Tax Reform

1. INTRODUCTION

The first thing to be said about tax reform is that politicians who promise tax cuts of more than a few dollars a week for average earners should not be believed.  The distribution of income in Australia and the level of government spending mean that whatever the tax regime most of the money will in the long term have to be raised from ordinary people one way or another -- unless very large reductions in government spending can be made.  Voters are now aware of this and treat promises of tax and spending cuts with the cynicism they deserve.

The experience of the last ten years shows how difficult it is to achieve large, real, sustained spending cuts.  Mandate to Govern has not found any easy way.  The proposals in other chapters will achieve useful savings in the first year or two, and they pave the way for large continuing savings in later years (the opposite approach to that adopted in the 1986 Budget, where much of the "saving" consisted of deferring expenditure and almost nothing was done on balance to reduce future expenditure growth).  Such savings as can be made in early years should be put towards balancing the Budget and thus reducing the future expenditure burden of debt servicing.

In the long term, Mandate policies will permit substantial reductions in taxation.  In the short term, no tax reform can be contemplated that will result in a significant reduction of revenue, because of the urgent need to reduce the deficit, or, to be more precise, the public sector borrowing requirement.  Remember that a deficit today means debt servicing costs in the future.  Deficits do not reduce the need for taxation, they merely defer it, and each new government's policy options are increasingly constrained by the debt burden it inherits from its predecessors.  As well as this, if governments borrow large amounts they tend to make it more expensive for the private sector to raise capital for job-creating investment projects.  Although only a small proportion of government debt is "overseas debt", the extent of government borrowing on domestic markets has been a factor in private-sector resort to international markets and the alarming growth in Australia's overseas debt.

There are three possible approaches to tax reform:  continue with minimal change to the present system until spending is under control;  continue along the line taken by the Hawke Government since the Tax Summit;  or go for radical reform.

2. MINIMAL CHANGE

This means maintaining the tax system more or less as the Government finds it on taking office, and legislating to block loopholes as their exploitation begins to cause serious embarrassment or loss of revenue, or as the distortions and misallocation of resources caused by the system become unbearable.  This was the basic approach of the Fraser Government for most of its time in office.

2.1 ADVANTAGES

The advantages of the minimal-change approach are:

• Tax reform is a minefield for a Government.  Well-meant reforms can often blow up in its face:  the Fringe Benefits Tax, for instance.  Unless revenue needs are reduced, any reform involves lightening the burden on some taxpayers and increasing that on others, who are likely to resist the reform (think of the tax summit).  If reform is delayed until expenditure cuts have been achieved, it becomes possible to make useful reforms which will meet less opposition.
• There are areas where reform is more urgently needed -- the labour market and trade and protection policy for example -- and these should have first call on the Government's attention.  The consequences of failure to loosen up the labour market and reduce protection will be much worse than those of delay in tax reform.
• The present tax system works, after a fashion, and raises the necessary revenue.  The economy adjusts to the tax regime in force at any time by shifts in relative prices which spread the incidence of taxes very widely.  The same market forces tend to even out differences in real after-tax income (including fringe benefits etc.) of people with similar skills but different tax avoidance opportunities.  Changes, even if they introduce a "better" system, disturb the equilibrium and may well temporarily increase inequity.  The argument is summed up by "old taxes are good taxes, new taxes are bad taxes".
• The tax system is a major part of the business environment, and changes to it (especially if they are major or frequent) are a potent source of uncertainty.  An excellent way to discourage investment in Australia is to create uncertainty about the future tax regime.  This applies to individuals' career and savings/investment decisions too.
• In a forthcoming paper, Geoffrey Brennan suggests another argument for the status quo:  as the tax system forms part of the environment in which all political decisions are made, it should have a quasi-constitutional status.  Brennan argues that if voters do not know how the future tax regime will affect them, they are not in a position to make rational judgments on public spending proposals:

  If the taxation system is not established and in place prior to the point at which individuals have to express their views (electorally or otherwise) on the level of public spending, then individual citizens cannot make relevant political decisions responsibly.  To change the tax system after relevant electoral decisions have been made is equivalent to asking individuals to decide on which house they want without telling them what the prices of various houses are:  no market can work satisfactorily on this basis.

