Reforming Taxation Isn’t About Increasing Taxes

1 May 2015
Reforming Taxation Isn’t About Increasing Taxes - Featured image

In the United States they say that the states are the ‘laboratories of democracy’.

What they mean is that a federal system—made up of a separate national government and numerous regional (state) governments—provides the opportunity for experimentation. The argument follows that it is experimentation that optimises the chance of the best mix of policies— in taxation, health and education provision, environmental protection and business development—for any given region’s population.

That was the view of Alfred Deakin, Edmund Barton and Samuel Griffiths—Australia’s leading Federation fathers—and it continues to enjoy the support of most Australians. They may not frame it in those intellectual terms, but the more pragmatic and widely held realisation is that ‘Canberra’ does not always know what is best.

The federal system we have today is far from ideal. It is, in fact, a sad mess. There are many areas of overlap and duplication which we as a nation have been struggling to get right for decades.

You do not need to go far to hear from people that the health and education systems are in need of drastic reform. Premiers complain that they do not have enough money to run these systems and are forced to beg for more and more assistance from the federal government, resulting in more and more federal intervention.

But centralisation is not always the answer. Indeed, the answer is often the opposite. The duplication across a number of sectors is enormous and most Australians will have heard that the federal government amazingly employs 1,868 education bureaucrats but does not own one school. There are many examples across the portfolios where because of the call on the federal budget, the federal government has inserted its sticky hands in state decision-making.

The primary reason for this mess is that the basic architecture of the system is flawed. The federal government raises more money than it directly spends and the states are in the opposite position.

Do not be misled, however, by the siren song from some premiers and self-serving lobby groups that this flaw would be fixed with more tax revenues—preferably by either an increase in the GST rate, or an expansion of its base, or both. This siren song is joined by a cacophony from individuals and groups making just this case. Some business organisations—such as the Business Council of Australia and the Australian Industry Group— should know better. But they have been caught up in the latest fashion. The problem for these fashionistas is that their arguments are 20 years old, and are now dated and stale.

Equally, those—mainly social welfare advocates—who argue that Australia is a low-tax country are categorically wrong. The IPA has done an enormous amount of good work that shows this is simply not the case. Taking into account social security mandates, the total tax burden as a share of GDP is 32.2 per cent, using the latest comparable figures from 2011. When taking account of economic size and trade, that compares with an OECD average of 30-31 per cent.

So why increase the GST rate, or increase its base? First let’s consider the economic case for the GST.

There were two principal economic reasons for introducing the GST. First was the fact that the pre-existing indirect taxes—like the wholesale sales tax—were very inefficient.

They taxed business inputs such that there was a cumulative cascading of taxes that added massively to business costs. This was particularly damaging to exporters and import-competing industries that were battling with businesses from overseas that were not suffering from the same handicap.

The GST removed that double taxation burden. This was the principal economic reform and it meant billions of dollars to Australian businesses. However, it is a reform that is completed. It was long overdue but it is now done. The efficiencies and productivity benefits have already been booked many years ago.

The second big economic reason for introducing the GST was that it allowed for what became known as a ‘tax mix switch’. Principally this meant a reduction of the revenue burden on direct income taxes to be replaced by indirect taxes. The important argument, supported by a large body of evidence, is that high marginal tax rates on personal income have a largely negative impact on economic activity, discouraging work and productivity improvements. The former Treasury Secretary, Martin Parkinson, was making similar observations in a speech last year.

A tax mix switch was attempted in the 2000 Howard-Costello tax changes. However, the bottom line is that this reform did not really work for the Howard government. At the time there were some substantial income tax cuts, but we still seemed to have a heavy reliance on direct rather than indirect taxes in Australia.

The reason for that is bracket creep on the income tax schedules and a heavy call on corporate income tax. Additionally, there was meant to be significant replacement of inefficient state taxes. However, a large segment of that was reneged on by state premiers.

The other point to make is that many of the same people who are arguing for increases in the GST to fund increased government services would immediately become the noisiest advocates for compensation through tax and welfare cuts. These cuts would soak up most of the new GST revenues, thus defeating much of the stated purpose for a change, namely to pay for other things.

Most of these advocates are actually arguing for bigger government and not a more efficient tax system. Business organisations like the Business Council of Australia and the Australian Industry Group should shake off their naivety and be very careful about supporting such calls.

Another issue is the simplistic call for the removal of the GST exemptions for fresh food, education, health, sewerage and water, and financial supplies. Some people are claiming that these were all politically expedient decisions. Admittedly, the fresh food exemption was the price of getting the support of the Australian Democrats in the Senate to pass the GST legislation. The other exemptions, however, were sound design features deliberately adopted.

They were not political decisions as much as they were tax administration decisions based on the difficulties of taxing these areas, especially given the heavy involvement of government in many of these sectors and the cross-jurisdictional issues in our Federation which could cause significant tax churning. They were not design flaws of the system but were in fact design features deliberately taken for good, on-balance reasons.

The prime minister has launched a taxation debate centred on repairing the financial problems of the Australian Federation.

The government is in the process of producing two parallel white papers (government policy positions) on reform of the federation and on tax reform. In that context, the prime minister said in a speech at Tenterfield on 25 October 2014 that ‘the Commonwealth would be ready to work with states on a range of tax reforms that could permanently improve the states’ tax base— including changes to the indirect tax base with compensating reductions in income tax’. It is assumed that when he spoke about an indirect tax option he was clearly referring to GST. But what is also clear is that the prime minister talked of considering ‘a range of tax reforms’.

