The future of tax reform

Feb 21, 2024
Tax wrote on wooden cubes on Australian dollar.

There are recurrent calls for tax reform, but it is typically too difficult to achieve a consensus. However, the necessary action to reduce carbon emissions by introducing a tax on carbon emissions could result in most people being better off and thus achieve broad support.

To coin a phrase: just like galahs in a pet shop there are always calls for tax reform, and especially by business who always want lower taxes, not least for themselves.

The possible content of the optimum reform agenda has been well marked out, especially since the Review back in 2010 by Ken Henry, the then Secretary of the Treasury. The Henry Report contained 138 recommendations, but almost none have been implemented.

Thus, a critical question is why tax reform is so difficult, and what can we expect over the next twelve months in the run up to the election.

Although it is too often not recognised, the obvious starting point to this discussion should be a recognition that the purpose of taxation is to pay for the services that our society demands, and which are best financed collectively.

But unfortunately, many of us are schizophrenic when we discuss taxation. We want increased access to more and better services on the one hand and less taxation on the other.

Instead, to be credible, politicians who promise lower taxation also should say how that will be paid for. Too often, however, they can’t or won’t.

In fairness, the former Coalition Government did nominate in their first 2014 Budget how they would finance lower taxation when they proposed a series of expenditure cuts to health, education, and the ABC to finance that lower taxation. But these proposed cuts broke several election promises, and in response to the very negative popular reaction, the Government itself promptly dropped all its proposed expenditure cuts.

Instead, during their remaining eight years in office the only way the Coalition Government could pay for the three stages of their income tax cuts was by stealth. They underfunded a host of government services, and even then they failed to meet their target of getting the Budget “back into the black”. In addition, tax revenue exceeded their self-imposed ceiling of 23.9 per cent of GDP in most years.

Since being elected the Albanese Labor Government has embarked on a number of program changes and has improved program funding somewhat. But an analysis by the Grattan Institute concluded that the structural budget deficit will be close to 3 per cent in ten years’ time. That of course is way too much, and my own personal assessment is that in order to meet public expectations for adequate services and income support, taxation revenue will need to increase by around another 4 per cent of GDP over the next few years.

So what can we expect from the two main political parties who will be vying to form the next government after the election in the next twelve months or so?

The Liberal Party

As all readers will know the Coalition (reluctantly) supported the Government’s changes to the original Stage 3 tax cuts to make them fairer to lower and middle income earners. As Dutton put it: “the Coalition is not going to stand in the way of providing support to Australians who are doing it tough”.

While Dutton would like to restore the original proposal and drop the income range subject to a 37 per cent tax rate, he has acknowledged that at a cost of $9 bn annually this change would be very difficult. Instead, at this point of time, the Coalition’s rhetoric is that it is the Party of “lower, simpler, and fairer taxes”. But what exactly that means and how it will be paid for is not known – probably not even by the Coalition at this stage.

Dutton’s only specific suggestion has been to imply that he could achieve savings by rolling back the 10,000 increase in the number of public servants since Labor was elected. All that shows is how out of touch Dutton is with the realities of running government.

First, the cost of these extra public servants hired by Labor has been offset by savings from reducing the number of consultants. Under the Coalition Governments spending on consultants doubled from $444 million in 2014 to $888 million in 2022. As Finance Minister, Katy Gallagher, says the Coalition had a “shadow workforce” of 53,000 and now the Labor Government “is saving $810 million over four years by converting contractor jobs to permanent jobs”.

Second, finding savings in the administrative costs of providing services will never go anywhere near paying for significant tax relief. For example, even if Dutton did manage to reduce public service numbers by as much as 10,000 and not replace them with consultants, the budget savings would finance very little tax relief.

The one specific area of tax relief that Dutton has chosen to highlight is the alleged problem of bracket creep. According to Dutton there will be a greater risk of average tax rising over time now that the Labor Government has restored the income bracket with a 37 per cent tax rate. But again, Dutton doesn’t know what he is talking about.

