I’ve been looking at a recently published paper by Allen Consulting on tax reform. Tax reform has become the New Thing To Do. The paper was commissioned by the Victorian Government and, given that I don’t know what the brief was, I’m not being critical of the consultants.
The report proposes base broadening – suggesting government choose from a menu of $12 billion worth of base broadening measures – ie removing CGT concessions (nothing so brave as suggesting that we remove CGT concessions on housing that I can see). Allen Consulting then argue that governments need to choose about half of these base broadening options to fund the reduction of the top marginal rate from 47.5% to 40%.
As I’ve indicated in several posts and columns I’m very suss on reducing the top marginal rates. It’s not that I wouldn’t like those of us on the top rate to enjoy a lower rate. It’s that from an efficiency perspective, I just don’t think it’s as high a priority as lower rates further down the income scale where incentives to work are already much worse with high effective marginal tax rates (EMTRs) produced by the combination of tax and benefit withdrawal and this is where the supply responsiveness of labour is higher than it is further up the scale.
Even where we are not targeting high EMTRs from welfare withdrawl as a priority, I think what the government has done since it’s come into office – namely lifting thresholds – makes much more sense than cutting the top rate. But it’s now pretty much accepted that cutting the top rate is a priority.
And various arguments are rolled out about ‘competitiveness’ of the tax system (a very seductive idea which is mostly wrong - but that’s another story pursued a little here). We’re told that we should be cutting tax if not to encourage the wealthy to work harder, then at least to attract highly paid skilled workers to our shores. But that argument doesn’t wash either. If we want to pursue this line of argument then we should be lifting the top threshold as far as we can afford rather than cutting the top rate. I make that assertion on the grounds that we’ll get larger tax cuts to more people in our target zone (high income earners) by lifting thresholds than by cutting rates.
If we want to lift it to $200,000, $250,000 or further well and good. Indeed, with the money we save lowering the top rate we could lower the second top rate a little – and so ‘incentivise’ more of those skilled people that are supposedly at the heart of ‘real reform’. But lowering the rate and creating a windfall for the very rich is mostly revenue down the drain for little GDP return (maybe you’ll get a few fewer sports exiles, but why shouldn’t they keep heading off to the Cayman Islands anyway.)
Anyway, as I was reading the Allens report I came upon this statement. “[W]ith more savings, more fundamental reform could be achieved�. That’s when it struck me that there’s something funny going on in this debate. I can accept that it’s a reasonable ‘rule of thumb’ to say that broadening the base is ‘real reform’ whether it’s fundamental or not I’m not sure. But given that the report is speaking of the rates side of the tax system, what is “more fundamental’ reform? Well to be charitable to its authors, perhaps the idea of reshaping the welfare and tax systems into a fully blown negative income tax system.
But I think something else is going on. I think these tag lines like ‘real reform’ (as opposed to ‘just tinkering’) are forms of unspeak the function of which is to do the thinking in advance for us by framing debate. In the tax debate we now have a strong rhetorical tendency to equate ‘real reform’ with cutting rates and lifting thresholds as ‘just tinkering’. This also goes on within a larger political drama in which Malcolm Turnbull, Craig Emerson and Lindsay Tanner are for ‘real reform’ and the establishment - John Howard and Peter Costello - are ‘just tinkering’.
Now though I think lifting thresholds is generally preferable as I’ve explained above, even if I held the opposite view on the merits (and I’d be happy to be persuaded that I’m wrong) I’d still think this language is deeply misleading. Because the choice between cutting rates and lifting thresholds is one of tradeoffs, and so one of degree not of kind. This is generally true of debates about tax – they’re about choices between costly alternatives.
In the GST debate we had much talk of how our indirect tax system was ‘broken’. Well the GST certainly was much more broadly based, and on those grounds it was a big improvement. But it got to be the ‘real reform’ and that meant that two things were sidelined in the debate. They’re not unimportant.
1) Transactions costs. WST was collected by of the order of 100,000 businesses. The GST adds another entry to every invoice of every one of over one million businesses in the country. What’s the cost of that? We didn’t really debate it but I don’t think it’s trivial.
2) I think I recall reading at around the time of the GST (please let me know in comments below if you can recall where you saw it if you did) that the allocative distortions involved in exempting medicine, education and finance from the GST were approximately the same as the allocative distortions generated by the different categories of WST and the resulting different rates of tax between specific goods and between those goods and services. That got virtually no discussion at all. After all the GST was real reform. Extending WST to services (as was happening in NSW in an ad hoc way) or harmonising WST rates was just tinkering.
