Michael Keating. Taxation Reform

Fairness, Opportunity and Security
Policy series edited by Michael Keating and John Menadue. 

Oliver Wendell Holmes, the great American jurist, is reputed to have said, ‘I like to pay taxes. In this way I buy civilisation.’ However, in contrast to Holmes’ noble ideal, too often today we hear people railing about the burden of taxation, as though it is in some way an unfortunate even illegitimate imposition upon ourselves, our economy, and our way of life.

Lower taxation has been embraced by all political parties without any evidence that, given our already low starting point, less taxation will in fact lead to higher economic growth, let alone pay for itself. Indeed there is no evidence that the advanced economies with high growth rates of per capita income have lower levels of taxation. Nor have past cuts in our income tax led to faster growth, such as when the top income tax rate was reduced from 60 per cent to 45 per cent.

So as John Howard put it when he was Prime Minister, tax cuts should be considered ‘after you have met all the necessary and socially desirable expenditures’ (my emphasis). And as I argued in previous articles (posted 6/4/2015 and 23/7/2014), all the evidence is that these expenditure demands, even if efficiently funded, are most unlikely to be fiscally sustainable without a modest increase in taxation relative to GDP.

Indeed Australia already has lower taxation than almost any other advanced nation, but we aim to provide the same level of public services and welfare as the others.

Thus the biggest challenge facing modern governments is the gap between expectations on them and their capacity to deliver. In these circumstances, encouraging unrealistic expectations of tax cuts is only making government more difficult.

In fact each of the major tax reform packages in 1985 and 2000 did not achieve any reduction in total taxation. Instead they were about changing the tax mix in favour of more efficiency, revenue protection and/or more equity. Although some tax rates were lowered – notably income tax to offset past bracket creep that had pushed more people into higher tax brackets – but these reform packages did not lead to any reduction in taxation overall.

Revenue Outlook

Projections in the Budget and the Intergenerational Report (IGR) show the ratio of Australian Government taxation revenue to GDP rising from 21.9 per cent in 2014-15 to an assumed maximum ratio of 23.9 per cent reached around 2020, and then maintained beyond. This 23.9 per cent ceiling for future taxation is the same on average as during the Howard Government years following their tax reforms starting in 2001-02.

Consequently if taxation revenue went back to where it was after the Howard Government’s tax reforms and before the GFC it would be about 2.0 percentage points higher than now. Furthermore, as I argued in yesterday’s blog on Fixing the Budget, restoring taxation revenue to this extent over the next few years would most likely be consistent with what needs to be done on the revenue side of the Budget to maintain long run fiscal sustainability. It would also be consistent with what the Government apparently regards as an acceptable level of taxation.

One significant difference, however, is that my proposals (below) do not rely on bracket creep as taxpayers move into higher tax brackets, whereas as much as 85 per cent of the increase in taxation revenue presently projected in the Budget relies on bracket creep.

The problem with this reliance by the Government on extra revenue through bracket creep is that according to the Treasury someone on full-time average earnings can expect to enter the second highest 37 per cent tax bracket in 2015-16 if the present income tax rate scale is maintained, and the average tax rate faced by such a taxpayer will have increased by 5 percentage points between 2013-14 and 2023-24. Furthermore, unchecked bracket creep in income taxes tends to be highly regressive, impacting more than proportionately on lower income earners.

As in the past, any government is therefore likely to want to provide future income tax cuts, at least sufficient to offset the impact of unchecked bracket creep. The Government itself recognises this and has promised lower taxes after the Budget returns to surplus. But this is not expected until sometime after 2020, and by then the Government will be relying on all of the extra revenue from bracket creep until that time. On the other hand if some of that extra revenue from bracket creep were returned to taxpayers through a reduction in income tax rates, then of course this would increases the amount of extra revenue or extra expenditure savings that would need to be found elsewhere.

Tax Reform Options

Accordingly it is necessary to consider the alternatives to this reliance by the Government on bracket creep to boost its income tax receipts. Instead I propose to consider the options for another round of tax reform, but especially having regard for the present deficit budget outlook and future expenditure demands, and the consequent need to raise more revenue both at the Commonwealth and State levels of government.

Strategically there are three broad approaches in these circumstances to taxation reform:

  • Broadening taxes
  • Adjusting the mix of taxes
  • Changing the tax rates

Typically tax reform involves a balanced mix of all three approaches. The task is to convince the public that the outcome is a more efficient system, especially in terms of its economic impact, that will raise the revenue that is necessary, but not more than necessary, and that it is fair.

Retaining company tax and broadening taxes

Judged against these criteria it is suggested that the best options to start with would be to:

  • Not cut the company tax
  • Broaden the tax base

Despite the lobbying by the business community, there is no need to cut the company tax rate. This would mainly advantage foreign investors, but the evidence is that Australia has no difficulty in attracting foreign investment. Instead, because of dividend imputation a cut in company tax would lead to lower imputation credits, and not benefit Australian investors much; indeed it could disadvantage Australian investors if it was financed in part by removing dividend imputation.

