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The Secretary
Review of Business Taxation
Department of the Treasury
Parkes Place
CANBERRRA ACT 2600

Dear Sir

SUBMISSION ON THE DISCUSSION PAPER A STRONG FOUNDATION

The Chamber of Commerce and Industry of Western Australia (CCI) would like to express its support for the key principles espoused in the Review of Business Taxation’s initial discussion paper, A Strong Foundation: Establishing objectives, principles and processes.

In recent years debate on sales taxes and personal income taxes has increasingly been framed in the context of broad principles and objectives such as equity and efficiency, an approach clearly evident in the Government’s taxation reform paper A New Tax System. The broad principles outlined in A Strong Foundation will extend a similar systematic and reasoned approach into the area of business taxation. Such an approach should not only be used to provide a context for the Review of Business Taxation’s review of business tax; CCI would also advocate that the principles outlined in A Strong Foundation should be extended to provide an ongoing framework for the design and implementation of business tax principles. In this respect, we also endorse the proposed Charter of Business Taxation.

CCI strongly endorses the public and consultative approach being adopted the Review of Business Taxation. Private sector involvement is a key ingredient to the successful design and implementation of a new business tax system, while a transparent and consultative approach to tax design is most likely to yield community acceptance.

While strongly endorsing the intent and general direction of A Strong Foundation, CCI has a number of concerns and issues which it would like to highlight.

State Taxes

It is crucial than any review of business taxes should be comprehensive. The Coalition’s tax reform proposals A New Tax System included both State and Commonwealth taxes, and indeed the purpose of introducing the proposed Goods and Service Tax at 10 per cent was to allow the replacement of a range of State taxes along with Wholesale Sales Tax. All of the State taxes which A New Tax System proposes to abolish fall mainly or entirely on business.

There are several reasons why the Review of Business Taxation should consider both State and Commonwealth taxes in its review process:

  1. Taxes levied by the States are among the most distortionary and inefficient in the Australian taxation system. Virtually all of the States’ taxes fail to comply with the basic criteria of equity, efficiency and transparency which should characterise an effective taxation system. Furthermore, the taxes which businesses most often identify as in need of reform include a large number of State taxes, notably payroll tax, financial transactions taxes and stamp duty. Tax reform cannot be judged a success unless they are addressed.
  2. The economic impact of a particular tax is not determined in isolation. Taxes across the various levels of government interact with each other, and the negative impact of any single tax can be greatly compounded if it is raised against a tax base also used in raising another tax.
  3. A comprehensive review of the appropriate structure of taxes on income, on capital or expenditure would be meaningless unless it encompassed the comprehensive range of taxes applied to those tax bases. Changing the tax structure in one jurisdiction without regard to the taxes raised in other jurisdictions could make the overall tax structure worse. Given the importance of taxes on capital within the spectrum of business taxes, a review of business taxes which failed to include stamp duty and land tax would be incomplete, to say the least

In this context, CCI is particularly disappointed that the Review of Business Taxation seems intent on addressing only, or mainly, Commonwealth taxes.

There is nothing in the Review’s terms of reference to suggest that it should confine itself to the Commonwealth tax base. On the contrary, its term of reference are explicit in noting that " no aspect of the taxation of business entities and investments should be precluded from the scope of the review" and that the review should " adopt a comprehensive approach to reform driven by clear, sound principles involving a move towards greater commercial reality". Far from precluding an examination of State taxes, CCI believes that the Review of Business Taxation will not be able to fulfil these terms of reference unless it looks at both State and Commonwealth taxes.

This issue has taken on greater urgency since the election. If the States could be expected to proceed with tax reforms along the lines outlined prior to the election then it might have been appropriate for the Review of Business Taxation to concentrate on issues left undecided in A New Tax System, which arguably relate mainly to the Commonwealth’s business taxes.

Unfortunately, at the Special Premiers Conference held on 13 November 1998 the Government diluted the proposed reform of States business taxation by referring the timing of the repeal of stamp duties on business conveyances of property to a special working group which has no fixed time for reporting its findings. This was a significant setback to the reform process, as stamp duty on business conveyance of property is a costly and complex impost on the business sector which raises more revenue than any of the other State taxes which are proposed to be repealed. It clearly indicates the importance of systematic and comprehensive reform of taxes. The reason why most business groups have been in broad support of the introduction of a Goods and Services Tax is that the introduction of a Goods and Services Tax will allow the abolition of existing taxes. It the range of existing taxes to be abolished it to be significantly undermined, the rationale for introducing a Goods and Services Tax will be similarly weakened.