2.2 DISADVANTAGES OF THE PRESENT SYSTEM

The main disadvantages of the present system are:

• It is extremely complex and uncertain in its operation, to the extent that even specialists are often uncertain of the rules.  Uncertainty is increased by the discretions granted to the Commissioner of Taxation, which often permit him to ignore the rules of natural justice;  but wide discretion is now essential to keep the complexity of the legislation from getting altogether out of hand.  Even with expensive tax advice, it is virtually impossible for a corporate taxpayer to be certain that it is paying neither more nor less tax than the law requires:  in other words the compliance costs are very high.
• The "old tax is a good tax" principle implies that horizontal inequity in an established tax system is likely to be very much less than it seems, as the labour market decisions of employees and the self-employed respond more to differences in after-tax, or after-tax-avoidance, earnings including fringe benefits rather than to differences in pre-tax cash wages.  But the principle does not apply to the effects of the tax system on the allocation of resources.  Favourable tax treatment of an industry, for example, brings about more investment in it than under a neutral tax system:  in other words, the favoured industry gets more than the economically optimal amount of resources, while other industries get less.  Result:  less growth, lower standards of living, more difficulty in achieving tax cuts later.
• It relies on too narrow a tax base.  Much income is exempt from the income tax, and much consumption is not touched by sales tax, excises, etc.  This means that although Australia is not a very highly taxed country by world standards, the actual rates of personal and company tax are very high.  This provides strong incentives for tax avoidance or evasion;  the high marginal tax rates on incomes not much above average are a significant disincentive for increased production by individuals.
• As well as encouraging avoidance and evasion, the high tax rates and numerous exemptions cause considerable distortion and misallocation of resources through the economy.  Not only income tax is at fault here:  for example, the tariff has serious effects (see the Trade and Industry chapter) as does the grossly unequal tax treatment of different minerals (gold is untaxed, coal and oil very heavily taxed, most others in between).
• The present system is widely perceived to be unfair (although different people have very different ideas about what are the unfair features).  The idea of reform is popular even if it is very difficult to mobilise majority support for any particular, realistic tax package.

3. IN KEATING'S FOOTSTEPS

The second approach to tax reform is that adopted by the Hawke Government after its rebuff at the 1985 Tax Summit:  attempt to move towards a wider tax base and lower marginal rates -- a priori a desirable direction for reform -- but without fundamental change to the system and without a visible, generally accepted rationale behind the changes.

3.1 ADVANTAGES

The only advantage of this approach is that it avoids the trauma and political risk of radical reform.

3.2 DISADVANTAGES

The principal disadvantage is the inevitable increase in the complexity of the system over time.  Fringe Benefits Tax and Capital Gains Tax required legislation that was perhaps not understood even by the draughtsmen:  witness the "unintended consequences".  With any increase in complexity comes an increase in compliance costs, both the first-order costs to business and individuals of the necessary record-keeping and form-filling, and the higher-order costs of opportunities lost because of doubt about tax consequences.

4. RADICAL REFORM

4.1 ADVANTAGES

The main advantages of a radical reform of the tax system are:

• Substantial efficiency gains could result from removal of the distortions and misallocations caused by the present system.
• Simpler tax laws and lower marginal rates would reduce the scope for tax avoidance and evasion.  This would make tax advice a less rewarding investment and encourage Australia's brainiest accountants and company lawyers into more productive activities.
• Simplicity would also make it easier for businessmen to make investment plans with confidence about the tax position -- as long as they were also confident that the tax system was not likely to undergo further drastic change.
• Useful savings on the cost of collection might be made.
• Business practices and attitudes have been shaped in part by the present tax system.  Radical reform of the tax system would force major rethinking in business and encourage the search for new and productive opportunities.
• With luck, a system might be both efficient and effective and perceived to be fair.  The way in which the economy adjusts to a tax regime means that almost any reform will cause a transitional increase in inequity.  The designers of a reformed system will have to make compromises between economic efficiency and superficial equity.  For instance, the idea of a progressive income tax seems fair, although a flat tax is preferable on economic grounds (neutrality, simplicity, etc.).  But the question of fairness must be considered in relation to where the burden of the tax will ultimately rest:  a high rate of tax on high incomes may not be so fair if the effect is to increase the prices people with low and average incomes must pay for the services of people with scarce skills.  This does not just relate to going to the doctor or getting legal advice:  everyone with superannuation or life insurance or a bank account is affected by the cost of employing money market experts, systems analysts, tax lawyers, accountants, and the rest.  Another unavoidable compromise will be between the demands of theoretical efficiency and the need to have a tax system that encourages the growth of internationally-competitive, export-oriented industries.

