Ken Henry: The interests of the most disadvantaged are not being served by our tax system

Sep 28, 2021
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Those who care about distributive justice cannot ignore the extraordinary intergenerational inequity inherent in our present tax system.

I am often asked how many of the tax recommendations of our review, published in 2010, remain to be implemented. That’s a bit like asking how much further we must travel to get from point A to point B when, for the past decade, we have been travelling in the opposite direction. Assessed against the benchmarks set out in our report, the Australian tax system is in a considerably worse place today.

The Australian tax system is in a parlous state. It is not capable of raising sufficient revenue to fund the activities of government — not in any particular year, nor on average over a run of years of any duration. Since that is the purpose of taxation, there can be no avoiding the conclusion that the Australian tax system is not fit for purpose.

Government spending is growing at a faster rate than GDP. The only tax base in the federation that is being relied upon to produce revenue growth at a faster rate than GDP is the personal income tax, through the operation of fiscal drag. Fiscal drag, which lifts the average rate of personal income tax by stealth, is the sole instrument being deployed in the cause of Commonwealth budget repair. All other tax bases are fiscally unreliable. They are either highly volatile or subject to tax competition and other sources of base erosion.

At the state level, taxes on things like insurance look increasingly antiquated. Property stamp duty and, for some states, resource royalties continue to be highly volatile sources of revenue. Interstate competition for businesses and jobs continues to erode the payroll tax base. The tax bases of the states are even more fragile than those of the Commonwealth.

We are back to where we were in the several decades following WWII. This was a period characterised by ill-disciplined public spending, only partly funded, with a heavy reliance upon fiscal drag that punished innovation, enterprise, and effort; distorted the pattern of saving; and rewarded tax avoidance and evasion.

The personal income tax was appropriated by the Commonwealth as a wartime emergency measure. Fiscal drag in the personal income tax system quickly became the principal instrument for managing the wartime public debt legacy, at least until the asset sales of the 1980s and 1990s. When confronted with a mountain of public debt, relying on fiscal drag to work its magic is understandable. But it is also dangerous.

According to Treasury projections, fiscal drag will lift the tax-to-GDP ratio from today’s 20.9 per cent to the government’s stated cap of 23.9 per cent 15 years from now. Because other tax bases are shrinking as a share of GDP, keeping the total tax-to-GDP ratio at that level requires an indefinite continuation of fiscal drag.

Capping the tax-to-GDP ratio at 23.9 per cent of GDP implies total Commonwealth receipts of about 25 per cent of GDP. Since payments are projected by the Treasury never to fall as low as even 26 per cent of GDP, the tax-to-GDP cap bakes in a permanent budget deficit, with ever expanding public debt.

At today’s interest rates, few people seem to care about the level of public debt. But when rates normalise, and debt servicing costs accelerate, attitudes will change quickly. With few asset sales options left, a future government will face an invidious choice between slashing spending or lifting tax rates.

Almost certainly, in the absence of major tax reform, draconian spending cuts will be relied upon to do most of the work. Why?

Well, because the government’s fiscal strategy, based on today’s tax system, proposes a degree of intergenerational inequity that will eventually prove intolerable.

We know from the post-war period that placing exclusive reliance upon fiscal drag in the personal income tax system for an extended period to fix the budget ultimately threatens the social compact. There is an even bigger risk of this now.

From the 1960s, the share of taxpayers in the population grew strongly as the baby boomers became of working age and because of steeply rising rates of female workforce participation. Today, demographic trends are reducing the share of the population that works. That, and the fact that superannuation end-benefits are largely exempt from tax, implies that the proportion of the population supporting the personal income tax base is now falling. Yet, the fiscal strategy demands that the proportion of total taxes coming from personal income tax must increase.

As the most recent intergenerational report shows, the fiscal strategy is designed to place a heavier and heavier burden upon the shoulders of a declining proportion of the population, principally workers.

The seriousness of the threat this poses to intergenerational equity is difficult to overstate. And that’s why I can’t imagine a future government seeking to extract even more out of the personal income tax system in the cause of budget repair. At some point, young workers, who are also voters, are going to say “enough!”.

So, the future choice is really between draconian spending cuts and major tax reform. Major tax reform that supports higher rates of income growth could avoid the need ever to raise tax rates.

Our review identified directions for reform of the Australian tax system, at both Commonwealth and state levels. With few exceptions, these have not been pursued. They must be now. And, in my view, they should be progressed together, in large part because some of the most obvious reforms demand a Commonwealth-state compact.

Several of the necessary reforms to the Australian tax system would be considered by some people to be regressive. We must be careful to avoid this becoming a stumbling block. An assessment of system fairness must take account not only of the impact of the various elements of a tax reform package, but also of what will be lost if tax reform is not pursued.

For those who care about distributive justice, the stakes are very high.

The interests of the most disadvantaged are not being served by a tax system that is already punishing innovation, denying people opportunity, depressing wages growth, undermining the sustainability of government service provision and increasing the risks of sweeping spending cuts in future “horror budgets”.

But even more importantly, those who care about distributive justice cannot ignore the extraordinary intergenerational inequity inherent in our present tax system.

This is an edited version of an address delivered on Wednesday, September 22 to a forum hosted by the Business Council of Australia and the Tax and Transfer Policy Institute at the Australian National University. Ken Henry has done consulting work for both.

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