Further, CCI believes that the Review of Business Taxation presents an opportunity to revisit one of the largest deficiencies in A New Tax System – namely, the retention of payroll tax. This tax consistently ranks amongst the top three taxes which businesses would like to see repealed or abolished and CCI believes that many of the arguments proposed in its defence are not persuasive. At the very least, it deserves closer scrutiny.

The attached copy of CCI’s more detailed tax reform policy, which was submitted to the government in March 1998, explores this issue in greater detail.

Advisory Board

A Strong Foundation proposes the establishment of an Advisory Board which would include or comprise private sector representatives reporting to the Treasurer on key business tax issues.

CCI supports this concept as a means of introducing a different perspective on tax issues as they emerge, with a view to developing tax policies and implementing those policies in ways which are effective, efficient and have the acceptance of the business community.

A Strong Foundation canvasses a range of issues which must be addressed in the constitution of such a body.

Role

Firstly, should the Advisory Board’s role be to review and report on the integrity and operation of the overall business tax system, or to be involved in broader policy design and development?

CCI believes that it should do both. Private sector involvement is important in both the broad design of taxation policies and principles and in their detailed application and implementation. Indeed, it is difficult to do one effectively and efficiently without at least a broad understanding of the other. CCI would envisage the Advisory Board performing a permanent role similar to that being undertaken on a once-off basis by the Review of Business Taxation – evaluating and suggesting improvements in the design and implementation of tax policy at the broadest level, and applying those principles (as embodied in the proposed Charter of Business Taxation) in detailed legislation design and implementation.

Stage of Consultation

Secondly, while the private sector is quite widely consulted on the implementation of tax policies at present, the benefits of that consultation are limited by the fact that consultation occurs late in the policy development process or even after the introduction of legislation. This is usually justified on the basis that revealing policy options would allow taxpayers to minimise their tax liability because they are forewarned of changes in legislation.

CCI agrees with A Strong Foundation that by and large these considerations are outweighed by the benefits of more effective consultation and the resulting better legislation which earlier consultation would engender.

Transparency

Thirdly, this issue should be resolved by government taking a more open approach to tax policy design, and risking public opprobrium if it is excessively secretive, rather than by including the Advisory Board in extensive confidential or informal discussions.

Unlike the Board of the Reserve Bank of Australia, for example, it would not be making policy decisions on the advice of a professional staff but would be advising government on appropriate policy and implementation. In this context a more transparent model than the RBA Board is desirable.

CCI would see the role of the taxation Advisory Board as counselling Government on the appropriate conduct of tax policy and on any deficiencies in the current system, along with detailed consideration of the implementation of tax programs and, perhaps, the extent to which the ATO and Treasury are complying with the Charter of Business Taxation and their internal program objectives. In short, its role should correspond more closely (though not exactly) to a National Competition Council or Productivity Commission model than an RBA model, with its consultation and inquiries conducted in public, its references and recommendations made public, and access to funding and staff outside of the resources of the ATO and Treasury. Most importantly, unlike the RBA Board, its only power would be the strength of its arguments.

The best defence against possible allegations of political favouritism, vested interest or capture on the part of the Board would be for its advice and recommendations to be demonstrably impartial and well-founded. This will only be possible if its contributions to policy are detailed, timely and public.

Finally, a key source of frustration on the part of businesses and business groups which are involved in consultation on tax policy is that their advice is so often ignored. In part, as already discussed, this is because businesses are more likely to be consulted on implementation than policy design, and so come into the process too late.

But it also reflects the fact that the departments responsible for implementing and administering tax policy have far less incentive to consider the economic impacts or compliance burden their decision might impose on businesses and the wider community than they have to consider their own administrative costs and their objectives of maximising revenue and minimising opportunities for tax avoidance or evasion.

Cross-departmental liaison, a clearer statement of objectives and performance indicators and a Charter of Business Taxation will all go some way to redressing this imbalance. But a formal and separate role for business advice to government, especially if accompanied by a role in monitoring the performance of those departments responsible for developing and implementing tax policy, might add to the incentive for departments to take a more balanced approach.

Composition

CCI sees no persuasive argument for including senior public servants from Treasury or the ATO on the Advisory Board. These departments could and should present submissions and provide technical assistance to the Advisory Board’s inquiries as a matter of course. Each already exercises significant influence over the development and implementation of tax policy. And on occasion it will be preferable that the Board provides independent advice, while the ATO or Treasury might have vested interests. This would be especially true if the Advisory Board were to have responsibility for monitoring the extent to which the ATO and/or Treasury were complying with tax policy or other performance indicators.

