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A brief history of tax (Part 3): the
trojan horse.
Peter Davidson, Need to Know Oz Social Policy Blog, 4 February 2015
‘The tax code, once you get to know it, embodies all of the essence of life: greed, politics,
power, goodness, charity. Everything’s in there.’ Sheldon Cohen, Former Commissioner of
the US Internal Revenue Service.
Tax reform is back on the agenda. Since those who fail to study history risk repeating it (and
I was involved in the latter-day history of tax reform) I’m writing this 3 part series as a guide
for those involved in the next phase. Parts 1 and 2 dealt with the dominance of income tax
since WW2 and the challenge from consumption taxes since the 1970s. This part: the ‘Trojan
Horse’ discusses new thinking about taxes and their impact on the economy. It argues that
our income tax already incorporates elements of a tax on consumption, that we should move
beyond a simple dichotomy (and old arguments) between taxing income or consumption, and
explore fresh ideas for reform.
Readers with an interest in the details can check out the references in Parts 1 and 2 of this
series. Brooks provides a more detailed presentation of the issues raised in these three blogs.
In addition, good summaries of some of the latest ideas in tax reform are provided
by Auerbach, Evans, the Henry Report, and Henry. Those wanting to keep up with current
Australian tax debates should visit the Tax Watch site.
A recap on the tax wars: income Vs consumption
To recap parts 1 and 2 of this series, the income tax became the main tax in Australia and
most wealthy countries after WW2. After the 1970s, as policy makers worried less about
income inequality and tax fairness and more about the state of the economy, there was a push
to replace income taxes with taxes on consumption. The basic difference between income and
consumption taxes is the treatment of investment income. Broadly speaking, this is taxed
under an income tax but not under a consumption tax. Income tax advocates argued that
investment income should be taxed because this, along with wages, was the best measure of
‘ability to pay’. Consumption (or expenditure) tax advocates argued that consumption was
the better measure of people’s resources and that taxing investment returns discouraged
saving and investment.
The income tax system continued to dominate the tax landscape, while for 30 years the battle
of ideas raged outside. Its ideological champion was the comprehensive income tax: the idea
that income from all sources – wages and investments – should be taxed at uniform
(progressive) rates. It’s war cry was ‘a buck is a buck’. Advocates argued that the
comprehensive income tax was not only fair – because spending power from different
sources would be taxed equally. Uniform income taxation was also economically efficient
because decisions to work, save and invest would be less influenced by taxes (e.g. people
would pay the same taxes whether they invested in property, shares or an active business).
The champions of expenditure taxation took up the fight – in Australia it was the GST, in the
US and UK cash-flow or personal expenditure taxes (different warriors, same suit of armour).
Their war cry was ‘save and invest!‘ In the 1970s, the Meade Report in the UK and the
Treasury in the US argued that by taxing investment returns, income taxes discouraged
saving and diminished investment, holding back economic growth. They also challenged the
fairness of income taxes, arguing that they were biased in favour of current spending and
against saving to shift spending into the future. Their answer was to tax consumption or
expenditure instead of income.
A fatal blow to the comprehensive income tax
The fatal blow to the idea of a comprehensive income tax came when the economic
efficiency benefits of taxing income uniformly were seriously challenged by ‘optimal
taxation’ research in the 1980s and 90s.
Actually, the idea that different activities should be taxed uniformly was challenged as early
as 1927 when Ramsey argued that because taxes on different goods have different impacts on
people’s spending habits, ‘optimal’ tax rates would vary from one good to the next. If people
were less likely to stop buying food in response to a consumption tax than (say) go to the
movies, then food should be taxed at a higher rate than the movies. The more responsive an
economic decision was to taxation, the lower the tax rate should be, and vice versa. Ramsey
was talking here about consumption taxes, but the idea was applied to income taxes as well.
Ramsey’s ‘optimal tax’ theories had little impact on public policy for many years. This was
due to concerns about the equity impacts of higher taxes on essentials, uncertainty about the
impact of taxes on different activities, and the complexity of a system that would impose
different tax rates on different goods, services and incomes. There was also a risk that if tax
rates on different activities were ‘up for grabs’, interest groups would lobby all the more
vigorously for their own activity to be taxed less (i.e. it would encourage rent-seeking).