4.2 DISADVANTAGES

• It is a big legislative and administrative job to devise and implement a radical reform of the tax system.  The Australian Taxation Office is overstretched by the present system, and major improvements will be needed before it could cope with the transition.
• As mentioned above, unless significant expenditure reductions can be made any tax reform worthy of the name is going to make some people better off and others worse off.  Governments are well aware that losers make more noise than gainers, and that any such reform will be opposed in some quarters.  But despite what the media and some "tax experts" lead people to believe, the pattern of losses and gains is not permanent.  In the short term, it will exist and perhaps be exacerbated as the economy adjusts to the new system;  in the long term, the benefits of an efficient tax system will reach almost everyone.
• An argument against radical tax reform often advanced, especially after dinner, is that an efficient tax system would merely encourage big government by producing more revenue for any given level of taxpayer complaint.  This argument should not be ignored:  but it could be met in part by constitutional restrictions on government expenditure or taxation if these could be devised and passed (see the Government and Administration chapter).

5. CONCLUSION AND RECOMMENDATIONS

The choice appears to be between minimal change and radical reform.  The efficiency costs and distortions of the present system mean that reform is needed;  the transitional costs of reform, and vested interest opposition to any particular proposed reforms, mean that it would be unwise for the Government to invest much political capital in it.  What is needed is a tax reform package developed outside the political marketplace, which can then take its chance in the marketplace as a package.

The Mandate to Govern project has not commanded the resources -- economists, tax lawyers, economic modellers, computer programmers, etc. -- necessary to design a new tax system that could be presented with confidence.  Relevant work is, however, taking place at the Centre of Policy Studies at Monash University and elsewhere.

Nevertheless, the debate on tax reform, which has been in progress at least since the Asprey Report of 1974, has yet to produce a consensus on any firm proposals.  Almost all changes have met strong opposition from affected interests (even the Fraser Government's announcement of income tax indexation was opposed by Treasury).

Modern computers have simplified the task of modelling tax systems, so it is possible to have more confidence as to the effects of particular changes than ever before.  A consensus is emerging that a reformed tax system for Australia should have:

• Lower marginal income tax rates, including combined company and personal tax on dividends.
• Fewer tax shelters.
• A wider tax base, achieved by means of a broad-based consumption tax (BBCT) and/or lower income-tax thresholds.  (Trade union opposition to BBCT has diminished since the Tax Summit.)

There is no consensus on whether the BBCT should be a retail sales tax or a VAT or something else;  on whether or under what circumstances capital gains should be taxed;  on the best way of taxing companies;  etc.  Even consensus is not enough:  early in 1986 there was very widespread support for the idea of taxing fringe benefits, but later in the year there was sufficient opposition to the actual Fringe Benefits Tax to force the Hawke Government to change the legislation and the Federal Opposition to promise to repeal it.  The lesson of this is that tax reform cannot be treated as an ordinary political exercise.  The Tax Summit was an attempt to avoid the pitfalls of the ordinary political process, but showed how people meeting as representatives of interest groups tend to set the interests of their constituency above the general interest in the course of showing what effective representatives they are.

5.1 DEPOLITICISED TAX REFORM

The design of a new tax system should be a technical exercise more than a political one, although political considerations can never be ignored if reforms are to have a chance of becoming law.  The aim has to be to maximise the general benefit while minimising damage to any particular group.  Sectional interests should as far as possible be excluded.  All Australians now and in the future share an interest in a better tax system.