As A Strong Foundation points out, "the arguments for public sector representation are probably strongest if the board’s activities were confined to the independent assessment and oversight role … public sector members of the board assessing the performance of the system would also be responsible for major aspects of that performance in their day-to-day work. This could create some conflict of interest."

Taxation Administration Departments

CCI strongly endorses the proposal for a more streamlined and coordinated approach to tax policy across government departments including a multi-departmental steering committee and cross-functional teams to coordinate activity between departments. Elements of the proposed Charter of Business Taxation should be incorporated into each department’s performance indicators. The Advisory Board might be asked to report on progress in complying with these objectives.

Conclusions

In summary, may I congratulate the Review of Business Taxation on having developed a useful and appropriate framework for the evaluation and development of business tax reform. I hope you will give consideration to the concerns which CCI has expressed on aspects of A Strong Foundation, and I look forward to seeing the Review of Business Taxation’s detailed recommendations on tax reform as they become available in 1999.

Yours faithfully,

 

Ross McLean

Deputy Chief Executive

 

 

CHAMBER OF COMMERCE AND INDUSTRY
WESTERN AUSTRALIA

FEBRUARY 1998

 

 

TABLE OF CONTENTS

 

1 SUMMARY AND OVERVIEW

2 tax reform principles

2.1 Transparency

2.2 Equity

2.2.1 Progressivity

2.3 Efficiency

2.3.1 Administrative Efficiency

2.3.2 Economic Efficiency5

2.4 Adequacy

2.5 Exceptions and Conflicts

2.5.1 Externalities8

2.5.2 Transparency Versus Efficiency

2.5.3 Equity Versus Efficiency

3 Introduction of a broad-based consumption tax

3.1 A Broad-Based Consumption Tax

3.2 Replacement of Payroll Tax

3.3 Simplicity, Equity and Efficiency

4 STATE REVENUES AND VERTICAL FISCAL IMBALANCE

4.1 Deficiencies of State Taxes

4.2 Problems With Vertical Fiscal Imbalance

4.3 Tax Reform Options Which Address Vertical Fiscal Imbalance

4.3.1 Centralise Tax and Spending

4.3.2 Tax Sharing

4.3.3 Raise Existing State Taxes

4.3.4 Introduce A New State Tax

4.3.5 Passing Tax Powers From The Commonwealth To The States

4.4 Summary and Conclusions

5 taxes on Income

5.1 Poverty Traps and Disincentives

5.2 Direct Tax Base Broadening

5.3 Company Tax

5.3.1 Abolition of Company Tax

5.4 Tax Simplification

5.4.1 Payroll Tax

5.4.2 Fringe Benefits Tax

5.4.3 Medicare Levy

5.4.4 Superannuation Surcharge

5.4.5 Lodging of Tax Returns

6 FISCAL POLICIES

7 OTHER TAX REFORMS

7.1 Fuel Excise

7.2 Capital Gains Tax

7.3 Superannuation and Saving

8 APPENDIX: WELFARE EFFECTS OF TAXES

9 Index

SUMMARY AND OVERVIEW

This report details the priorities and policies on taxation reform of the Chamber of Commerce and Industry of WA. It has evolved from many years of discussions with members, considerations of economic priorities and, most recently, from the results of a survey of tax reform issues conducted amongst CCI members in late January 1998.

Tax reform should be directed towards achieving three broad objectives:

1. The tax system should be transparent, so that it is apparent to taxpayers and those meeting the real costs of taxation that they are paying tax, and how much they are paying.

2. Taxes should be equitable, so that the burden falls similarly on taxpayers with similar capacities to pay, and proportionately more or less on taxpayers with greater or lesser ability to pay.

3. Taxes should also be efficient. Efficiency has two aspects - it should be economically efficient, so that the economic distortions caused by taxation are minimised; and it should be administratively efficient, so the cost of managing and complying with a tax should not be excessive relative to the revenue raised.