Nevertheless, a branch of economics called ‘optimal taxation’, inspired by Ramsey’s ideas,
grew in influence from the 1970s. It spawned fresh research on the impact of taxes on
economic activity.
These studies generally found that taxing all
income (wages and investment) uniformly
(at flat or progressive rates) was not as
efficient as comprehensive income tax
advocates made out. They concluded that
investment income should be taxed at lower
rates than wages. This meant that
a comprehensive income tax that was levied
at uniform rates could only be defended on
equity grounds. At a time when
Governments worried more about declining
economic growth than growing income inequality, this was a fatal blow to the ideal of a
comprehensive income tax, despite the fact that reforms during the 1980s in the US and
Australia moved us closer to it.
The problem was not that income taxes diminished saving. The evidence from optimal
taxation research suggested that lower taxes on saving impacted people’s choice of savings
vehicles (e.g. bank accounts Vs superannuation), but not the overall level of household
saving. Further, in an open economy investment could be partly financed from foreign
savings.
The problem was that income taxes were likely to discourage investment, especially across
national borders. By the end of the last century, the consensus among economists was that
more ‘mobile’ economic factors were more sensitive to taxation, and could pass the cost onto
less ‘mobile’ factors. Being relatively mobile, capital was more likely than labour to shift to
investments (or nations) with the lowest tax rates. Under these conditions, the cost of the
company income tax was more likely to be passed on to workers. At the other end of the
spectrum, land and mineral resources were said to be immobile. Taxes on these factors were
more likely to ‘stick’, and less likely to affect investment decisions.
By the 1990s, the debate among most economists and tax experts was no longer whether all
income should be taxed uniformly. It was about whether investment income should be taxed
at all, or at a lower rate than wages.
The fatal weakness of expenditure taxes
Despite the defeat of the comprehensive income tax in the battle of ideas, as Part 2 showed
the income tax system remained the dominant source of public revenue.
The idea that income taxes should be replaced by
a tax on expenditure (viewed as the polar opposite
of the comprehensive income tax) had its own
fatal weakness. The public still equated ‘ability to
pay’ with annual income, and it was clear that
those with the lowest annual incomes would be
adversely affected by higher taxes on
consumption. For the most part (e.g. in the US,
Canada and Japan, with New Zealand as an
exceptional case), this equity argument proved
fatal to any push to dramatically increase reliance
on consumption taxes, or to Governments that
successfully did so. As outlined in Part 2, despite
three attempts in Australia to shift taxation from
income to consumption, the tax mix between them
remains much as it was before the GST was
introduced.
Outside the United States (which relies less on consumption taxes than almost all other
OECD countries), the idea that income taxes should be completely replaced by taxes on
consumption has lost favour. Optimal taxation research has also begun to question the notion
that this is a sure path to improved economic efficiency and growth.
Forty years after the UK Institute for Fiscal Studies’ Meade Report advocated replacing
income taxes with a progressive expenditure tax, the same organisation reviewed the
arguments for taxing income and consumption. The Mirrlees Review still favoured
expenditure taxes over income tax, but it drew a distinction between different kinds of
income – the ‘normal rate of return’ and ‘economic rents’ (see discussion below) – and only
proposed to exempt the former from taxation. The Institute commissioned Banks and
Diamond to evaluate the arguments for and against taxing investment income. Contrary to the
overall thrust of the review’s proposals, they found that the case for complete removal of
taxes on investment income was weak. Research studies supporting this view used over-
simplified assumptions (for example that capital is perfectly mobile). They concluded that
while the case for taxing investment income at the same rates as wages was weak, it should
still be taxed.
Back in Australia, a similar critique was made by Apps of a report by KPMG for the ‘Henry
Review’ which estimated the economic cost of different taxes. She argued that the model
used in this report overestimated the impact of the Australian income tax on the supply of
labour (compared with that of taxes on consumption) because it assumed that all households
had a single wage earner who increased his working hours in direct proportion to increases in
his after-tax wage. The fact that women on lower incomes were more responsive to the costs
of paid employment than men on higher incomes did not feature in the model. Yet they
would be more adversely affected by a shift towards taxing consumption.
