It’s unfortunate that there is no bipartisan support for a major tax overhaul. In fact, some describe the current political climate as toxic. So far, the tabloid tax debate has centred on whether the GST should be increased or not. Understandably, the public is very concerned about the rising cost of living and the resultant impact on their hip pockets. To date, no one has made the case for why major tax reform is necessary and discussed the options for establishing a better tax system.
The conversation with the public has to be elevated beyond just the GST; Australians need to understand how the reforms will deliver increases in living standards. However, explaining the benefits of reform is difficult, as changes are often complex and not necessarily intuitive.
Winners and losers
Reform comes with considerable risk and effort. You need a lot of political capital up your sleeve to embark on a major tax reform, because there will be political fallout. There will be winners and losers in any structural reform to our tax mix and losers will inevitably complain loudly.
That said, it is well understood in Treasury that tax reform represents one of the strongest levers the government has at its disposal to revive productivity, competitiveness and growth. That’s why future policy settings for tax are critical to maintaining Australia’s envious growth record (two decades of economic growth, which has contributed to one of the highest living standards in the world). Our current tax system is now seen as a drag on economic growth rather than supporting the effort. Add to this a rising number of challenges facing the economy and unless we lift productivity growth, we risk a long period of sluggish income growth.
Recovery and repair
So, Australia faces interconnected twin challenges: ensuring fiscal sustainability, as outlined in the recent Budget update, combined with the need to boost productivity growth to sustain growth in living standards.
The productivity challenge requires a wide-ranging and comprehensive response, of which tax reform is a key part. Future tax reform is no longer an option, especially now that the resource boom has run its race, exposing structural problems mainly on the revenue side. The most recent Mid-Year Economic and Fiscal Outlook (MYEFO) reveals the parlous state of our finances and the size of the Budget repair task. The government is not expecting a return to surplus until 2020, some 12 years after the global financial crisis (GFC). Put simply, we have less firepower to withstand another GFC or downturn.
The 2010 intergenerational report (IGR) also stresses the need for significant tax and federation reforms. Previous IGRs have projected increasing expenditures on health and social security. We can no longer rely on booming commodity prices to support our living standards.
The government has committed to a tax white paper and, at the time of writing, this was expected to be released early in 2015. Any proposed changes that come out of the white paper will be taken to the next election. The main thrust of the tax white paper will be on modernising our tax system, Issues of flexibility and competitiveness are being examined through the Competition Policy Review, the Productivity Commission review of the Fair Work Laws, and the Financial System Inquiry.
The prime minister has already indicated that tax reform is not about finding a way to raise taxes, Genuine tax reform also requires more than an across-the-board cut in tax rates. It is about improving the structure of the tax system to reduce the cost that raising revenue imposes on the economy. In other words, it is as much about how much revenue is raised, as how it is raised.
Tax mix challenge
Our tax mix is heavily weighted towards direct taxes on personal and corporate income. This was identified some 40 years ago in the 1975 Asprey Taxation Review committee report, which recommended that the weight of taxation should be shifted towards the taxation of goods and services and away from the taxation of income. A recent OECD report released in December 2014 highlights that Australia is one of the countries that would benefit greatly if it shifted its tax mix in that direction.
Despite the introduction of the GST and reduction in corporate and personal tax rates over the past decade, the balance of taxes has remained reasonably consistent. Without changes to current policy settings, our reliance on income taxes – both personal and corporate – will continue to increase.
This is, in part, due to our personal tax thresholds not being indexed and the GST base not including expenditure on things like fresh food, health and education.
With a rate of 10 per cent and broad exemptions, the GST raises only half the revenues as a share of GDP as compared with the OECD average. As a result, the tax burden falls on labour and business, which are not a growth-friendly tax mix, Bracket creep means that someone on the minimum wage will lose a third of their additional income to tax by 2017/18, while someone on average wages would be paying a 37 per cent tax rate.
The only way out is to start shifting the burden from direct to indirect taxes.
Attracting investment
Another key issue for the tax white paper will be the competitiveness of our tax system, particularly corporate tax and, with it, our capacity to attract new foreign and domestic investment. Over recent decades, the international trend has been for countries to lower corporate tax rates. While the government has committed to lowering the company tax rate by 1.5 percentage points from 1 July 2015, more needs to be done to make our corporate rate more competitive.
The importance of this is magnified given the increased digitisation of the economy across all sectors, the rise in corporations that operate across multiple international borders, the increased mobility of capital and the growing importance of intangibles. All these factors are placing more pressure on the international tax system.
A globalised economy and global supply chains mean that companies have greater choice about where they locate their production and productive assets, including intellectual property. Along with the significant differences in after-tax outcomes that can result from such choices, this places pressure on our corporate tax system, particularly our high corporate rate and Australia’s heavy reliance on corporate income tax.
Funding government
The government has also committed to a federation white paper to address issues in commonwealth and state operations and funding. The tax white paper and the federation white paper are linked. The tax white paper will look at the revenue-raising side of the equation (optimal tax mix), while the federation white paper will examine spending and service delivery (most efficient allocation of roles and responsibilities).
In Australia, the states raise just over half their revenue through their own sources, including payroll tax, stamp duty and land tax. The rest of their revenue comes from the Commonwealth through untied and tied grants, including the GST.
This mismatch between the level of government that raises the revenue and the level of government that spends it is referred to as vertical fiscal imbalance, State expenditure exceeds the revenue states collect. It has already been well documented that some of the most inefficient and distorted taxes are state-based taxes, such as stamp duties.
The federation white paper will need to address overlapping responsibilities, uncertainty and confused accountability in the delivery of services to our community.
The structure of our federation also reduces the incentives for states to reform their own taxes. Because the states don’t raise the marginal dollar they spend, they have less reason to make their tax systems more efficient.
The two concurrent, interconnected white papers provide a once-in-a-generation opportunity to achieve substantive reform.
Selling reform to the public
Explaining the benefits of tax reform can be extremely difficult, because the positive impacts on individual effort, investment and growth are not always obvious (try explaining to ordinary wage earners that they will benefit from a company tax cut), Recent work by a group of Treasury analysts published in the Economic Roundup suggests that more than half of the long-run economic burden of Corporate tax is borne by wages.
Benefits of reform often take time to be realised and are shared across large, dispersed groups of individuals. Conversely, losses are felt immediately and often by highly concentrated groups. If there is an expectation that each individual element of a reform package must be ‘fair, the reform opportunity will be doomed. Instead, the public needs to assess whether the overall reform package delivers fair outcomes that are in the national interest.
Changes in the tax mix will require policies to assist those least able to adjust to the changes, while increasing living standards in general across the community. Our social welfare payment system is better placed to compensate low-income earners for regressive changes in the indirect tax mix, rather than maintaining the current distortions in the tax system. What is not well understood is that a low rate of indirect taxes benefits the wealthiest citizens.
There will be significant transitional challenges, but the issues we face over the decade ahead require an appropriate response.