Tax is about tradeoffs. So finding that there are difficulties and problems in a tax system isn’t an argument for replacing it before you’ve given the alternative – however attractive it might be in removing those problems – the ‘once over’ and you’re confident that it has fewer problems that the thing it is replacing.
Sloganeering about ‘real reform’ is very effectively preventing us from debating the issues sensibly.
Thanks, Nicholas, a good post.
I’m in general agreement with the tax policy aspects of what you say so I’ll confine myself to noting a bit of the political context.
The first I noticed the “real reform” theme coming out was around the time Malcolm Turnbull put out his tax paper. It appears to be a way of saying that what Costello does is “tinkering” as opposed to “real reform”, which as we all know is what Howard must do in the fourth term with a Senate majority, lest he be branded another Fraser. Funny how this “real reform”, as advocated by various groups in the national interest or as contributing to output and productivity, always concentrates on lowering the top rate or aligning rates with the company tax rate.
Wow. Naomi. I’ve been so busy following the American scene I didn’t realise that some of the local politicians were pushing forth what I would consider to be my agenda.
Actually Nicholas. From a pure efficiency point of view reducing top rates for income tax is really important. Which is unfortunate since were it not so one would just like to concentrate on lifting the tax free threshold as high as it can go to compensate low-paid workers for these Industrial Relations changes and for hoped-far slashing of spending programs.
But there is a way around this. You’d bring another tax over the top as it were. You would maybe put up a 1% total (non-financial) assets tax. With (lets say) a one million dollar threshold per family member for individuals but no exemption at all for pty ltd’s
The reason that high income tax rates are so harmful for the economy is that they affect decision-making through the endless interlinked chain or production. It affects resource allocation at every stage. Tax-deductibility has a similiar effect on resource allocation and decision-making as what a subsidy would. And of course the distortion gets exponentially worse the higher the rate.
But a total assets tax of only 1% would not affect resource allocation a great deal. And then you could stitch together a package where poorer families were gaining more then richer families in total dollar amounts. Which cannot be done by lifting the tax free threshold alone.
With the income tax; anything over about 15% is pretty much a dead-weight loss.
Everyone has their minds fixated on income alone. The mental block in this department is just incredible. Just so hard to overcome that I suspect its impossible for most people to so much as read what I’m writing here.
There is INCOME. There is ASSETS.
And its better to spread the burden across both.
But both at very low rates.
This is all very interesting. Not that I know much about it.
Graeme I understand that in Germany if you buy certain luxury goods, like expensive jewellery, you have to keep paying tax on them while you own them.
I’ve always thought it was silly to tax low income earners and give it back in the form of welfare. It is churning and must have a cost burden on the economy. But I was shocked by Des Moore who says that the well-off get half the tax they pay back as welfare. Surely eliminating this churning should be part of the ‘real reform’ if we are fiddling with thresholds or reducing rates.
For a radical idea, Brian Toohey, occasionally puts forward the notion that we should scrap company tax entirely. The idea is that the impost on business in terms of administration and compliance is huge. The tax man would get some of the lost tax back through greater productivity. Also shareholders would get higher dividends, but no franking credits, hence would pay more tax.
Speaking of franking credits, Labor and the Dems often regard franking credits as a lurk for rich people. But to eliminate them would mean that shareholders would pay double tax, firstly as part-owners of a company and secondly at a personal level.
On distortion, one of the greatest must be the tax-free status of the family home. Chris Richardson in the latest BRW says that we lock up two-thirds of our wealth in housing rather than in productive assets. This can’t be good. It seems that we are now building the biggest houses in the world, bigger than the US, and our ratio of cost of median home/average annual wage is the highest, ahead of Ireland, NZ, Britain, the US and Canada in that order.
Surely ‘real reform’ would involve tackling this problem, at least above a certain threshold.
Real reform IMHO would involve doing something about poverty, equity, welfare to work, churning and distortionary effects on the economy, targeting extreme wealth, while reducing transaction/compliance costs and encouraging initiative and enterprise. I’m not clever enough to know how to do it.
