MICHAEL KEATING. Budget commentary, Part 2: Sustainable tax cuts for low-income households

May 12, 2018

Part 1 of this series of Budget comments criticised the credibility of the Government’s projected return to a budget surplus and argued that the proposed tax cuts were therefore not in fact sustainable. In this second part I will argue that nevertheless some tax relief targeted at low-income households should be supported, and other alternative sources of revenue should be found to return the budget to surplus and make those tax cuts sustainable.

I concluded in the first part of this three-part series of Budget comments that the Government’s proposed tax cuts were not consistent with returning the budget to surplus, let alone a surplus equivalent to 1 per cent of GDP as previously promised. I do however, consider that tax cuts for low-income households should be supported, but they will require additional financing, as I will discuss below.

Why personal income tax cuts for low-income earners should be supported

Although inequality has increased less in Australia than in many other advanced economies, it has nevertheless been increasing, and income tax cuts targeted at low-income people will make a modest contribution to reducing that inequality. These tax cuts should be supported for ethical reasons. They will help build a more inclusive society, which is important for the future of our liberal-democratic order, and which capitalism actually depends upon. Tax cuts targeted at low income households will also assist economic growth as they will best support the increase in demand that is required for future economic growth.

As Stephen Bell and I show in our recent book “Fair Share”[i], the secular stagnation that western economies have been experiencing for the last decade is primarily a result of low wage increases and therefore low consumption demand. Prior to the Global Financial Crisis (GFC), this demand was sustained, despite low income growth by increasing resort to credit, and that in due course brought on the GFC. However, household debt in Australia has increased since the GFC and is now running at 189 per cent of household disposable income – one of the highest ratios in the world.  An increase in interest rates would now create major difficulties for many households. Credit expansion may well therefore be more constrained, and demand could well stagnate without some reversal of the increase in inequality. Furthermore, recent experience of secular stagnation in the US shows that there is the risk that the rate of growth of potential output will then adjust downwards because the rate of productivity increase declines, as investment stagnates, capital equipment is not renewed, leading to slower technological progress, and skills atrophy for those facing extended unemployment.

For these various reasons the Government’s proposed first round of income taxes should be supported. However, the second tranche of the tax cuts which take full effect from 2024-25 should be opposed. They will result in a much flatter tax structure which is accordingly much less progressive. For example, when this revamping of the tax scales takes full effect in 2024-25, someone with a taxable income of $40,000 would get a tax cut of only $455 in a year, whereas someone with a taxable income of $200,000 would get a tax cut of $7225, or almost 16 times as much (see Table 1). Furthermore, even in proportional terms, the person with $40,000 taxable income gets only a 1.1 per cent tax cut, whereas the person with $200,000 taxable income gets a 3.6 per cent tax cut. That clearly demonstrates the regressive nature of the Government’s proposed tax changes. It is also why modelling by the Australia Institute shows that only 7 per cent of the total tax cut goes to the 3 million taxpayers who are low income earners, while 31 per cent goes to the 5 million taxpayers who are middle income earners, and the lion’s share – 62 per cent – goes to the 2 million taxpayers who are high income earners.

As I have previously noted Australia has a problem with increasing inequality, which is both socially and economically damaging, and this sort of redistribution in favour of the rich is precisely the opposite of what is needed from tax reform. Of course, the Government argues that high income people deserve to keep more of their income, and that this sort of tax cut will incentivise them. Frankly these arguments don’t hold up. First, income tax has always been based in all countries on capacity to pay, and that is deemed to rise more than proportionately with income.  Second, the reality is that the senior executives and professionals earning high incomes have very little discretion to vary their work effort. They are driven by the demands of their jobs, and the limited empirical evidence available supports this view. The Government’s other argument is that its new tax scales will remove most of the bracket creep, but Governments have always acted every few years to offset the effects of bracket creep and can continue to do this in the future while maintaining a progressive income tax system.

In short, I think that there is no argument for this sort of change to the progressivity of our tax system, and it should be opposed. In addition, as I have argued in my previous article in this series, it is highly probable that the cost of this tax change cannot be afforded. And even if that conclusion were debateable, given the uncertainties about the future budget outlook, it is unnecessary and irresponsible to legislate these tax cuts now seven years before they take effect. Indeed, that is why no government has ever previously legislated so far in advance for tax cuts to take effect so many years later – the uncertainties are just too great. For these reasons, it is important that even if Labor does not reject immediately the regressive cuts in taxation proposed by the Government  to take effect in the mid-2020s, it is important that it opposes their legislation at this time.