In a previous posting (22/7/2014) I discussed the possibilities for broadening the tax base. In brief, the possibilities that would seem to have the most positive impact as well as raising extra revenues are

  • Reducing the favourable taxation of superannuation. The present tax concessions are more than necessary to encourage this form of savings for retirement, and they are inequitable, with more than half their value accruing to the top 20 per cent of income earners.
  • Removing the 50 per cent capital gains discount. This discount is a distortion and its removal would help improve the efficiency of the housing market in particular, and make homes more affordable to new home buyers. Some commentators have similarly argued that negative gearing should no longer be allowed under the income tax, but strictly this is not a distortion because interest is a normal deduction before deriving taxable income.
  • Restoring carbon pricing which is the most efficient and effective way of reducing carbon emissions and the risk of climate change.
  • Removing the tax credit for fuel excise and increasing that excise. There is no economic case for subsidising one type of input to only some producers. Indeed it would be better to encourage greater fuel efficiency by increasing its price over time, up to say the price levels in New Zealand, and then fully indexing the excise rate.
  • Improving the anti-avoidance measures. The Government is proposing some such action in this Budget, but much more needs to be done and can be done to protect the revenue.

A rough estimate is that these measures would increase annual tax revenues by around $29 billion when fully implemented; that is equivalent to filling the remaining gap of around 1.5 per cent of GDP that is needed to ensure ongoing fiscal sustainability after allowing for the expenditure savings identified in yesterday’s article on Fixing the Budget. 

Changing the tax mix in favour of more reliance on the GST

The other major possibility for base broadening which would increase the revenue substantially is the GST. The proceeds, however, of the GST accrue entirely to the States, and so they cannot be used directly to improve the Federal Budget. Nevertheless, if these extra GST transfers were used to offset reductions in some other payments by the Australian Government to the States, then such an increase in the GST could help restore and maintain Australia’s fiscal sustainability over time.

The implications of such a strategy based on an increase in GST revenue will mainly be discussed in tomorrow’s article on Federalism. Suffice to say here that the coverage of the GST is now only 47 per cent of total consumption, down from a peak in 2005-06 of 56 per cent, which was close to the OECD average, but much less than in New Zealand where 96 per cent of consumption is taxed.

If the GST base were broadened to include expenditures on food, child care, private health and private education, and water, sewerage and drainage, the total GST revenue would be roughly doubled raising revenue by more than $50 billion extra each year. While an increase in the tax rate from the present 10 per cent to 15 per cent on the present GST base would raise around another $25 billion each year, and on the extended base it would raise around another $100 billion annually.

The experience of the Howard Government, however, when it first introduced the GST was that a very large part of the proceeds were used to compensate lower to middle income families who were deemed to be disproportionately disadvantaged by the new tax. If that precedent continued to apply it might be prudent to assume as much as one third of the extra revenue would be needed for this purpose and not available to improve long-run fiscal sustainability. Indeed if the GST base were broadened as described above to include expenditures on food, health and education that are regarded as essential, then the pressures for compensation might be even greater[1].

Of course less substantial changes in the GST could readily be contemplated. The size of the package would probably depend mainly upon what is the preferred basis for future Federal-State financial relations and the overall governance arrangements for the Australian nation. As already indicated these issues will be explored in tomorrow’s article, but even if no substantial change in our federal-state financial relations is envisaged, a modest package of GST reforms to increase the revenue would be a good option if the other policy changes already canvassed do not prove sufficient to ensure on-going fiscal sustainability in the long run.

Increase in the income tax rates

As noted the income tax rates will effectively increase over time if nothing is done because of bracket creep as incomes rise and tax payers move up the rate scale. But this is an arbitrary and unfair way of raising additional revenue if that were needed. Instead in that case it would be better as a matter of deliberate decision to introduce a new income tax rate scale. Such a new rate scale could at least maintain the present progressitivity of the income tax rather than letting it degrade in an arbitrary way.

A further consideration is the overall tax mix. Many argue that Australia is too dependent on the taxation of income and that there should be more reliance on taxation of expenditure. In fact if we allow for various forms of compulsory social security contributions plus payroll taxes then direct taxes in Australia comprise around 63 per cent of total taxation compared to an OECD average of 61 per cent. This suggests that the present balance between direct and indirect taxation in Australia may well be sustainable. Nevertheless if additional revenue is needed to ensure long-run fiscal sustainability then it would be prudent to consider the options for increasing the GST before an increase in income tax rates.

Dr Michael Keating AC was formerly Secretary of the Department of Finance, and Secretary of the Department of Prime Minister and Cabinet.

[1] According to the Treasury, as a proportion of total spending, lower-income and higher-income households spend a similar proportion on GST-exempt goods and services in aggregate. However, while households may spend a similar proportion of their total spending on GST-exempt goods and services in aggregate, this is not necessarily true for the individual exempted categories of spending. For example, lower-income households may be more likely to spend comparatively more of their total spending on GST-exempt food, medical products and health services, or residential rent. Conversely, higher-income households may be more likely to spend comparatively more of their total spending on GST-exempt education or childcare services.

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