.

Clearly, Australia desperately needs fundamental tax reform. But what exactly?

As shown below, the Federal Budget is primarily funded via four forms of taxes:

  • Personal taxes, which comprise roughly half of all revenue, and will increase their share without reform;
  • Company taxes, which comprise less than a quarter of revenue;
  • GST, which comprises around one-sixth of revenue; and
  • Indirect taxes, such as fuel excise, whose share is similar to GST, but projected to shrink over time, since it is no longer linked to inflation.
ScreenHunter_1945 Apr. 04 08.34

Raising company tax is not a viable option for Australia. As noted yesterday, Australia already has one of the highest reliance on company taxes in the OECD. The Henry Tax Review also found that company taxes are one of the most distorting forms of taxation going around, with a “marginal excess burden” – i.e. the loss in consumer welfare relative to the net gain in government revenue – of 40%, because “it is applied to capital, which is highly mobile” (see next chart).

ScreenHunter_97 Sep. 26 08.53

Clearly, boosting the GST and/or reinstating indexation of fuel excise are good options. Again, according to Professor John Freebairn, both taxes are highly efficient and “changing the tax mix from (income taxes to indirect taxes) brings gains of 20c to 30c in the dollar and beats anything that a major corporation could do on productivity”. The Henry Tax Review supports Freebairn’s claim, with a marginal excess burden arising from the GST of just 8%, because it is broadly applied, is difficult to avoid, and does not significantly distort behaviour.

Unfortunately, the Government has so far shown minimal interest in broadening or raising the GST. During last year’s election campaign, Tony Abbott ruled-out changing the GST, not only for this term but altogether, stating: “The GST will not change. Full stop. End of story”. While nothing is ever set in stone, and the Coalition’s position can always change (just as it did under John Howard), it does make reform less likely. Meanwhile, reinstating the indexation of petrol excise could be even more unpopular, particularly if petrol prices begin to rise as the Australian dollar trends lower.

As noted yesterday, the Government could also look to raise taxes through broad-based land taxes and resource rent taxes. While not shown in the chart above, both taxes would have similar efficiency to the Petroleum Resource Rent Tax (PRRT) and Municipal rates, since they would be applied to a tax base that is completely immobile – land. They are also more equitable than consumption taxes.

A broad-based land tax would also have more favourable distributional impacts than the GST, and would effectively boost land supply and help make infrastructure investment self-financing for governments.

Again, reform in these areas would also be very difficult. Wealthy, well connected, landholders would likely scream blue murder if a land tax was introduced (effectively removing a comfy tax haven), whereas the Government has obviously painted itself into a corner on resource rent taxes, given that it lobbied so hard against “Labor’s great big tax”.

Ultimately, fundamental tax reform is essential if Australia is to achieve the types of productivity reform required to grow living standards as the population ages. But reform won’t be easy, and will require strong political leadership and a retreat from entrenched ideological positions.

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Unconventional Economist

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. Sadly this is an oxymoron in today’s political environment…

    ‘strong political leadership’

    • ‘allowing personal taxes to rise ahead of other forms of taxation risks creating a nation of working tax slaves’

      as compared to todays

      ‘mortgage paying bank slaves’

  2. In parallel with this must come the push to improve the efficiency of the way government income is spent. Canberra has over 900 government departments, virtually all with overlapping portfolios. Fantastic place to start. Willy_nilly, however, provides us with the correct answer. Forget it. Walk away…

  3. Isn’t balancing the budget itself an ‘entrenched ideological position’?

    The flipside of ‘deficits don’t matter’?

      • I’m proposing nothing, I’m asking questions on an agnostic crusade for knowledge and understanding. Perhaps macroeconomics will be my Waterloo.

        To a lay person, government spending more than it earns ad infinitum is plainly absurd. But what’s the economic law that states it’s impossible?

      • Alex Heyworth

        Merk, it’s not so much an economic law as a practical constraint. There are only two ways a government can spend more than it gets in taxes. Either the government creates more money by fiat, or it borrows the money. In the first case, continually creating more money that is not matched by production of goods and services desired by the population will result in inflation. Obviously, some of what the government pays for is actually desired by the population. But a good deal of government spending is unproductive or is given to people who are unproductive. If the spending and subsequent spending can be kept within bounds that are acceptable to the population, this situation can continue for a long time. Experience suggests, however, that eventually government spending will overstep this boundary and inflation will get out of control. Often a recession will be the trigger that forces the government deficit into territory that cannot be sustained for more than a year or two, because it both increases spending and decreases revenue. If there is already a substantial mismatch between the two, the combined disparity becomes too much of a deadweight for the rest of the economy to support.

        Even if it is kept reasonably controlled, there are still adverse side effects, particularly in regard to discouraging saving and introducing growing distortions in the economy.

        If the money is borrowed, eventually there comes a stage where lenders are reluctant to lend any more, no matter what interest is offered. At this stage governments commonly default, usually with disastrous effects on the national economy. Serial offenders in this way include several South American countries and Greece. None of them are really places most people would want to live.

  4. Our heavy reliance on company tax is not surprising given the resource sector’s large share of company profits. The OECD country with a greater reliance on company tax revenue (Norway) is also resource rich.

    The 40% MEB estimate relies on an assumption of perfect capital mobility, which is a strong assumption and clearly not appropriate for resource sector investment. Neither would it be appropriate for the other big source of company profits- the finance sector, where the market is dominated by the big four beneficiaries of an implicit govt guarantee.

  5. Two points: first, so much for the daft rhetoric that the income tax cuts introduced by Howard and Rudd are responsible for the parlous state of the budget.

    Second, changes to the GST may not happen under Abbott, but they might under a more hard-nosed successor. As well as a champion for change, they would need to be (or have on their team) a consummate salesman.

    However, with time this will change. At the moment the politics of envy (soak the rich etc) are dominating the debate. Wait until three quarters of the work force is in the second to top tax bracket. People might be more willing then to accept paying more GST in return for substantial income tax cuts.

  6. Two points: first, so much for the daft rhetoric that the income tax cuts introduced by Howard and Rudd are responsible for the parlous state of the budget.

    Second, changes to the GST may not happen under Abbott, but they might under a more hard-nosed successor. As well as a champion for change, they would need to be (or have on their team) a consummate salesman.

    However, with time this will change. At the moment the politics of envy (soak the rich etc) are dominating the debate. Wait until three quarters of the work force is in the second to top tax bracket. People might be more willing then to accept paying more GST in return for substantial income tax cuts.

    • Strange Economics

      But the higher incomes don’t pay 40% tax – they can pay 0%to 15% !
      After deduct 7K for the FBT rort luxury car, 20K on top of compulsory, for Super Salary sacrifice, 40K for 3 negative geared apartments, 40K for negative geared shares – (then theres receive private school subsidies of 20K for the 2 kids), they’ve got an effective tax rate of 0% to 15% (at most for long term capital gain). So thats 107K of the 200K per annum income thats tax free…
      Then retire in tax free $2m house and collect pension…

  7. two plus twoMEMBER

    Leith (or someone else), would you mind explaining on what you mean by a ‘broad-based land tax’, and how that differs from the one that is already in place (in QLD anyway. I’m not familiar with what the other states have).

    Does the current one not bring in much revenue, therefore you dismiss it as though it doesn’t exist?