This article explores a different option for reform that has been considered before but in recent times is too readily discarded. It is, however, an option that has in the past had substantial support in both economic and political terms.

Importantly, it is an option that would not raise the overall tax burden and consequently it should be given serious consideration in the government’s Taxation White Paper. That option is an income tax sharing agreement between the federal and state governments.

The basic problem that needs to be addressed is clearly stated in the government’s September 2014 issues paper on Federation Reform. This paper notes that the states’ revenue base is inadequate to fund their spending growth responsibilities in areas such as health and education. Demand is outstripping supply.

A brief history of income tax is relevant. Up until 1942, the states levied income taxes. Due to the funding demands of World War II, it was mutually agreed to hand the tax to the federal government. After the emergency passed, the federal government refused to hand it back.

In 1977, Prime Minister Malcolm Fraser proposed a ‘New Federalism’ policy and passed legislation to allow state income tax surcharges (or rebates, for that matter) to help states meet their funding needs. Unfortunately NSW Premier Wran waged a short sighted scare campaign on the issue, alleging this would lead to ‘double taxation’ and the option was never taken up.

Fourteen years later, Prime Minister Bob Hawke was inching towards re-introducing such a policy through a series of Special Premier’s Conferences when he lost the leadership ballot to Paul Keating in 1991. Hawke had set up a ‘Working Party on Tax Powers’ that noted one option for reform was the introduction of a State Income Tax Surcharge. In response, all state and territory leaders at the time signed a communiqué on 8 November 1991 calling for its implementation. They sought a 6 per cent surcharge in a broadly revenue-neutral package of reforms, whereby the federal government would reduce income tax and also payments to the states. In other words, it was recommended by experts and it was politically doable. New Prime Minister Paul Keating, however, was personally against the proposal and it died there and then.

More recently, an income tax surcharge was recommended by the National Commission of Audit (NCA) in its February 2014 report.

Many so-called experts will complain that reordering the intergovernmental share of income tax revenue would do nothing to fix the relative balance between direct (e.g. income) taxes and indirect (e.g. GST) taxes—the tax mix switch issue referred to earlier. There is truth to this.

However when you think about it, basically all taxes— including GST— are paid out of an individual’s earned income. So it is not apparent that this is an overwhelmingly decisive argument. And to make it clear, the income tax sharing option that should be debated is not designed to raise more total revenue, but to substitute federal taxes with state taxes, thus not increasing the reliance on income taxes.

Indeed, any possible economic efficiency benefits from this reform would be lost if all that we are doing is locking in the deleterious effects of further increases in the overall tax burden.

The other economic benefit claimed by a tax mix switch is that GST as a consumption tax on balance encourages further saving. Again, Australia does not at present suffer from a household savings problem— with indexes at historical highs.

Helpfully, the NCA not only raised the topic; they actually got the Treasury to do the economic modelling that shows how the figures would stack up.

Last financial year, the total transfer of funds (tied grants) from the federal government to the states, not including $51.2 billion in GST receipts, was $45.1 billion. The NCA notes that of this total, $13.9 billion is for National Health Reform Funding, $13.2 billion is for specific education payments, $3.9 billion is for payments for skills, disability and housing, and $14 billion in payments for 144 different National Partnership Agreements).

As an option, the NCA proposed that 10 percentage points of the tax bracket base between incomes of $37,000 and $80,000 be allocated to the states. Currently that tax bracket attracts a tax rate of 32 per cent. So a change would mean that for taxpayers in that bracket they would actually have a 22.5 per cent federal income tax and a 10 per cent NSW (or whichever state a tax payer lives in) income tax.

Treasury calculated that this 10 per cent state income tax would raise $25 billion. The NCA shows that this would allow the federal government to completely withdraw from all education funding, public housing projects and a large number of National Partnership Agreements.

Indeed the NCA have also done the calculations to show that a once and- for-all solution to the otherwise intractable problem of distribution of GST revenues to states would cost $4.9 billion on an annual basis.

That solution would be to largely scrap the existing Grants Commission formulas for dividing up the money between the states, and substitute per capita grants based on population. For example, today Western Australia argues that it only receives 4.2 per cent of GST total revenues which is only 10 cents in the dollar generated in that state. To fix this problem means either taking GST revenue off subsidised states like Tasmania and South Australia or increasing the pool, thus the $4.9 billion. The NCA argues the ‘top up’ would be found from savings elsewhere in the federal budget. They argue the structural reform would be worth it. With that extra money, all 144 of the National Partnership Agreements ($14.0 billion) could also go.

So the end result would address the states’ revenue problem, remove the federal government from a very large proportion of expenditure, and do it without increasing total revenues. That is a win-win proposition.

After the initial implementation, states would be allowed to vary their tax take. In a left-leaning state—where they seem to reward big-spending governments—one might see the ALP raise the tax from 10 to 11 per cent. In NSW— where a fiscally responsible Baird government can deliver budget surpluses—one might see a cut to 9 per cent if they thought it was sustainable. So be it: that is democracy.

We should thank Chairman Tony Shepherd and his NCA team for having the foresight to commission this modelling.

In conclusion, the income tax sharing proposal should be the basis of a long-lasting reform of our Federation. It would not be a perfect solution but, as with other options, should at least be considered in the white paper process. Treasury has already done the first cut of the economic modelling. Let’s widen the debate, forget about increasing the GST, forget about raising the tax burden, and get on with selling federal-state reform.

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