The economic case for tax reform

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.