In order to achieve these objectives, CCI proposes that the following key policies should be central to the process of taxation reform:

  1. the introduction of a broad-based consumption tax with minimal exemptions at around 15% in order to finance the abolition of a range of indirect taxes and to allow some reductions in the level of income tax. Both State and Commonwealth indirect taxes should be abolished, with the highest priority taxes being (in order) Wholesale Sales Tax, Payroll Tax, financial transactions taxes (FID/BAD) and stamp duty on financial transactions.
  2. In order that the states do not lose net revenue as a result of reforms, and to reduce the degree of vertical fiscal imbalance, the states should receive a guaranteed share of revenues from the broad-based consumption tax, and also raise their own income taxes. State income tax would be levied at a single rate by each state on a personal income tax base identical to that of the Commonwealth. States might apply different rates in order to achieve their own budgetary and spending objectives, but would not vary the tax base. The Commonwealth Government would act as a central collection agency in order to minimise compliance costs. Initially, the Commonwealth would reduce its own income tax rates in order that the new state income taxes do not lead to an increase in the total tax take.
  3. The income tax base should be substantially overhauled with the aim of simplifying tax collections and reducing poverty traps and the disincentives to extra effort which arise through relatively high marginal tax rates. The top marginal rate of personal taxation should be aligned with the company tax rate. This measure should be financed in part through broadening of the existing direct tax base, for example by eliminating the favourable taxation treatment of family trusts. However, it is unlikely that such measures will, in themselves, raise sufficient additional revenue to finance the degree of restructuring necessary to improve Australia’s income tax structure. As a result, the broad-based consumption tax should be set at a level sufficient not only to finance the abolition of several indirect taxes, but also to finance reductions in income taxes.
  4. Other taxes should be reformed in order to make them less complex and more equitable. The highest priorities are Fringe Benefits Tax and fuel excise. The range of fringe benefits subject to tax should be reduced, and fringe benefits should be taxed as part of employees’ remuneration, with tax remitted by the employee at their appropriate personal marginal income tax rate. Fuel excise should be reviewed in order that the level of tax (over and above the broad-based consumption tax) more closely corresponds with the costs which fuel users impose on governments and the community (primarily road construction and maintenance). As with the current diesel fuel rebate, users who do not impose those additional costs on the community should not be subject to penal rates of taxation.
  5. The government should not compromise its policy of fiscal responsibility in order to finance taxation reform. Debt reduction should remain a high priority. Substantial reductions in the total tax take should be considered only when a structural budget surplus has clearly been restored and/or if accompanied by corresponding reductions in outlays. The cyclical surpluses indicated in current forward estimates have not yet materialised and, if they do, they may not persist in less favourable economic conditions. They should not be used to finance taxation cuts.
  6. The tax reform process must give great emphasis to tax simplification. The tortuous processes and modest achievements of the tax simplification process to date indicate that simplification of existing taxes is an extremely difficult task. The aim of tax simplification is achieved in this taxation reform policy primarily through the abolition of complex and onerous taxes and their replacement by a more simple and equitable broad-based consumption tax. For this reason, administrative simplicity must be given extremely high priority in the design of a broad-based consumption tax. Such a tax will encompass hundreds of thousands of tax payers, most of them small businesses, many of them entering the indirect tax net for the first time. In order for such a move to enjoy continued support from the business community and to result in a net improvement in businesses’ compliance burden, the new tax must be as simple to administer as possible.
  7. In the case of direct taxes, tax reform will mostly entail restructuring rather than abolition. However, if simplification is achieved in this area it has the potential to yield great benefits for Australia’s millions of personal tax payers as well as its hundreds of thousands of business tax payers. In particular, CCI supports the introduction of deemed allowances, and standard revenue and deduction profiles which could allow personal and small business taxpayers the option of not filing a tax return.

Table 1

Approximate Costing

$ Billion

Abolition Of Wholesale Sales Tax

-13

Abolition Of Payroll Tax

-8

Abolition Of Financial Transactions Duties

-2

Partial Abolition Of Stamp Duties

-2

Reform Of Excise Taxes

-2

Equalisation Of Company And Top Personal Marginal Tax Rates

-9

Reductions In Marginal Income Tax Rates*

-8

Compensation For Low/Fixed Income Earners*

-2

Total Tax Reductions

-46

Broad-Based Consumption Tax @15%

39

Income Tax Base Broadening Measures*

5

Captured From "Black Economy"

2

Total Financing Measures

46

tax reform principles

Taxation is the most costly, intrusive and unwelcome facet of the interaction between government and business, or indeed between government and the wider community. Tax probably has more impact on the profitability and day-to-day operations of most businesses than any other government activity. Getting the tax structure right is the single most constructive reform which governments can do to promote a productive economy and competitive business sector.

