Michael Keating. The Key Options for Tax Reform

One useful outcome from the Council of Australian Governments (COAG) meeting on 11 December, was its acknowledgement of the “emerging budgetary pressures across all levels of government, particularly in the health sector.” This acknowledgement must be the critical starting point for any serious consideration of tax reform.

Quite naturally it was equally acknowledged that government expenditures must be efficient. However, the understandings reached at both the Treasurers’ meeting and at COAG, seemed to be that action on the revenue side of government budgets could also not be avoided.

Prior to these two meetings the principal direction for tax reform under consideration seemed to be to increase the GST revenue by some combination of increased tax rates and/or base broadening by removing some of the presently untaxed expenditures. Interestingly the meetings agreed to widen the scope of the options to include:

  • Further consideration of the States own revenue raising efforts, and
  • Granting the States access to the personal income tax revenue

The implications of each of these three strategies for raising additional revenue will be examined below.

State Government Revenue Raising Capacity

Many State taxes are inefficient and ideally would be removed. The States do, however, have two major tax bases – land taxes and payroll taxes – from which revenue can be efficiently raised without much if any damage to economic activity and development. This is because:

  • Land is the ultimate immovable factor of production; increased taxation of land will not lead to any land being withdrawn and redeployed elsewhere; while
  • Payroll taxes may appear to be a tax on employment, but in fact payroll taxes are not very different from a value added tax, as wages account for over half of value added, and therefore the incidence of payroll taxes (in terms of who finally bears their cost) is likely to be broadly similar to the GST.

With a good deal of justification, the Australian Treasurer, Scott Morrison, argued that the States need to improve their revenue raising efforts with both these taxes before the Australian Government would agree to augment the States’ revenue further. In particular, the States have competed with each other to exempt businesses from their payroll tax and to lower the rates. As a result this tax is now raising much less revenue relative to wages than it used to when it was passed over to the States by the McMahon Government more than 40 years ago. In addition, the coverage of the State land taxes is typically very low, with most properties exempt, so again the States could do more to help themselves before asking the Australian Government to increase its revenue raising effort.

The GST

As I argued in my posting on this blog (dated 10 December), “Ultimately the problem for the Australian government in relying heavily on the GST to raise extra revenue is that [under present arrangements] the proceeds only flow to the States”. So if the Australian Government wants to share the benefits of that extra GST revenue it necessarily would have to make offsetting cuts to the other main form of financial transfers to the States – namely the tied grants paid to the States by the Australian Government. Other things being equal, the bigger the increase in the GST revenue passed over to the States, the bigger the likely cuts by the Australian Government in its tied grants.

For the most part, however, these tied grants are closely related to the Australian Government’s own responsibilities and reflect its own priorities. Furthermore, the politics are not straight forward either, as there would be many interest groups who would be most concerned if the Commonwealth were to withdraw from funding their preferences.

Indeed, a relatively recent and interesting example, of these problems occurred when the Keating Government agreed with the States on a separation of road funding responsibilities. Instead of the previous shared responsibility for road funding, under this reform the States became solely responsible for all road funding other than designated National Highways, which were the sole responsibility of the Commonwealth. Immediately the States started lobbying to have more of their roads transferred to the Commonwealth as designated national highways. Then shortly after the Government changed in 1996, the National Party succeeded in abandoning this separation of responsibilities so that it could get back into its traditional business of doling out money to rural constituencies for their roads.

In addition, the States have a further concern about their reliance on funding from the GST. This is because the GST has not proved to be the “growth” tax that was expected when it was introduced. First the coverage of the GST is just under half of total consumption, and household expenditure on the other excluded consumption items, notably private spending on health, education and financial services, is growing faster. Second, over the last decade household savings rates have increased (albeit from a zero base), and consequently household consumption expenditures have grown more slowly than incomes; although with currently falling incomes this might be about to change.

