The economic case for tax reform

Most Australians would surely agree with the following hope for Australia's tax system: “Simpler; fairer; lower rates; less distortions; a broader tax base; make the states earn what they spend.” (John Garnaut, Sydney Morning Herald, January 16, 2006). There are powerful economic arguments for this wish list.

The government, with luck as well as good management, has done much to reduce unemployment from the catastrophic levels created by the severe recessions in the last third of the 20th century.

I am old enough to remember when the top marginal rate of income tax was 66 cents in the dollar, when loans by banks were rationed, when labor markets danced to the tunes of the union bosses and when inflation took off during a mining boom because monetary policy was rendered unworkable by regulated financial markets - including a very sticky exchange rate. Much has been achieved since then for the Australian economy.

Low inflation seems well entrenched under current arrangements that make the Reserve Bank accountable and responsible for the outcome. Financial markets have been deregulated - loans are allocated by the likely returns rather than a customer’s place in the queue outside their bank manager’s door. Labor markets are certainly freer than they were, and the current round of reforms will improve things further.

There are, however, major issues still with the labor market. The evidence is that Australia’s labor market participation is well behind that of other countries and the effective rate of unemployment is well above the rate as officially measured. In particular, when one allows for people who have retired prematurely; those who are working many less hours each week than they would prefer; women who are forced to stay at home by the high cost of childcare; and people on disability pensions who would still be working in other circumstances, the effective rate of unemployment is nearer 15 per cent rather than the 5 per cent suggested by official statistics. This is a judgment provided to me by Professor John Freebairn, Director of the Melbourne Institute, but one I fully endorse.

Part of the reason for our internationally low labor market participation lies with major unresolved issues with Australia’s tax and welfare system. Closely related is the question of the sustainable rate of growth. Some say this is as low as 3 per cent a year, others say 4 per cent. Sustainable growth at 5 per cent should be Australia’s aim but continued economic reform will be required if this is to be achieved.

How can tax reform help?

The biggest single problem is the high rates of personal income tax and particularly the high effective marginal tax rates (EMTRs) that confront those on welfare who are trying to move to paid employment. These features of Australia’s tax system are a major impediment to higher labor market participation and higher sustainable, non-inflationary growth.

Economists are often (unfairly) derided for having a multiplicity of views on any subject one cares to choose. But on the question of reform of Australia’s tax and welfare system there is a high degree of unanimity. Peter Saunders writing in The Australian newspaper on January 20, 2006 said:

One can't help but feel some sympathy for Peter Costello. Armed with huge budget surpluses, he has been splashing money around in all directions in recent years, but no sooner does he placate one section of the population than another pops up, making fresh demands. Even when he sprays cash directly at people, they seem ungrateful.

But the Government really has nobody to blame but itself. Our income tax system is riddled with distortions and disincentive effects that cry out for serious attention, but the Treasury has set its face against tax reform. Complaints and demands will keep surfacing from different sections of the electorate until these fundamental problems are addressed.

The income tax system is inefficient, hugely complex, unfair, destructive of incentives and corrosive of the spirit of self-reliance. The Government's preference for tinkering - tweaking a rate here, fiddling with a threshold there - does not begin to recognise the scale of what needs to be done.