A tax structure should have three key characteristics:

1. It should be transparent, so that it is readily apparent to both taxpayers and those meeting the real costs of taxation that they are paying tax, and how much they are paying.

2. It should be equitable, so that the burden falls similarly on taxpayers with similar capacities to pay, and proportionately more or less on taxpayers with greater or lesser ability to pay.

3. It should also be efficient. Efficiency has two aspects - it should be economically efficient, so that the economic distortions caused by taxation are minimised; and it should be administratively efficient, so the cost of managing and complying with a tax should not be excessive relative to the revenue raised.

Taxation should also be adequate to finance appropriate levels of government expenditure. But while the size of the tax take and the efficiency of government spending are crucial components of fiscal and political policy, they are separate from issues of the structure of taxation.

Transparency

Because people don't like paying taxes, there is an incentive for governments to disguise from taxpayers how much they are actually paying.

This process can take two forms - contracting the tax base so that initial collections are made from a relatively small proportion of potential taxpayers; and loading taxes onto business inputs or intermediate processes so that their final impact on consumer prices, though potentially substantial, is virtually impossible to quantify.

Most State taxes and many Commonwealth taxes are not transparent.

Consumers are seldom aware of the cost even of taxes such as Wholesale Sales Tax whose direct impact on prices is readily calculable. It is virtually impossible to determine the precise effect of, for example, the 130 per cent effective rate of tax on vehicle fuel on the prices of consumer goods which must inevitably be transported by road.

State governments' taxation options are severely constrained by the constitution and by various High Court interpretations of it. Nonetheless, their complex and opaque taxation structures are not entirely due to factors beyond their control. Over many years State Governments have tended to shrink their own tax bases - for example, by raising payroll tax thresholds or exempting certain properties from land tax - in a process which reduces the number of taxpayers but not, of course, the size or ultimate impact of the tax burden on the community.

In order to appreciate the effects of such policies it is important to understand the difference between the initial and final incidence of a tax. The initial incidence of a tax basically describes the person or organisation which remits it to government. The final incidence describes where the true cost of a tax is actually borne. The impact on the community is much the same whether governments tax some businesses, all businesses or individuals (Appendix 1).

Businesses are organisations which generate income for people (whether wages and salaries, remitted profits, or retained earnings which finance investment). All taxes, even those levied on business activities, are ultimately taxes on people.

There are sometimes other benefits from collecting taxes from a relatively narrow tax base. In particular, aggregate compliance costs may be lower when only a few taxpayers are responsible for remitting tax (see Section 0 Replacement of Payroll Tax on page 11).

But the key danger with narrow and opaque tax bases is that they make it difficult or impossible for the community to discern the real incidence, and therefore the real cost, of tax.

Equity

Equity in the tax system requires that taxpayers and groups of taxpayers with similar abilities to pay face similar tax burdens ("horizontal equity"), while taxpayers with different abilities to pay remit taxes in proportion to their exposure to the tax base ("vertical equity").

This implies that, in general, an equitable tax will be levied at a single rate on the whole of the tax base, except in cases where exposure to the tax base is a poor proxy for "ability to pay" (for example, in the special treatment of agricultural compared to other businesses in the application of land tax).

Equity also requires that opportunities for tax evasion and avoidance be minimised, because people who engage in tax evasion or avoidance will generally be paying less tax than others with a similar ability to pay, or even others with a lesser ability to pay.

Equity is a crucial consideration in the design of tax structures, for two reasons.

Firstly, it is fair that businesses or individuals should remit taxes in proportion to their ability to pay.

Secondly, unless a market has characteristics which justify special treatment, an inequitable tax base will reduce economic efficiency. Taxing certain people, goods, services, businesses or activities more heavily than others will tend to distort demand and supply. This not only causes "unfairness", it also reduces economic welfare (see Section 0 Economic Efficiency on page 5).

Progressivity

Progressivity is a variation on the principle of equity which seeks to redistribute resources by taking proportionately more in taxes from the relatively affluent than the relatively poor. It is a key taxation principle which underpins most developed economies' income tax structures.

It has not been included in this Report as a general taxation principle because it is appropriate only for certain types of taxes.

Indeed, some of the more absurd and unjustified anomalies in Australia's tax structures arise from attempts to incorporate "progressivity" into taxation structures where it is clearly inappropriate to do so.

The key objective of progressivity is to take proportionately less in tax from those individuals with a lesser "ability to pay". It follows that tax bases where progressivity should be applied are those which are directly and proportionately related to a taxpayer's actual ability to pay.