Sharing Income Tax and GST Revenues

Given these difficulties with relying heavily on an increase in the GST to remedy government budgets, it is perhaps not surprising that another revenue raising option was proposed to assist in meeting all governments’ future fiscal challenges. This latest strategy would involve:

  1. The Australian Government increasing the GST and keeping some or all of the additional revenue
  2. The States obtaining some or all of the extra revenue that they are seeking by gaining access to a share of the income tax, and
  3. Some or no cut to tied grants depending upon how much revenue is raised for the Commonwealth to retain and relative to the States by 1 and 2 above.

On the face of it, this proposal represents a neat pragmatic solution to some of the various political problems involved in relying mainly on an increase in the GST to resolve future budget problems. In particular, it is easy to see why it would appeal to the States as it would seem to provide a stronger growth in their future revenue, while from the Australian Government’s point of view it would most probably require less reduction in its tied grants.

On the other hand, this strategy would involve for the first time in more than seventy years, two levels of government sharing the major sources of revenue – the principal taxes on expenditure and income.

This revenue sharing would completely contradict the principles of responsible and accountable government. It would most probably result in a return to the annual wrangle between the Australian Government and the States over their respective revenue shares. Furthermore, whenever there was a perceived deficiency in State government services, the States would be able to claim that they had insufficient revenue and needed a bigger share of either the GST or the income tax. In other words, the States would be able to argue that they should not be held accountable for poor State government services. Instead the States could blame the Australian Government on the grounds that the Australian Government was preventing State governments from accessing sufficient revenue.

Most importantly, if fiscal policy is to retain its effectiveness for counter-cyclical purposes the Australian government must retain its flexibility to unilaterally set and change the income tax rates – reducing them to ward off recessions and increasing them in a boom. Furthermore, with interest rates testing new lows there is a risk that monetary policy may be less effective in future and that reliance on fiscal policy will therefore need to increase; indeed the evidence from a number of countries is that monetary easing since the GFC has mainly resulted in increasing asset prices, but has not produced the hoped for increase in real activity.

In this context it also should be remembered that experience suggests that tax variations are much more effective in moderating fluctuations in economic activity than variations in government expenditures. Essentially history shows that consumers respond more quickly to variations in income tax, and that there are especially long lags before decisions to invest in more infrastructure start to impact on the economy. In addition, it is easier to make temporary variations in tax rates which can subsequently be reversed, whereas many form of government expenditure are difficult to reverse after the economy recovers.

The use of the income tax to moderate fluctuations in economic activity means that the revenue from this source is more variable than other revenue sources. Furthermore, this is still true even if tax rates are not varied, although in that case the variations in income tax revenue would be less.

A key issue would be whether the State budgets could cope with this amount of volatility in one of their key revenue sources. A risk with any sharing of income tax revenue is that the States could spend up in the boom years and return cap in hand to the Australian Government seeking extra revenue in the lean years. Of course, any development along these lines would be the opposite of what would be required by a counter-cyclical fiscal policy.

Conclusion

In brief, the options for the Australian Government and the States to share tax bases, and especially the income tax, would represent a triumph of pragmatism over principle. Such a triumph of pragmatism is not unknown in Australian policy development – indeed some may consider it part of the Australian policy genius.

In the present instance this pragmatism may help resolve some difficult political problems, but in terms of effective federalism arrangements it would represent a major step backwards. Not only would there be no clear assignment of many expenditure responsibilities, but if governments also share their revenue bases the accountability for financing all State government services would also be muddied.

It would be particularly strange for a Liberal Government to adopt revenue sharing along these lines, as historically the Liberals have been more concerned about separation of roles and responsibilities of the different level of government than Labor. And any national government must be concerned about any weakening of its capacity to meet one of its greatest responsibilities – to ensure economic stability and growth.

Thus effective tax reform would still seem to be some way off. The end result will almost certainly represent a compromise involving a mix of options, including measures that were not on the COAG agenda, such as broadening the income tax base by reducing concessions.

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