Similarly, some economic models assume that capital is perfectly mobile. This leads to the
conclusion that a small open economy cannot sustain a tax on company income. Yet if this
key assumption is relaxed, the results look different. In his summary of this
research, Auerbach refers to:
‘possible outcomes ranging from capital still bearing a large share of the [company income]
tax (Gravelle & Smetters 2001) to most of the tax being shifted to labour (Harberger 2008).’
As the 12th largest, Australia’s economy is hardly ‘small’. Our economy has always relied on
foreign investment, but it also relies on domestic savings. Around two thirds of equity in
Australian companies is owned by local investors. Company income tax revenue has taken a
hit recently with the fading of the resources boom, but it remains higher (in proportion to
GDP) than its average level in the 1980s and 1990s.
The challenge for income tax advocates is that the growing reach of multinational
corporations and capital markets, and innovations in financial markets and information
technology, are easing constraints on the mobility of capital and making it harder to follow
the money trail. International capital is moving into black holes and ‘bermuda triangles’
where no national tax administration can reach it. This suggests it will become harder to tax
investment incomes, especially those accruing to foreign investors. A key part of the solution
is to strengthen international cooperation on tax and close off the worst abuses, but this won’t
fully solve the underlying problem.
The trojan horse inside our income tax system
While the battle of ideas raged outside, the income tax appeared to be safe inside its citidel.
Yet its rival, the expenditure tax, was
already concealed within. Recall that the
main difference between income and
expenditure taxes is the treatment of
investment. The tax treatment of many
investments is closer to expenditure tax
principles: there is either a deduction for
new investment, or investment income is
fully or partly exempted from tax. The table
below ranks the main investment assets in
Australia and compares their tax treatment.
Tax treatment of major investment vehicles (2010)
Asset type % of of all
household assets Tax treatment
Own home 43%
Taxed on purchase,
capital gains and
imputed rents exempt
(expenditure tax)
Superannuation 15%
Contributions & fund
earnings partly taxed
with deductions for
new contributions,
benefits
exempt (hybrid tax)
Investment property 15%
Rent fully taxed,
capital gains partly
taxed (hybrid tax)
Other financial assets
(e.g. shares and bank
deposits)
7%
Bank interest fully
taxed (income tax);
Share dividends fully
taxed & capital gains
partly taxed (hybrid
tax)
Own business 5%
Profits fully taxed,
capital gains on
business assets partly
taxed (hybrid)
We can see from this that investment income derived from over 40% of household wealth
(capital gains and imputed rents from owner-occupied homes) is untaxed while income from
at least another 40% is only partly taxed (mainly because capital gains are taxed a half the
standard rate and only when the asset is sold – if at all).
Slemrod estimated that the effective tax rate on all investment income in the US was just 14-
24% in 2002.
‘Calling a tax system an income tax or a consumption tax does not make it so. This is
certainly true of the U.S. income tax system, which has long been recognised as a hybrid of
an income and consumption tax, with elements that do not fit naturally into either pure
system.’ Gordon et al, 2003
All income is not equal
Even the difference between ‘pure’ versions of income and expenditure taxes is not as stark
as once believed. If we break investment income down into four component parts, it turns out
that two of the four are taxed the same under income and expenditure taxes. The key
difference is that only an income tax taxes the ‘normal’ or ‘risk free’ rate of return on
investments, which is roughly equivalent to the Government bond rate.
Tax treatment of different components of income
Investment income
component
Income tax
treatment
Expenditure tax
treatment
Inflation component Not taxed Not taxed
Risk free or ‘normal’
returns Taxed Not taxed
Above-normal returns
from risk Not taxed Not taxed
Above-normal returns
from economic rents Taxed Partly taxed
Part of the value of annual income flows from an investment such as a bank account is offset
by inflation in the price of goods and services. Since this does not represent a gain in
spending power, a ‘pure’ income tax should adjust investment income downwards for the
effects of inflation. This was advocated by the Mathews report in Australia in the 1970s and
implemented in our first tax on capital gains in 1985 (though not for other forms of
investment income). So this ‘inflation’ component of investment income is not taxed under
either a pure income or expenditure tax.