There are two key problems with attempts to approximate progressivity into other tax bases - for example, Wholesale Sales Tax.

Firstly, it makes presumptions about the spending patterns of different income groups which may be true on average or in aggregate but will not be true for all individuals. Different Wholesale Sales Tax rates are applied to different goods on the assumption that they account for a larger or smaller proportion of consumption by low or high income groups. This means that many people with spending patterns not typical of their income group will be paying more or less than would be warranted under an efficiently progressive tax regime. Crude approximations of the principle of progressivity are unnecessary when other tax bases - notably the income tax base - are more efficient reflections of ability to pay.

Secondly, pursuit of progressivity through differential price structures can undermine the broader equity concern of taxing all goods and services in a roughly equal manner in order to minimise the allocative inefficiency caused by distorting price signals in the markets.

Finally, it is worth pointing out that progressivity of tax structures is meaningful only for the taxation of people. It has no relevance for business taxation. Two arguments suggest that "progressivity" is inappropriate for business taxes.

Firstly, the income generated by businesses is ultimately the income of people - whether as wages and salaries, dividends remitted and other owner income, or earnings retained for investment. Income or "size" as measured for a particular business (eg by turnover, profit or payroll) bears no relation to the financial circumstances of the employees and owners who derive personal income from that business. Share dividends remitted by large companies may form part of the income of pensioners or millionaires. A small business may represent the whole livelihood of its owner or a minor investment. Differences in levels of people's income are accommodated in the tax structure by the appropriate means of income tax, which applies progressive taxes to all forms of income - whether wages and salaries, dividend or interest income, or small business revenue - according to the circumstances of the individual recipient, not the characteristics of their sources of income.

Secondly, a significant proportion of the taxes collected from businesses are in fact passed on to customers (in the form of higher prices) and/or employees (in the form of lower employment or real wages). Whether the final impact of differential business taxes is in fact progressive or regressive bears little relation to the business's size or ownership but depends on the nature of its market, customers and work force.

For both of these reasons, there is no general justification on equity or redistributive grounds for "progressive" taxes aimed at discriminating between different sizes of business.

There are other good reasons for treating small and large businesses differently for tax purposes in some circumstances (see especially "Efficiency" below, and 0 Replacement of Payroll Tax on page 11), but these are based on other rationales, not "progressivity".

Efficiency

Administrative Efficiency

An administratively efficient tax is one in which the costs of government policing and taxpayer compliance are not excessive relative to the revenue raised. In other words, great majority of the total cost of the tax is the sum collected by the government in tax revenue.

Achieving efficiency requires that governments give careful attention to compliance and administrative costs. The more complex a tax, the more rates, exemptions etc which it applies, the more onerous its reporting and record-keeping requirements, the greater the compliance cost is likely to be.

The efficiency of the whole tax system tends to be greatest when there are relatively few taxes - compliance costs are relatively high when taxpayers must pay a large range of diverse and separate taxes. Efficiency can also be improved if tax bases which taxpayers use are harmonised or at least broadly consistent - for example, if the tax base for PAYE income tax was the same as the tax base for calculating the superannuation surcharge.

As a general rule, broad-based taxes which raise large amounts of money are more efficient than broad-based taxes which raise small amounts of money. This arises simply because compliance costs are usually not entirely proportional to the level of tax remitted - a large proportion are fixed costs.

So a small business with 10 staff usually spends far more per employee on compliance with PAYE than a large company with 1,000 employees. If the rates of income tax were halved, the PAYE compliance costs of both the large and the small business would be unchanged but government revenue would halve - the tax would become twice as inefficient.

This principle of tax efficiency has been given too little weight in the past in the design and revision of tax structures. It has also tended to be given relatively little weight in academic discussion on tax, in part because the true level and nature of compliance costs is notoriously difficult to estimate, and in part because macro-economic and theoretical analysis of tax structures has tended to ignore business-level practicalities (see, for example, 0 Replacement of Payroll Tax on page 11).

In summary, tax structures which are likely to be relatively efficient will tend to apply a small number of taxes with simple and consistent structures and few exemptions.

Economic Efficiency

Economic efficiency is achieved if the tax system does not distort consumer or producer behaviour in ways which reduce welfare. Taxes which fall more heavily on some goods, services or activities than others reduce demand for those goods, services etc relative to others. Prices no longer reflect the true cost of production.

