Treasury Secretary, Martin Parkinson, earlier in the week implored the states to wean themselves of Federal Government dependence and suggested they raise their own revenue through payroll taxes, which Parkinson claims is just as efficient as the GST:
The economic effect of a comprehensive payroll tax with no exemptions was “effectively the same as a GST”, he told a business lunch on Tuesday.
“This is something that everybody pretends is a terrible thing, it’s no more a tax on labour than the GST…
Dr Parkinson said the states and territories looked to the commonwealth for revenue.
“What this has actually done is allowed them to run very poorly what are very good tax bases,” he said.
Whether payroll tax is as efficient as GST is debatable.
The Henry Tax Review showed that the “marginal excess burden” (i.e. the loss in consumer welfare relative to the net gain in government revenue) from payroll taxes are 41%; although their loss in efficiency has more to do with their narrow base rather than its disincentive effects:
The Review also noted that the marginal excess burden of payroll taxes would be around 15% if exemptions were abolished, bringing it closer to the GST in terms of efficiency. It also argued that payroll tax’s impact on consumer prices would be similar to the GST. This is because “payroll tax increases the cost of employing labour, and since prices are equal to marginal cost of production, firms must pass this cost on. This will be through either nominal wages or increased consumer prices”.
However, Dr Gavin Putland, from Prosper Australia, disagrees with Dr Parkinson’s and the Henry Tax Review’s findings, instead arguing that payroll taxes depress both employment and wages. He has penned the following critique of payroll taxes via email:
He [Dr Parkinson] is supported by a notorious economic theorem which states that under certain assumptions a tax on income from labour, whether implemented as a payroll tax or as a personal income tax, is equivalent to a tax on consumption. The assumptions leading to this result are:
(1) there are no pre-existing savings or capital;
(2) savings are invested in capital or land at a rate of return equal to the discount rate;
(3) the borders are closed;
(4) if any labour-income is saved or invested, the proceeds together with the principal are consumed later.
Under these conditions it can be shown algebraically that the consumption base and the labour-income base have the same discounted present value (PV).
Let me show you how to bypass all the algebra. Assumption (1) means consumption cannot be funded by drawing down pre-existing assets. Assumption (2) means investment in capital or land does not affect the PV of the consumption budget. Together with (1), this means the consumption budget is equal to the return on the remaining factor of production, namely labour. Assumption (3) means the consumption budget is not altered by cross-border flows. Assumption (4) means all proceeds of labour are eventually consumed. In sum, the four assumptions mean that in present-value terms, consumption is funded by labour-income, the whole of labour-income, and nothing but labour-income.
So, what this profound economic theorem says is this: If we assume that consumption equals labour-income, a tax on labour-income becomes equivalent to a tax on consumption! Whodathunkit?
Now let’s see what happens when assumptions (1) to (4) are replaced by the corresponding realities.
(1) If we change the tax base from labour-income to consumption, we start taxing consumption financed by drawing down assets acquired through past decisions, which cannot be deterred by the tax change. Hence, if we reduce the tax rate to compensate for the broader base, we get the same revenue with reduced disincentives.
(2) If we change the tax base from labour-income to consumption, we start taxing consumption financed by returns on investment above the discount rate. These additional returns include (a) insurance, which is the reward for bearing risk, (b) economic profit, which is the reward for bearing uncertainty (the difference being that “risk” is quantifiable while “uncertainty” is not), and (c) economic rent, which is the return to any sort of protection from competition (the archetypal example being the limited supply of land, especially well-located land). All of these (especially the last) tend to account for higher fractions of higher incomes, so their inclusion in the tax base makes the system less regressive. The last — economic rent — is not an incentive for productive activity. By adding it to the tax base, we can lower the rate and reduce disincentives while collecting the same revenue. (But of course it’s even better if the tax system targets economic rent exclusively.)
(3) In an open economy, a domestic tax on labour penalizes the labour content of exports while exempting the labour content of imports at the point of entry, whereas a consumption tax captures imports but exempts exports. Hence, if we change the tax base from labour-income to consumption, we start taxing the consumption of imports but stop taxing the labour expended in production of exports.
(4) Capital can accumulate indefinitely, and such accumulation is not part of the consumption base. Hence, if we change the tax base from labour-income to consumption, we stop taxing the labour expended in capital formation.
Realities (1) to (3) imply that the base of a consumption tax extends beyond labour. Realities (3) and (4) imply that certain categories of labour are outside the consumption base. Any one of these realities is enough to show that payroll tax is indeed “more a tax on labour than the GST.”
I do not deny that payroll tax and GST have a common propensity to be passed on in prices; indeed, the similar effects on prices should make it politically easy to replace the former tax by the latter. I would merely add that indirect taxes are shifted not only downstream, in higher prices for consumers, but also upstream, in lower production and lower prices for producers. When a consumption tax is shifted upstream, it depresses production and producer prices in general. When a payroll tax is shifted upstream, it depresses employment and wages alone. Thus the continuing existence of payroll tax in the presence of viable alternatives is an aspect of the continuing war on the working class.
Parkinson, if he has been accurately quoted, was talking through his hat.
Anyone out there with an opposing view?