A second component of income is the ‘risk free’ or ‘normal’ rate of return which is also
called the ‘reward for waiting’. Borrowers must usually offer a rate of return above inflation
to attract investment; otherwise there would be little incentive for people to defer
consumption. The minimum rate required is the ‘risk free’ rate, which applies to ‘safe’
investments such as Government bonds. This component of investment income is taxed by an
income tax but not by an expenditure tax.
The third component is the extra (‘above normal’) return from risk. Riskier investments are
more likely to make losses which attract income tax deductions (a pure income tax allows
unlimited deductions for losses). This means that the extra or ‘above normal’ returns from
risky investments are not in effect taxed under a pure income tax (and nor are they by an
expenditure tax).
The fourth component of investment income is above-normal returns from economic rents.
These arise where a business occupies a monopoly position in a market (as many believe the
‘big four’ banks occupy in Australia) or through scarcity in the supply of ‘immobile’ factors
such as land or mineral resources. Where economic rents exist, returns are higher regardless
of risk. Taxes on locally-specific economic rents, such as those arising from the exploitation
of scarce mineral resources, are not a drag on economic growth because they remain an
attractive investment proposition despite a tax on above-normal profits.
The economic rent component of profits is taxed under an income tax, but it may also be
taxed under an expenditure tax. This is because even if new investment is fully deducted from
tax (as it is with expenditure tax treatment) this concession is less valuable than the ‘super
profits’ that can be obtained from economic rents. An important exception is the taxation of
economic rents that accrue to foreign investors. In the absence of a domestic tax on company
profits or on specific economic rents (such as those relating to mineral resources), these rents
might escape tax in the source country (the country where the profits are made).
Of course, key elements of our income tax are either more or less generous than the ‘pure’
version. But these distinctions between different kinds of income are still important for tax
policy. There is a strong case for taxing income derived from economic rents, whether
directly or through company income taxes. On the other hand there is a strong case for taxing
investments generally at lower rates than wages to take account of the impact of inflation on
investment returns.
New ideas in tax reform
These more nuanced views of income and how it is taxed point to the real battle being fought
within the income tax itself, over such issues as deductions for investment expenses, the
treatment of capital gains, and tax breaks for long term saving. The set piece duels between
the ideal of comprehensive income taxation and its expenditure tax rival have burnt up a great
deal of political capital with limited effect, and may have distracted us from the main game.
These new (and not so new) understandings of taxation suggest that advocates of a
progressive tax system should turn their attention to reforms of the income tax which:
tax investment income more consistently, but at lower rates than wages (especially
for long-term savings and foreign investment);
target economic rents;
take account of the impacts of tax on workforce participation by different groups,
(especially low-paid women).
Another key problem to be solved (worthy of a separate blog) is the way the income tax
interacts with the social security system. Income tests, together with the income tax, impose
higher effective tax rates on low income earners. This problem can only be avoided entirely if
social security payments are paid to everyone (as ‘demogrants’), and gradually clawed back
above a high tax free threshold (e.g. through the tax system). In a revenue neutral reform, this
would greatly increase tax rates on middle income earners (since the cost of semi-universal
social security payments is too great to be borne by high income earners alone). In Australia
these problems are sensibly addressed, but not solved, by income-testing income support
payments for adults relatively strictly, and payments for children less so.
I’ll conclude with comments on some of the best reform ideas informed by this new thinking,
including income taxes targeting economic rents, north European dual income tax models,
wealth taxes, and the Henry Review proposals which draw upon all of these.
(1) Taxing economic rents
The basic approach to taxing economic rents is to tax profits minus an allowance for the risk
free or ‘normal’ component of investment returns, on the assumption that the difference
consists mainly of the proceeds of economic rents. This ‘residual’ profit is then taxed at a
higher rate. This tax on ‘super-profits’ could be applied in conjunction with a standard
company income tax (usually in industries where rents are likely to comprise the majority of
investment income), or it could replace the corporate income tax altogether. In the latter case,
the company income tax would be replaced, in effect, with a tax on corporate expenditure
(this is proposed by the Mirrlees Review). The idea is to shift taxation away from investments
that might be discouraged by tax towards those which are more likely to be indifferent to it.