The Government should set up a committee to design a reformed tax system, including draft legislation.  The Committee should be given a year in which to report, and should work in private. The report and draft legislation should be published, and the Government should make it clear that the reforms are to be considered as a package -- take it or leave it, except for unavoidable technical amendments.  This should also apply when or if the legislation is introduced into Parliament:  the idea is to minimise the opportunity for vested interests to lobby for special favours and thus reduce the strain on the Government of resisting them.

The committee's members should be economists and tax specialists, although political, business and trade union expertise would be useful.  The four or five members should be appointed for their personal qualities only and not as representatives of interest groups.  The committee should work in private because it is virtually impossible for public hearings to be conducted without giving indications of committee thinking and thus helping vested interests plan their opposition.  The Government should set up the committee and then leave it alone, thus minimising the political capital it invests.

Obviously, much will depend on the Government's choice of committee members.  These should not be the customary wise old men and party hacks:  the usual process of interest-group representation and compromise has been tried and has failed.  The members need not be famous, and need not be chosen with a view to ensuring that they come up with conclusions acceptable to the Government, because the Government will have very little at stake.  What is at stake concerns the nation as a whole:  a chance of faster growth and reduced social tensions;  so what matters is the energy and expertise of the committee members.  This is not the place to suggest names, but I will be happy to advise the Government when the time comes.

The terms of reference should leave wide discretion.  Some relevant matters are listed in the box below.  The draft legislation must include transitional arrangements.  The committee should be given a small secretariat and ample funds to commission research in universities and the private sector.

If the committee's proposals are widely accepted (no proposals can possibly gain universal acceptance), the reforms should be implemented.  If not, the Government should give up the idea of tax reform and continue a policy of minimal change.

The tax reform committee must consider, among other things: Efficiency and simplicity and perceived fairness. The taxing powers of the States, with a view to reducing Commonwealth taxation and making the States raise more of their own revenue. The needs of export industries and financial markets. Incorporation of Family Allowance and Family Income Supplement and perhaps some other benefits in a system of refundable income tax credits, to assist working people with low incomes (see the Welfare chapter).

5.2 MINIMAL CHANGES

Some changes to the tax system should be made without waiting.

5.2.1 Tax Indexation

It is well known that, with a progressive income tax like Australia's, as nominal incomes increase with inflation the tax impost increases faster, driving a widening wedge between costs and after tax incomes.  In an early flush of righteousness, the Fraser Government promised to adjust tax thresholds to compensate (tax indexation);  but indexation was soon abandoned as it was realised that there was then more to be gained by allowing bracket creep to assure revenue increases and by claiming political credit for "tax cuts" which in real terms were tax increases.  Tax indexation was included in Option C at the Tax Summit, but was dropped from the Hawke Government's tax package -- although excises were indexed, an asymmetry decidedly to the taxpayer's disadvantage.

Any promise of tax indexation will therefore be received with distrust by the electorate.  But if the Government can promise and deliver tax indexation for a single term in office, it will have set a precedent for honest public finance that it, or successors of other parties, will find it hard to break.  The atmosphere thus created will help lessen the "them-and-us" feeling of many taxpayers, and will make it easier for a tax reform package to gain acceptance.

The Government should index income tax thresholds and allowances to the Consumer Price Index.

5.2.2 Tax Administration

The Government should not ignore the possibility of minor improvements to the present system, particularly those -- such as increased self-assessment backed up by US-style random audits of ordinary taxpayers -- already foreshadowed (it should, however, be remembered that self-assessment is not fair to taxpayers unless the rules are simple enough and firmly enough established for the average taxpayer to have a reasonable chance of assessing himself for the right amount).  Reports of the Auditor-General have pointed to inefficiencies and inadequacies in the Australian Taxation Office:  attention should be paid to these.

It is safe to assume that the tax reform committee will design its package with a view to making the best use of computers for routine work;  the Taxation Office's present computer systems are inadequate;  so expenditure on modern, well-integrated computer systems is unlikely to be wasted.