Of course, average tax rates do rise as people’s incomes increase and they move to a higher tax bracket. For that reason, there is an expectation that a less progressive tax system with fewer tax brackets, which the Liberals favour, will be less subject to bracket creep. But even if people remain in the same tax bracket their average tax rate can rise as their income increases and a higher proportion of that income is then subject to their marginal tax rate.

Indeed, Treasury analysis shows that because the first tax rate will be reduced from 19 to 16 per cent, the Government’s redesign will produce a smaller increase in average tax rates for the first seven income deciles over the next ten years. In other words, it reduces bracket creep for more people compared to the Morrison Stage 3 plan and also compared to a no change scenario.

In sum, the Liberal Party mouths slogans that they are always the Party of lower taxes, but they cannot find the expenditure savings to honour that pledge. That also means, however, that they are not likely to contribute anything to tax reform.

The Labor Party

The Labor Party regularly acknowledges that various government services need more funding, but they seem unwilling to reform the tax system to raise the necessary additional funds. In the end, Labor is telling us that the quality of service provision and assistance to needy families will be determined, not by what is needed, but by the amount of revenue that can be raised without changing the tax system significantly.

But as stated at the beginning of this article, we should be prepared to pay the taxation necessary to fund the services that we want and need. In addition, high commodity prices are helping the budget at the moment, but if they return to normal, the Grattan Institute estimates that there would be a structural budget deficit close to 2 per cent of GDP, which is unsustainable.

So there is a real need to raise more revenue. The experts would like the government to raise indirect taxes and close the loopholes in the income tax. However, a broad reform agenda along these lines will inevitably be controversial. Generally, there is resistance to this sort of tax reform because those who think they will lose are much more vociferous than the winners who are less conscious of their possible future gains.

Nevertheless, there is one source of additional revenue that might appeal. As I reported (Pearls and Irritations, 17 February) two leading economists, Ross Garnaut and Rod Sims, have shown how Australia’s prosperity can be restored by capitalising on Australia’s enormous cost advantage in the production and use of green energy.

But as Garnaut and Sims point out, Australia will not be able to realise this potential prosperity without introducing a price on carbon emissions. Accordingly, they recommend a Carbon Solutions Levy (CSL),

This CSL would help finance the necessary innovation and investment needed to make Australia a leading producer and user of cheaper renewable energy. It would also ensure that the green steel and other green materials made in Australia would be eligible for tariff free entry into the main overseas markets. Australia could thus expect to become a leading supplier to the rest of the world, with enormous benefits to Australia’s future prosperity.

Garnaut and Sims estimates that the CSL will raise well over $100 bn in the first year, equivalent to around 4 per cent of GDP, or the extra amount that I estimate will be needed to fund adequate service provision.

That additional tax revenue will decline over time, as carbon emissions fall as intended. Nevertheless, that additional revenue would not only help finance the investment needed for a green economy, it will also be available to significantly improve government services.

Of course, carbon pricing has been bitterly debated in Australia, with the Coalition being most opposed. But introducing the CSL will not result in higher electricity prices as the green energy that it will help to promote will be cheaper. And today there are many signs that the majority of the electorate are concerned about climate change and want government to take the necessary action to reduce carbon emissions.

In addition, most of us will gain from the introduction of a Carbon Solutions levy. Our energy costs will fall over time, and there will be faster economic growth from the new opportunities presented by Australia’s cost advantage in the production and use of green energy. In fact, the only losers from a Carbon Solutions Levy will be the producers of carbon emissions, but that is inevitable if we are to halt global warming, and these relatively few losers can be found new jobs in the new industries.

Surely it should therefore be possible for Labor to get on the front foot and promote these tax reforms recommended by Garnaut and Sims. Most people will be better off with cheaper electricity and an enhanced rate of economic growth.

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