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.

Our top rate of almost 50 cents in every dollar is pernicious and is increasingly out of line with other Western countries. The wealthiest people in the country don't even pay it: they take advantage of the much lower 30 per cent company rate, and they further reduce their tax liability by exploiting myriad loopholes and concessions scattered through 9,000 pages of tax legislation. There are now so many special allowances and exemptions (another 100 have been added since 1996) that tax law has become almost indecipherable.

Another problem is tax on retirement savings. Australia is the only country in the world that taxes superannuation when money is put into a fund, when the fund earns profit, and when the money is withdrawn. By raiding people's super in this way, the Government is shooting itself in the foot, for retirees who could have been self-reliant will end up with inadequate savings and will then have to be supported with a government age pension.

Professor Ross Garnaut, no right wing ideologue, nearly a decade ago showed how Australia could achieve serious tax reform by a gradual move down in marginal rates of income tax. Garnaut in 1997 presented a paper called Investing in full Employment to a meeting of the Business Council of Australia. In this important paper he pointed out that:

... the social security system has become increasingly comprehensive, with a relatively small number of Australians outside employment now being denied benefits, and with many people in employment now receiving benefits.

Furthermore:

Australia is approaching the stage where personal income tax and social security transfers together can almost be seen as one system of income redistribution, with one being applied almost entirely to the financing of the other, and together contributing little revenue to finance the general purposes of government.

This issue of tax and welfare “churn” is widely seen as a major area for reform. The consequences are considerable.

Ad hoc and separate growth and change in social security and tax have led to a total system that is now highly damaging to economic growth and to full employment. Integrated reform of the tax and social security systems is now centrally important to any program to restore full employment and to raise economic growth on a sustained basis.

In particular:

High marginal income (including capital gains) tax rates at all levels in the income range inhibit productivity growth in Australia. At higher levels in the range they inhibit personally risky innovation. They reduce the competitiveness of Australia as a base for footloose, high-skill industries. In addition, the divergence between corporate and income tax rates introduces uneven opportunities for avoidance that reduce community respect for the taxation system

High effective marginal tax rates (EMTRs) at lower incomes inhibit productivity growth, are a major deterrent to labour force participation, and block the labour market deregulation that is necessary for full employment. Here the problem of high effective marginal tax rates derives from the interrelationship of the tax and social security systems. This inter-relationship generates severe "poverty traps". It is a tribute to the foresight and work ethic of Australians that low-skill people enter the labour force at all, since for some millions of Australians the short-term net financial benefits of doing so are small and often negative when the additional costs of going to work (including transport and clothing) are taken into account. High EMTRs also introduce large incentives for tax evasion through employment in the "black economy".

We must acknowledge that the government has tried to do something about high EMTRs, mainly by reducing means test tapers. It reduced FTB Part A taper at bottom end of income range from 30 per cent to 20 per cent at the last budget, and Parenting Payment taper has been reduced from 50 per cent to 40 per cent. But this only creates problems elsewhere, for flattening the taper necessarily extends the range of incomes over which it applies, thereby dragging more affluent people into high EMTRs trap. This shows just how difficult this problem is to deal with in our current system with such widespread tax/welfare churn.

In commenting on a draft of this paper, Garnaut added: “I’d make even more than you do of the ridiculous complexity of our tax system … compare our complex GST with NZ’s simple one; our thousands of pages of income tax act with US or NZ, the incomprehensible superannuation tax rules, etc. We are the world champions in high transaction costs in just about everything.”

Then there are the views of Dr Vince FitzGerald, Chairman of the Allen Consulting Group, who might be described as being in the middle of the ideological spectrum. An extensive study for the Victorian Labor Government, put lower tax rates (with a top marginal rate of income tax of 40 per cent) and a flatter structure at the core.

This report proposed that tax cuts should be funded by reductions in tax breaks, such as deductions for work-related expenses, capital gains concessions, negative gearing, fringe benefit concessions for vehicles, and others. FitzGerald estimated that there are around $12 billion in tax breaks that could be removed, so finding $6 billion to fund his proposed reforms to tax rates should "not be difficult".