A good example of an industry specific tax on rents is a mineral resource rent tax. To the
extent that mineral resources are scarce and geographically immobile, they are likely to yield
‘above normal’ profits and taxing them in the source country is unlikely to discourage
investment. The original idea for a resource rent tax came from Brown in the 1940s. Under
his formula, expenses associated with exploration and extraction would be fully and
immediately deductible and profits taxed well above the standard company income tax rate.
In effect, the Government, as the owner of mineral resources, would join the investor as a
silent partner, sharing the risk should a project fail and the returns if it succeeds. Ideally, this
would replace royalties for the extraction of mineral wealth (based on the quantity extracted),
which are more likely to discourage marginal investments and yield less revenue for
Governments in the long run.
One problem with this ‘pure’ Brown tax is the long delay in collecting public revenue from
mining projects (and the attendant tax avoidance opportunities). Indeed, there may be an
initial revenue loss from the up-front deductions for exploration and other costs. To deal with
this problem, mineral resources taxes such as the Norwegian one, and the Resource Rent Tax
proposed in the Henry Report, required miners to carry forward these expenses and offset
them against future income. If the project made a loss, any remaining expenses would be
refunded. In return for the deferral of deductions for investment, these resource rent taxes
only taxed profits above the ‘normal’ rate of return (often proxied by the public bond rate).
One problem with this approach is that tax revenues would take a hit from loss-making
projects in the aftermath of economic downturns – without any clear benefit to the ‘real’
economy. Nevertheless, a well designed resource rent tax is likely to raise more revenue than
royalty payments, with less distortion of investment. Australia still has a Petroleum Resource
Rent Tax on offshore oil mines.
In theory a similar result could be obtained across all sectors of the economy by deducting
‘normal’ returns from company income before taxing it, and taxing the remaining profits at a
higher rate. In one prominent corporate income tax reform proposal, this ‘deduction’ is called
an Allowance for Corporate Equity (ACE). The basic idea is that a company’s income tax is
reduced by a percentage of shareholder equity in the company equivalent to the normal rate
of return. Companies with low profits relative to investment assets would gain at the expense
of those with higher profits (at least some of which are assumed to come from economic
rents).
The case for taxing economic rents seems to be straightforward – public revenue is collected
with less disruption of investment than from traditional company income taxes or mining
royalties. If, however, taxation of economic rents replaced company income tax this would
narrow the tax base since the normal rate of return would be exempt from tax. Taxing
economic rents alone is equivalent, in principle, to replacing the personal income tax with a
tax on expenditure (as discussed previously).
This raises some difficult questions: Would such a system raise the same public revenue
without a much higher tax rate? Or would it reduce taxes on corporate income and make it
harder to tax personal income, given the cross overs between the two sectors? Could a single
country introduce such system and what would be the transition costs? The Henry Report
raised the ACE as an option for the future but did not advocate it, opting instead for an
industry-specific approach in the form of a minerals resources rent tax.
In the meantime, our company income tax captured – however imperfectly – a share of the
income from economic rents during the mining boom at little cost to economic growth – but
that revenue bonanza wasn’t going to last forever.
(2) Dual income taxes
While the Anglophone countries debated taxing investment income less, the high-taxing
northern Europeans – under pressure from the easing of restrictions on capital movements
across Europe – went ahead and did it.
From the 1990s on, the Scandinavian countries and Holland have formalised a previously
implied distinction in their tax systems between income taxes on wages and investments. The
logic of these dual income tax systems was that wages would continue to be taxed at
progressive rates but investment income would be taxed at a lower rate, identical to the
company income tax rate. This was a compromise between comprehensive income taxation
and an expenditure tax (under which the tax rate for investment income is set at zero).
As described in an ACOSS Paper on personal income tax, the income tax system would be
split into two parts: wages and investment income.
Dual income tax systems in Nordic countries (2004)
Norway Finland Sweden Denmark
Tax rate for
earnings 28-48% 29-52% 32-57% 38-59%
Tax rate for
investments 28% 29% 30% 28/43%
Company tax rate 28% 29% 28% 30%
Offset of
investment losses
Within 1st tax
bracket only Tax credit Tax credit
Within 1st and
2nd brackets only
Net wealth tax 0.9-1.1% 0.9% 1.5% None
An important feature of dual income tax systems is that deductions against one form of
income (e.g. investments) against the other (e.g. wages) are restricted. This had a surprising
impact on public revenues when Sweden established a dual income tax system in the midst of
a deep recession in 1991. Despite the lowering of tax rates for much investment income,
revenues rose substantially. More revenue was gained from denying deductions to home
owners and property investors than was lost from the lower tax rates on investments.