Economic resources flow from the production of high-taxed goods to the production of low-taxed ones. Allocative efficiency is impaired. If distorted prices affect investment decisions and innovation, dynamic efficiency can be affected.

Unless there are good reasons for treating certain items as special cases, the objective of tax policy should be to minimise the impact of taxes on production and consumption decisions.

Adequacy

Taxation should deliver sufficient funds to support the services which the community requires from government.

It is sometimes argued that Australia can afford to increase its tax levels because, compared to other OECD countries, Australian taxes are relatively low.

Against this argument it is sometimes proposed that OECD countries have by and large experienced at best modest economic growth in recent years, and that the appropriate benchmark for Australian policies should be its high-growth trading partners in southern and eastern Asia.

CCI has concerns about both of these arguments.

Primarily, Australia should determine the mix of taxes and government services it wants. International comparisons might inform but should not define that determination.

Furthermore, it is likely that the Australian community would be outraged if an administration tried to introduce levels of social security spending or government services on a par with those provided in the newly industrialised economies of Asia.

Equally, it hardly seems sensible to embark on a major expansion of taxes and government spending because our budgetary position and debt levels compare favourably with those of fiscal basket cases such as Italy (where government debt exceeds GDP, and interest consumes almost 10% of GDP).

Further, a closer examination of revenue and expenditure data for OECD countries shows that Australia's fiscal position is not so parsimonious as a straight comparison of tax levels suggests.

Because the impression of Australia as a low-tax country has become so widespread, the data are examined further here.

The Figures above show Government spending, revenue, debt and interest as a percentage of GDP in 1996 for 18 OECD countries. Australian (State, Commonwealth and local) government receipts were equivalent to 35 per cent of GDP in 1996, the fourth lowest of the 18 OECD countries described ahead of Korea, the USA and Japan.

The composition of government revenue in Australia is markedly different from most other OECD countries. Direct taxes (mainly income taxes) provide a large proportion of total revenue. Direct taxes in Australia represent 18 per cent of Gross Domestic Product, the fifth highest of the 18 countries described, behind Denmark, Sweden, Finland and Belgium.

Perhaps surprisingly, Australia ranks about the middle of the group (9th highest) in its indirect tax take as a percentage of GDP. Although the other countries described in the graph operate some form of GST or VAT, Australia also derives a significant proportion of Government revenue from its own indirect taxes such as the Wholesale Sales Tax and State taxes.

Revenue from direct and indirect taxes combined represents 31 per cent of GDP, the fifth highest of the 18 countries described behind Denmark, Sweden, Finland and Norway.

The relatively low total revenue take in Australia results from the fact that it finances public pensions and unemployment benefits entirely from this tax base. So unlike the other OECD countries listed, Australia does not collect social security contributions. The schemes offered in other countries are diverse and may cover some or all of the costs of government transfers such as retirement incomes, some medical benefits and/or unemployment insurance, notably income-related unemployment benefit schemes typically provided in most of the OECD's European members.

In contrast, Australia covers all of the cost of Government-provided unemployment benefits, pensions etc from taxation revenue. Individuals do not accrue insurance-type personal benefits related to previous earnings, but receive universal flat-rate entitlements. Some income insurance and protection schemes are offered by the private sector, but these are voluntary and not delivered through taxation.

In Australia, superannuation is increasingly accrued under the Superannuation Guarantee Charge. Although its intent and effect are broadly similar to other OECD countries' compulsory retirement income contributions, the Australian Government's compulsory superannuation legislation mostly results in payments direct to private schemes rather than to or through government, so they do not count as government revenue. Because Australia does not offer income-related unemployment benefits (which tend to be expensive) and because its compulsory superannuation operates almost entirely in the private sector, government expenditure on social security benefits is relatively low at 13 per cent of GDP. This is the third lowest of the 18 countries described, ahead only of Iceland and Korea.

Australian own-purpose general government consumption spending accounts for 17 per cent of GDP, ranking eleventh of the 18 OECD countries described. Australia also ranks relatively low on "other" expenditure as a percentage of GDP. While this category covers a range of items one of the reasons for this relatively low spending is that, despite the rapid growth of recent years, Australia's government debt as a percentage of GDP is still lower than in many other OECD countries. As a result, its interest bill is lower.

In summary, Australia's direct and indirect taxes, and its government consumption spending, are in the mid to high range compared to other OECD countries. Its status as a "low tax, low spending" country appears to derive primarily from three factors:

1 It does not collect social security insurance type payments from its taxpayers, nor does it use these collections to provide income-related unemployment or retirement benefits.