The proposed reforms would reduce effective marginal tax rates across the income spectrum, but especially at very low income levels, where the interaction of the income tax system and the social security system has particularly bad effects on incentives to participate in the workforce. The report estimates that these reforms would lead to around 92,000 additional people entering the labour force.

I have quoted these three fine economists as I agree with all of them, and share their views. One could also note that, as the political debate is evolving, Labor is emerging as the party more keenly interested in tax and welfare reform, which is another sign of the emerging consensus on this matter.

To prove the benefits of tax reform is a deeply difficult subject. Experience of countries which have cut taxes suggests to most economists who have studied them closely that there is a substantial effect, but it is relatively easy for a sceptic to deny or downplay such effects. Perhaps the most relevant evidence is the powerful growth of tax receipts in Australia when particular rates of tax have been cut - the best example being the cut in the company tax rate from 36 per cent to 30 per cent between 2000 and 2002.

We should not ignore the logical point used as the basis of the so-called “Laffer curve” in this debate. This is that when the marginal rate of income tax is 50 per cent (or more) a taxpayer earns as much (or more) from evading or avoiding tax than he does from earning more. It is no coincidence that Australia’s richest people pay relatively little tax, which does nothing to maintain the confidence in the overall fairness of Australia’s tax system. But there is another point to be made - ability to take measured risks and to work hard, when combined with a relatively low personal burden of tax, is a recipe for building great wealth. The aim of policy should be to offer the possibility of such a combination to all Australians, not just the already wealthy, who have used tax minimisation within our complex system so well.

Sinclair Davidson has surveyed the literature on effects of cutting tax rates on the overall tax take and suggests Australia is on the “wrong” side of the Laffer curve (i.e. tax cuts would raise revenues).

To implement reform the government will look to Treasury, which of course takes very seriously its role as guardian of fiscal probity, and is understandably reluctant to endorse what might be seen as “experiments” on the economy. But this natural conservatism can go too far. When one forecasts with extreme conservatism about the likely growth rate, plans for a moderate rate of “sustainable growth”, makes no allowance for “second round” positive effects of tax cuts and embraces a view that the budget must in virtually all circumstances remain in surplus one is indeed inhibited. It is like blindfolding and shackling a man, placing him is a small but weighted box and throwing him into the river. A Houdini might escape, but most will not.

Clearly we need to proceed at a measured rate so as not to overheat the economy. But what is needed is great clarity about the end point so that measured implementation can be planned. Many if not all economists would agree with the following endpoint for Australia’s tax and welfare system:

• a top marginal rate of income tax of 30 per cent, with corresponding cuts along the schedule, with capital gains taxed at the same rates as normal incomes;
• a company tax rate of 30 per cent, maintaining full dividend imputation for domestic owners of shares;
  • abolish most if not all tax deductions - retaining depreciation allowances in particular as well as tax deductability for loan interest capped at income from that investment;
• abolish most if not all special payments to “disadvantaged” individuals and groups, substantially reducing the tax-welfare “churn” in the process;
• introduce either a negative income tax, including a base tax free allowance for every Australian, or earned tax credits to eliminate the problem of very high effective marginal tax rates for welfare beneficiaries - the principle being that no-one should be faced with an effective marginal tax rate above 30  per cent; and
• greatly simplify the tax act, which all the above changes would make possible.

I would be astounded if the fine economists in Treasury did not agree that something like this package would put Australia at the forefront of global fiscal efficiency. The task for Treasury, apart from fine-tuning the end point, would be to plan implementation in a way that minimised the chances of an overheating economy and minimised unintended consequences. This would be a major exercise in itself.

Australia’s economists generally agree on three propositions about unemployment. The first is that the problem is far worse than suggested by the current official statistics, and the damage to the fabric of Australian society correspondingly greater. The second is that most of the solution lies in radical reform of the tax and welfare system. The third is that a carefully constructed program of phased reforms would make Australia one of the most dynamic economies in the world, without creating a risk of overheating or other unfavourable side effects.