An important benefit of the dual income tax is that it gives policy makers the flexibility to
respond to downward pressures on tax rates on investment without undermining the
progressivity of the tax on wages. This is balanced by some desirable elements of rigidity: tax
rates applied to most investments are more consistent and the investment income tax rate is
‘anchored’ at the first step in the tax scale for wages (see table above). This is important for
both equity and acceptability reasons. It means that high-income investors do not pay tax at
rates that are lower than typical workers.
Dual income taxes have been criticised on equity grounds for not taxing all forms of income
consistently. As shown above, the reality is that effective tax rates for most investments in
Australia are already well below the standard marginal rates (especially for owner occupied
homes and capital gains on other investments). If we abandoned the quest for a uniform
comprehensive income tax and introduced a dual income tax, it would in a sense formalise
the status quo, except that that investment income taxes would be more consistent and less
distorting. To the extent that this results in higher tax rates on capital gains it would improve
equity as these are heavily concentrated among the top 10% of income earners in most
countries. Another bonus is that ‘negative gearing’ strategies would no longer be viable.
One problem from an equity standpoint is that low-income investors would pay tax at the
same rate as high income earners. In the absence of a tax free threshold on investment
income, this would bring many retired people on modest incomes into the tax net for the first
time.
The main practical weakness of dual income tax system is the difficulty in drawing clear
distinctions between labour and investment income, especially when labour is supplied
through a private company. Scandinavian countries deal with this problem by taxing an
implied return from small business assets at the (lower) investment income tax rate, and any
remaining income at the (higher) tax rates for wages.
(3) Taxes on wealth
The defining feature of income taxation is that it taxes the accumulation of wealth (whereas
consumption taxes tax the dissipation of wealth). An indirect way to achieve the same end is
to tax the stock of wealth itself.
Since wealth is much more unequally
distributed than income (the top 10% of
Australian households by wealth holds
roughly half of all wealth while the top 10%
by income have roughly a quarter of all
income), an effective wealth tax is likely to
have a stronger inequality-reducing impact.
In Australia over the last 30 years, the top
10% of income-earners received around half
of all increases in private income while the top 1% gained more than 20%. Taxes on wealth
are another policy tool to offset this trend.
Annual wealth taxes – at low rates above a high tax-free threshold, and with owner occupied
housing exempted – exist in three OECD countries. Their main weakness (as with taxes on
investment income) is that to the extent that they tax mobile factors the revenue base could
slip away. Broad-based wealth taxes in most countries that previously used them were easily
avoided, and collected little revenue at relatively high cost (including annual valuation of
assets).
Recognising the ‘mobility’ problem, Picketty advocates a modest broad-based international
tax on wealth holdings, at progressive rates above a high threshold. His motive is to avoid the
entrenchment and growth of wealth and income inequality, especially at the very top (1%) of
the distribution. A wealth tax is easier said than done in a global context, but it could be an
future option for international federations, especially Europe.
The ‘mobile wealth’ problem does not arise with immobile factors such as land. A well
designed land tax is not only hard to avoid, it encourages the efficient use of land. Since it is
tied to a specific location, land tax is an ideal tax base for Local or State Governments.
Replacing taxes on housing transactions such as Stamp Duties with a modest land tax with
minimal exemptions would improve the efficiency of property markets.
The tax base for taxes on estates or inheritance is transfers of wealth rather than the overall
stock of wealth held by an individual. Unusually, these taxes attract ‘bipartisan’ support from
income and consumption tax advocates. Inheritances would be captured under a
comprehensive income tax. Consistent advocates of expenditure taxation argue that estates or
inheritances should be taxed, on equity grounds, if income taxes were replaced by an
expenditure tax. They are among the most equitable and economically efficient taxes. A tax
on a windfall gain (or an estate whose final value is not known in advance) is unlikely to
distort investment decisions, and it should encourage workforce participation to the extent
that the beneficiaries are close to retirement and the windfall allows them to retire earlier.