Table 1 Tax relief in 2024-25 by taxable income

Taxable income $ Tax cut $ Tax cut as per cent of income
20,000 0 0
30,000 200 0.7
40,000 455 1.1
50,000 540 1.1
60,000 540 0.9
70,000 540 0.8
80,000 540 0.7
90,000 675 0.8
100,000 1125 1.3
120,000 2025 1.7
140,000 2925 2.1
160,000 3825 2.4
180,000 4725 2.6
200,000 7225 3.6

How best to return the Budget to surplus

Any consideration of how best to return the budget to surplus needs to recognise that taxes serve a purpose; they are not just a “burden”. Instead, taxes represent how we pay for government services that we want and the income transfers that reflect a long egalitarian history. Accordingly, Government revenue should be determined by what is necessary to pay for the efficient delivery of the services and the type of society that we want to achieve. As John Howard put it when he was Prime Minister in 1998: ‘tax cuts should be considered after you have met all the necessary and socially desirable expenditures’ (my emphasis). Similarly, public opinion surveys regularly find that the most people would prefer to maintain expenditures rather than sacrifice government services to pay for a tax cut.

This view seems to be the underlying reason why the Committee for the Economic Development of Australia[ii] and the Grattan Institute[iii] have independently concluded that budget repair will require action to be taken on both the revenue and expenditure sides of the budget, and that most of the proposed fiscal adjustment will have to come from increased revenue. Indeed, the Grattan Institute is quite adamant that “governments will not be able to restore budgets without also boosting revenues”.

The Coalition Government, however, is hamstrung in its approach to fiscal repair by its commitment to not allow taxation receipts to increase above 23.9 per cent of GDP. There is of course nothing sacrosanct or even logical about any such revenue ceiling. However, such a ceiling then puts a ceiling on expenditures as well if the budget is to remain in surplus. Consequently the Coalition is always under pressure to cut or squeeze the funding of services and transfers in order to restore the budget surplus; or more likely, as I argued in Part 1 of this series, the Coalition Government’s budget will not in fact lead to a sustainable budget surplus. In contrast, Labor has no such binding constraint on either its taxation or expenditure levels.

So, if we return to what I consider to be the two primary objectives for this Budget: tax cuts targeted at low income earners and a return to a sustainable budget surplus, then Labor’s Plan as outlined by the Opposition Leader, Bill Shorten, seems to have considerable merit. First, Labor’s Plan offers considerably more assistance to the lowest income earners at an extra cost of around $3 bn in a full year. Second, Labor should be able to readily finance this extra tax cut and achieve a return to budget surplus as soon as the Government or even quicker. Labor will have more revenue because of its decisions to (i) not go ahead with further extension of the company tax cut to big companies, and (ii) to reduce access to a variety of concessions. I have written previously[iv] why there should not be a cut in company tax: the benefits will mainly accrue to foreign companies and there will not be a significant increase in investment as profits are already high. Instead, the savings from not cutting company tax would be much better used to increase consumer demand and/or reduce the budget deficit. Equally the tax concessions that Labor plans to reduce or remove flow primarily to the rich, and too often result in the rich not paying their fair share of taxation. In addition, limiting access to many of these concessions should also improve policy outcomes, such as in the housing market.

But looking further ahead, in the longer run, Labor is likely to face much the same difficulties in maintaining the budget surplus that I outlined in Part 1 of this series of Budget comments yesterday, although Labor will be more cashed up to start with. In our recent book, Fair Share, Stephen Bell and I analyse the demands on the Budget over an extended period and come to the conclusion that it will be necessary to increase the ratio of government revenue to GDP by three percentage points over the next three decades. In our view, that is not much to maintain an inclusive society, and it would still leave Australia as a low tax country with a lower revenue to GDP ratio than New Zealand already has.

Dr Michael Keating is a former head of the Department of the Prime Minister and Cabinet

[i] Bell. S. & Keating, M., 2018, Fair Share: Competing Claims and Australia’s Economic Future, MUP

[ii] CEDA, 2016, Deficit to Balance: budget repair options, The report of the Balanced Budget Commission

[iii] Grattan Institute, 2015, Fiscal Challenges for Australia

[iv] Pearls and Irritations, 18 January 2018.

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