Yeah that’s all good economics. I reckon the only way to deal with this churning is to just say:
What level of income are people still struggling at. At what level is it a struggle just to make ends meet. Then go a bit higher then this figure since there will be some blow-back from the slashing that you’ll need to do to make financial ends meet.
Then you just lift the threshold up to your figure outright and that’s the beginning of the budgeting process. I cannot see any other way to end the churning. What politician would crusade to cut even a few of those programmes and destroy his career.
I said $25 000 plus $10 000 per dependent but that might be conservative.
“For a radical idea, Brian Toohey, occasionally puts forward the notion that we should scrap company tax entirely.”
That’s a mighty fine idea and would boost growth enourmously because it would eliminate the resource-allocation distortions of high company tax rates. But it is not my preferred option. Because the political imperative tends to take over in these big Corps and I find big Corps stifling to individualism. If there is no incentive to disperse their earnings then they’ll have all this largesse. And many shareholders, knowing that they’ll be paying high income taxes on the money dispersed will allow the companies to keep the retained earnings. This will lead to the growth of big corporatism that will crowd out the little guy. And since the yield on shares will be relatively lower this will bias in favour of the already rich who can buy and hold for years without worrying about dividends.
So we will wind up with good growth no question but not necessarily a fairer more equitable society. A sort of benevolent sovietism.
So my approach to rigging the tax system in favour of the little guy and to improve the distribution of wealth is a bit similiar to my approach on ending churning. I would ask the question: “What overall tax system would funnel assets downwards rather then upwards and how much can we get away with without doing great damage to the economy.”
And I would build up the tax system in that way then see what can be left in the budget.
Supposing
1.We had the income tax and it kicks in as already suggested but only at 10%.
2. We had a (non-financial) total assets tax of only 1 or certainly no more then 2% per year but a million dollar exemption for each real human being. So a family of five gets a five million exemption. Corporations can make cheap loans to employees on non-dividable assets to dodge the tax but must do so without caveats. So if you are a forklift driver they sell the forklift to, and finance the sale, but to avoid the tax at any time you can drive it the hell out of there.
3. Supposing that (non-financial) assets tax starts from dollar one for pty ltd’s rather then for real humans.
4. Also the land value tax for the States is deducted straight from the assets tax for the Feds. This encourages the land tax which is the best of all taxes but heretofore a political hard sell. Henry George may not have been right at 100% but at (lets say) 30% I think his reasoning is pretty solid. And it deals with a problem you just mentioned but in a phased-in non-threatening way. (The Australian Labour party began as a Georgist party by the way).
5. I would go further then franking. I would want dividends treated as a tax-deductible expense with no tax attached to it to the receiver. But for sole proprietorships I’d want only drawings to be taxed at 10%. The opposite approach. And I’d want capital equipment to be expensed straight away for tax purposes.
6. I’d want interest earnings tax-free.
Now combine this all to a move to growth deflation in the monetary system. Which data from David Hackett Fishers book seems to suggest will lead to greater equality of wealth, less domestic and international violence, and explosions of creative achievement.
You put this all together with a generalised deregulation (including especially an end to height restrictions on buildings) and come back twenty years later. You’ll have an individualist society where pretty much anyone can get into small business and expand. You’ll have a very fair society without compromising (in fact you’ll be enhancing) wealth creation.
Shoot. That’s my whole economic agenda right there.
“including especially an end to height restrictions on buildings”
I’m fairly certain your belief in that tenet won’t last long if yer next door neighbour decides to add couple of stories that will plunge your sunny backyard into permanent shadow.
Yeah but we have to break through the cold evil of height restrictions on buildings in the interests of the other species on the planet, and cheaper rents, reduced cost of living and working space, higher real wages, better layed out cities and so forth.
I could get together with the neighbour set up a joint investment and instead just the buildings on our two holdings up above all the others. In fact I’d probably have to to stay ahead of the shakeout.
In fact the competition for whose got the highest Penthouse might be in the way of things if you substitute towards land tax and get rid of the tax on rental income.
I remember going out to the forestry as a kid. And they’d tie another faster-growing plant to a pine sapling so it would be a race to the top.
You do things right and come back in two hundred years and the hobby farms, Edwardian estates and nature corridors will invade into the big cities. The Plebians will look down on all this from impossibly spacious sky-houses. And you’ll be able to ride your trusty hoss through land good land, along a curvy path, from the middle of town to anywhere at all.