Around two thirds of OECD countries have estate or inheritance taxes. Australia did until the
1970s when they were wiped out by interstate tax competition.
Apart from their unpopularity, the main challenge for a tax on wealth transfers is stemming
avoidance through such devices as gifts and private trusts, so that they fall on people with
substantial wealth rather than those lacking the wherewithal to avoid them.
An interesting variation on wealth taxation is the use of wealth as a proxy for income. The
Netherlands replaced its income tax on interest bearing accounts, shares and investment
property with a tax on a (low) deemed rate of return on investment assets (owner occupied
homes and small business assets were exempted). The idea was that it would be easier to
measure (and capture) wealth than the income derived from it, and that such a tax would
encourage its efficient use (since any income above the deemed rate of return is not taxed).
Australian pensioners will recognise this idea – a ‘deemed rate of return’ on investments is
used in the pension income test. Aside from its potential complexity, one disadvantage of this
approach is that economic rents would not be taxed. Indeed, ‘deeming’ moves in the opposite
direction to tax reforms which aim to tax rents but not normal rate of return.
(4) The Henry Report
I’ll end this series at the best place to begin a serious discussion of tax reform in Australia:
the Henry Report. This major review of the Australian tax system undertaken by an expert
panel chaired by the then Treasury Secretary, Ken Henry, sat somewhere in between the
comprehensive, academic-led Mirrlees Review in the UK and the more short-term oriented,
politically endorsed Taxation Working Group review in New Zealand.
The Henry Report pitched its reform proposals to the medium term (so I’ll ignore the short
term responses of the major political parties – this is a longer game). It identified a number of
challenges including revenue adequacy as the population ages, the internationalisation of
economies spurred by technological innovation, distortions in the system that discourage
investment or workforce participation and undermine housing affordability, and to strengthen
equity in the income tax and transfer system.
Critics argue the Henry Report lacks a coherent reform narrative or framework, based on
‘ideals’ such as comprehensive income or expenditure taxation. Yet the outline of a
framework is there, just below the surface. Its first recommendation is that:
1. ‘Revenue raising should be concentrated on four robust and efficient broad-based
taxes:
o personal income, assessed on a more comprehensive base;
o business income, designed to support economic growth;
o economic rents from natural resources and land; and
o private consumption.
We can see already that the Review Panel favoured an income tax that taxed different kinds
of income more consistently, but mindful of the optimal taxation literature it did not advocate
uniform taxation of investment and labour income. Its reform framework for income taxation
is closer to the dual income tax model, or perhaps a ‘triple’ income tax comprising:
1. Progressive taxation of wages;
2. Taxation of income from shorter-term savings vehicles (including interest, dividends,
and rent) at a 40% discount off marginal tax rates on wages;
3. More concessional tax treatment for the two main longer-term savings vehicles (the
current expenditure tax treatment for owner occupied housing, and a capped rebate for
saving through superannuation).
The idea is to tax investment income at lower, progressive rates than wages (though less
progressive than the present system due to a proposed flattening of the tax scale for wages,
the economic benefits of which are not demonstrated). The proposed 40% discount is
borrowed from the current tax treatment of personal capital gains, which attract a 50%
discount off marginal personal tax rates. The 40% discount is a ‘rough and ready’ adjustment
for the effects of inflation on investment income.
Under the proposed income tax system, taxes on capital gains would rise while taxes on
interest and rents would fall, creating a more level playing field. While the proposed
progressive tax rates for investment income are on the face of it more equitable than the flat-
rate investment taxes in Northern Europe, there is no clear logic to the 40% discount. There is
a risk that the discount would be ‘bargained upwards’ through the political process. In its
response to the Report, the then Government proposed to increase the discount to 50%, albeit
with a cap on the level of investment income to which it would apply. Alternatives to the
proposed 40% discount include an explicit discount for inflation (one that varies with the
inflation rate, which of course is now very low) or a variant of the northern European system
with a tax free threshold for all investment income together with a flat tax rate ‘anchored’ in
the marginal tax rate of a typical middle income wage-earner.
