An overhaul is needed to restore fairness to a repressive tax system

To date, the tax policy debate has overlooked a key aspect of our fiscal malaise: the way in which the present tax system has undermined the rule of law.

Recent research shows that most of the international variations in income per capita - perhaps as many as 85 per cent - can be explained by the institutions and policies countries adopt. Specifically, as The Australian Law Journal noted recently: "Institutional economics has established a high correlation between economic growth and the rule of law."

Broadly, the rule of law means that the conduct of individuals, groups and governments is guided by law, and the law is such that most people will obey it voluntarily most of the time. Otherwise, the amount of coercion needed to enforce it will lead to government by arbitrary force rather than government under law.

Today's extensive cash economy, coupled with unending trench warfare between Canberra and an unwilling public, is a comparatively recent phenomenon that dates only from the 1970s. The '50s and '60s, one perplexed tax academic observes, were marked by an "almost sheep-like compliance" that mysteriously broke down in the next decade.

But there was no mystery. What transformed taxpayer attitudes was the ravaging inflation unleashed by federal Labor treasurer Frank Crean's 1973 and 1974 budgets, which distorted the tax scales out of recognition. The Fraser Coalition government prevented further deterioration by introducing tax indexation, but the Hawke Labor government abolished it. So the inflation-distorted tax scales remain substantially uncorrected today.

Until the '70s, most people complied with the tax laws, partly because they considered them reasonably fair and partly because at prevailing tax rates non-compliance did not pay.

The people have never voted for income taxes at the present rates and would have defeated any government that proposed them. The result has been a decline in voluntary compliance: people do not regard working in the cash economy as cheating because they believe they are paying too much.

Governments have responded to this quiet rebellion by trying to legislate away every imaginable way of avoiding tax. Consequently, federal income tax law, which before World War II occupied 81 pages, has exploded to 13,500 pages, plus an even greater mass of court decisions, Australian Taxation Office (ATO) determinations, rulings, bulletins, policy papers, circulars and policy guidelines.

The sheer bulk and continual amendment of this material make tax law an unreliable guide to human conduct. A federal judge has described the law as unintelligible, adding that: "Many provisions in the legislation are not applied for the simple reason that no one is able to comprehend them."

Further damage to the rule of law has been done by granting the ATO (and, on appeal, the courts) wide discretionary powers to alter the scope of tax law. The most far-reaching is in the "general anti-avoidance rules" of Part IVA, which overrides the rest of the act and which empowers the ATO to strike down an otherwise lawful arrangement on the basis of the commissioner's opinion as to its purpose.

Former chief justice Harry Gibbs considers that these powers amount to an abandonment of the rule of law. Neither Britain nor the US has an equivalent provision and practitioners from those countries aver that the rule of law has survived relatively well in their tax systems.

Many taxpayers increasingly treat the law and the courts as irrelevant. Legal advice leaves them unmoved. All they really want is an ATO ruling that will protect them from penalties or prosecution. While the binding rulings system serves a valuable purpose in the present legal wilderness, it suggests that the tax system can scarcely be called law at all rather than direct bureaucratic rule.

The rule of law cannot be revived just by attacking the tax laws' complexity or wide statutory discretions. That would only make the conflicting pressures of enforcement and resistance break out elsewhere in the system. Effective reform will mean restoring positive incentives so that, as in the '50s and '60s, most people will obey the tax laws and enforcement will be needed only for the greedy few. It will mean removing the distortions in the scales caused by the high inflation of the '70s and '80s, and restoring tax indexation to prevent similar bracket creep in future.

Experience in the US after 1981, in Russia since 2001 and since the Howard government's company tax cut from 39 per cent to 30 per cent in 1999 shows that large tax cuts, because of their incentive and growth effects, can often boost revenues.

Australia faces a once-in-a-generation opportunity to opt for the rule of law, fairness and growth. It should not be allowed to pass us by.