According to the Government its first objective for tax reform is lower taxes. A responsible government would, however, first consider what revenue will need to be raised to efficiently fund the sorts of services that our society expects.
Of course, opinions may differ on what level of service provision is appropriate, and how it should be paid for. Unfortunately the various Intergenerational Reports and the Government’s decision to abandon its own Budget do not install confidence that lower taxes are in fact realistic.
Instead, given our present Budget deficit and the consistent projections of future deficits, it would be prudent to approach tax reform with the objective of restoring the present low ratio of taxation to GDP and even increasing it modestly in the future. Indeed, neither of the previous major tax reform packages in 1985 and 2000 reduced tax revenue, but instead they changed the tax mix, and in reality that is what we probably can expect from any future tax reform package.
In considering any changes to the tax mix, as the Treasury Tax Discussion Paper points out, we should seek to balance the core principles of efficiency, equity and simplicity as briefly discussed below.
A more efficient tax system
The Government’s starting point for a more efficient tax system seems to be that our system relies too heavily on direct taxes on income and not enough on indirect taxes on consumption and other immobile factors of production such as land. But if we allow for various forms of compulsory social security contributions plus payroll taxes then direct taxes in Australia comprises around 63 per cent of total taxation in Australia compared to the OECD average of 61 per cent, which suggests that our balance between direct and indirect taxation may well be sustainable.
However, what probably most concerns the Treasury is that our company tax rate at 30 per cent is higher than many other countries, and with the exception of the United States (whose company tax rate is close to 40 per cent), other countries have been reducing company taxes. Indeed, the Executive Summary to the Discussion Paper (probably written by Mr. Hockey) goes so far as to make the unsubstantiated claim that
‘each additional $1 collected by way of company income tax reduces the living standards of Australian households by around 50 cents in the long run because of reduced investment. This impedes Australia’s productivity and, in turn, reduces opportunities for better paying jobs’.
Living standards are of course determined by productivity and common sense suggests that company tax would cause nothing like a 50 per cent reduction in productivity. Instead Treasury estimates that the marginal excess burden of company tax is 50 per cent, presumably because around half of company tax is passed back into lower wages and forwards into higher prices. But this ability to pass company tax on makes it less likely to inhibit investment and productivity.
Furthermore, because of dividend imputation, dividends paid by companies are much more lightly taxed for Australian residents than in most other countries. This means that the argument for a lower company tax really is primarily about what is necessary to attract foreign investors. But experience suggests that the returns on investment in Australia are sufficient, and that there has been no problem in attracting foreign investment, notwithstanding our higher company tax rate. Indeed, it is arguable that there has been too much foreign investment, which has pushed up existing asset prices (for example in property), and that this increase in Australians’ wealth has actually led to lower savings and investment by Australians themselves.
A proposal floated in the Discussion Paper is that dividend imputation should be scaled back or even dropped, presumably to help pay for a lower company tax rate. This proposal would effectively mean raising the taxes paid by Australian investors in order to finance lower taxes for foreign investors. But it is hard to see why Australians would want to back that, especially when it appears to be quite unnecessary, and when as Treasury used to believe, there are considerable merits in our system of dividend imputation.
The other major issue of tax efficiency I want to comment on is the taxation of savings. As the Treasury states:
‘Australia’s tax system treats alternative forms of saving differently. At one end of the
spectrum, savings held in the family home are taxed at average effective tax rates
approaching zero. At the other end of the spectrum, savings held as financial deposits are taxed at full marginal rates, without any recognition for the costs of inflation.’
The policy rationale for these differences in the tax treatment of savings is not always clear, and they can distort the allocation of investment. In particular, the real estate market has probably been distorted in favour of investor housing by the incentive provided by the 50 per cent discount on the taxation of capital gains, and some would also argue by the possibilities of negative gearing. Removing that 50 per cent capital gains discount, or at least reducing it, would reduce housing demand, thus releasing more savings for other productive investments, and the lower housing prices would help first-time owner-occupier buyers.
A more equitable tax system
The proposal for improving equity that seems to be gathering support is to scale back the tax concessions for investment in superannuation funds. Some concession is justified because of the compulsory nature of superannuation savings and the fact that they cannot be accessed before retirement age.
But the rate of the superannuation concession is about four times as high for people on the top marginal tax rate as for people on a zero tax rate, and more than half the value of these concessions accrues to the top twenty per cent of income earners. So some scaling back in these concessions for superannuation and also the concessional treatment of capital gains should be a priority. In addition these changes would improve efficiency of the tax system.
The other change that I suggest will need to be introduced some time to improve equity is a reconstruction of the income tax rate scales to offset the effect of bracket creep as incomes rise over time. As the Treasury Discussion Paper points out unchecked bracket creep affects lower and middle income earners proportionally more than higher income earners. For example, present projections of earnings show that if the present income tax rate scale is maintained over the ten years from 2013-14 to 2023-24, the average tax rates for different multiples of average full-time earnings can be expected to rise as follows:
- half average full-time earnings by 7½ percentage points
- average full-time earnings by almost 5 percentage points
- twice average full-time earnings by less than 4 percentage points.
In addition, someone earning full-time average earnings could expect to enter the second highest tax bracket as soon as 2016-17.
The Treasury Discussion Paper raises the possibility that these projected changes in average and marginal tax rates facing ordinary workers may affect their participation rates and thus the efficiency of the tax system. How far that is an issue is a moot point. Furthermore, the evidence suggests that there are other more important factors influencing workforce participation for those most at risk.
Nevertheless, these presently projected changes in average tax rates would clearly affect the progressivity of the income tax system and for good equity reasons the income tax rate scale should be adjusted in time to maintain the system’s present progressivity. One way would be to index the rate scale, but that does lock in government, arguably to an undesirable extent. On the other hand, if changes to the income tax rate scale are to be discretionary, they should still be factored into future fiscal planning.
A simpler tax system
One indication of the complexity of the Australian tax system is that Australians are more likely to use a tax agent to complete their tax return, and our businesses spend a lot on compliance and also on financial planning to avoid taxation.
A good way to achieve a simpler tax system would be to reconsider many of the present concessions. Indeed one reason for many of these concessions is that they are less transparent and less subject to review than Budget outlays, although their rationale is typically no different. They should be subject to the same level of scrutiny as the outlays.. So given the need for restoring the ratio of revenue to GDP and even a bit more, probably the best place to start would be with a genuine review of the various tax concessions.
One of Australia’s leading tax experts, Greg Smith, argued in an article posted here on 4 April, that Australia has a broadly effective tax system but some tidying up is now needed to restore the performance levels of the early 2000s. I would generally agree with this conclusion, although I might go a bit further if, as I expect, additional revenue will be needed to restore a modest Budget surplus and keep it there over the long run.
The priority for change to achieve the necessary increase in revenue will be to scale back the tax concessions, starting with the superannuation and capital gains tax concessions. In addition, the recent Intergenerational Report assumes more income tax revenue through bracket creep than is really desirable, and avoiding that will most likely require alternative sources of revenue.
The obvious additional revenue resource is the GST, but as recognised in the Discussion Paper, reforms involving the GST raise major questions regarding the future of federalism in Australia. Accordingly I propose to address the issues of fiscal federalism in another future article.
Dr Michael Keating AC was formerly Secretary of the Department of Finance and Secretary, Prime Minister and Cabinet.