The exemption of owner occupied housing is politically and fiscally sensible. If Capital Gains
Tax was extended to the main residence it would probably be limited to a small minority of
home-owners, and home buyers should arguably be entitled to claim deductions for mortgage
interest, at far greater cost to the fisc.
Special treatment for long term saving through superannuation is also desirable, since the
impact of both inflation and income taxes on savings compounds over time. The review
proposes fairer and more efficient tax breaks for saving through superannuation, including a
capped rebate similar to proposals advanced for many years by ACOSS.
On the indirect tax side, the Report advocated the replacement of inefficient State taxes on
business inputs and transactions (mainly Stamp Duties) and a broadening of the State Land
Tax base to include owner occupied housing.
Its company and business income tax reforms focus on ‘supporting economic growth’. Here a
trade-off is proposed between higher taxation of mining resource rents and the removal of
some business tax concessions, and a lower company tax rate (from 30% to 25%), which is
the ‘average rate for small to medium OECD economies ‘. The Review bought the argument
that international capital is becoming more mobile and sensitive to tax, but wished to avoid
a ‘race to the bottom in company income tax rates’ of the kind that created speculative
investment booms in Ireland and Iceland. The quantity of investment matters, but so does its
quality. Once again, this approach is more consistent with the Dual Income Tax model (with
company income still subject to tax but at a lower rate) than the expenditure tax proposals of
the Mirrlees Review. The transfer of resources from a booming mining sector to other
industries (via a lower company tax rate) was also designed to aid Australia’s economic
adjustment to the mining boom (since the high dollar was strangling other industries).
The Government’s ‘riding orders’ to the Panel to avoid discussion of the GST or taxation of
superannuation benefit payments limited the scope of the Review. On the other hand, the
state of media and public debate on taxation in Australia is such that if the Report had
advocated a higher GST (or, for example, the introduction of an inheritance tax), none of the
other recommendations would have been publicly discussed. The Review’s ‘core’ proposals
as outlined above are arguably more important.
There were gestures in the direction of expenditure tax treatment of business income: the
ACE was given a positive review (but not recommended for now) and there was a suggestion
that State Payroll Taxes be replaced by a business cash-flow tax. Here the Review came
perilously close to advocating an extension of broad based taxes on consumption, though the
distributional impact of such a move is not clear since Payroll Tax already falls mainly on
wages and consumer prices. As discussed in Part 2, replacing an inefficient tax on
consumption with a more efficient one is not necessarily regressive.
As discussed above, the implications of such proposals for the future of personal income
taxation are unclear. But rather than argue for ‘fundamental tax reform’ of the kind long
advocated in the US (a major shift from taxing income to taxing expenditure) the Review
Panel was content to wait for the dust to settle on the research evidence, and also the
practicality, of such a move, noting that ‘a business level expenditure tax could suit Australia
in the future.‘
The Henry Report, like the northern European Dual Income Tax model, is a working
compromise between the old ideals of comprehensive taxation of income and expenditure, a
bridge between the existing ‘mess’ (as Freebairn puts it) and a more coherent system. The
proposals aren’t perfect, but that’s how tax reform works.
Concluding comment
Writing this three part ‘brief history of tax’ was a bit like walking through a hall of mirrors.
The same passage looks different each time we walk through. In Part 1, the income tax was
king and the main goal of reform was to tax income as uniformly and comprehensively as
possible. Things looked different in Part 2 when viewed from the perspective of the ‘clash of
the titans’ between two idealised tax systems: comprehensive income and expenditure. It
turned out that the big difference between them is timing – whether we should tax returns
from investment now or later. Still, this is an important distinction especially from an equity
point of view, and that’s why consumption taxes (despite the vital contribution the make to
efficient revenue raising) have not gained the upper hand.
In Part 3 we took a walk inside the income tax system while the champions slugged it out
beyond the walls. The king is now not what he seemed to be. Our income tax system has
expenditure taxes hidden within. It’s no longer obvious that the path to reform leads to either
a pure comprehensive income tax or its replacement by a consumption tax.
The most important battles for reform lie within the
income tax itself. Some are familiar, such as the
unceasing effort to rid the system of unproductive
tax shelters (Sisyphus comes to mind here). Others
are new, including efforts to seek out and tax
economic rents. I hope this series helps equip a few
people to fight them.