2 Its compulsory superannuation arrangements take effect almost entirely outside of taxation and government spending and so are not included in the data, even though the intent and effect of the Superannuation Guarantee Charge are broadly comparable to other countries' compulsory retirement income provisions.

3 Although general government debt in Australia has risen dramatically in recent years, many OECD countries have been running significant deficits, and accumulating debt, for much longer. As a result, their debt servicing costs consume a higher proportion of GDP and government spending, and require a higher level of taxation, but do not reflect any current benefit to their citizens.

International comparisons which define Australia as "low taxed" compared to other OECD economies or a "high taxed" country compared to others in the Asian region are fraught with over-generalisations and, ultimately, are largely irrelevant. Australia can, and should, choose the tax-government servicing mix which suits its economy and its aspirations.

As a matter of sound fiscal policy, the government should aim for small structural surpluses (seepage 27). This requires that the level of government revenue should, over the course of the business cycle, marginally exceed expenditure. It is in this sense that taxation should be adequate.

However, adequacy does not imply any single optimal level of taxation or government spending. These should be determined through wider fiscal and political processes. These processes in turn can only be properly informed if the first principle discussed in this section - that of transparency of the tax system, so than taxpayers know how much they are actually paying - is achieved.

Exceptions and Conflicts

By and large, the preceding analysis indicates that an ideal tax structure would contain relatively few taxes and treat all classes of goods and services, and all classes of taxpayers, in a neutral manner. The true costs of taxes should be readily apparent to all who bear those costs, even if the responsibility for remitting a tax is carried by another taxpayer. Progressivity should be achieved through applying different tax rates to people with different ability to pay, but should be sought only for those taxes where the tax base is an accurate proxy for ability to pay, and in a manner which minimises associated loss of economic efficiency.

Sometimes, tax structures deviate significantly from the principles of transparency, equity and efficiency outlined above. And sometimes, those deviations are justified. By and large, this occurs when there are conflicts between two or more of these principles, or where the achievement of one of them requires special treatment of a class of taxpayers.

Externalities

Perhaps the key exception to the principle of tax equity - that all classes of taxpayers should be treated neutrally - occurs when certain taxpayers engage in activities which generate associated costs or benefits which accrue to other people.

Negative externalities are, at least in theory, the key justification for the high rates of tax currently applied to tobacco (600%+) and vehicle fuel (around 130%). So the relatively high taxation on tobacco is at least in part a reflection of the additional cost which smokers impose on the health system. Relatively high vehicle fuel taxes reflect the direct costs of providing and maintaining roads, and also the indirect costs associated with pollution and possible associated health effects, etc. Conversely, favourable taxation treatment of businesses' research and development costs reflects the positive externalities - improvement in the knowledge base etc - which flow from research.

For goods, services and activities which generate externalities, economic efficiency is enhanced by differential taxation treatment, by bringing the market price of goods and services into line with their true cost.

Of course, this assumes that the extent of the tax differential is in some way a reflection of the extent of the associated externalities. CCI has some concerns about whether the level of fuel tax, for example, is actually justified on the basis of the costs imposed on government and the community by motor vehicle users.

Transparency Versus Efficiency

The efficiency of a tax depends on the cost of compliance and administration compared to the revenue raised. By and large, the fewer the number of taxpayers, the smaller the aggregate compliance (and usually, administration) bill.

In some instances, the efficiency benefits of concentrating the compliance bill on relatively few taxpayers may be deemed to more than compensate for any loss of equity and/or transparency which may result.

For example, the fact that employers rather than employees are responsible for remitting the bulk of individuals' income tax (through PAYE) is justified on the basis that employers' compliance costs, though substantial, are significantly lower than the aggregate compliance costs which their employees would face if they were individually responsible for their regular income tax payments.

Employers' compliance is easier to regulate and monitor than employees', so the incidence of tax evasion or unintentional wrong payment is also lower, as is the government's administration cost.

Conversely, there is no loss of equity because employers not employees remit PAYE (individuals' total income tax liabilities still reflect their ability to pay), while the loss of transparency is only partial - regular pay slips and end-of-year financial statements ensure that employees are at least notionally aware of, and ultimately responsible for, the tax they pay.

In other cases, the effect of making the employer not the employee responsible for remitting taxes on remuneration is more damaging. For example, Australia and New Zealand are the only OECD economies where the employer not the employee has responsibility for remitting taxes on fringe benefits. This arrangement is largely non-transparent, because employees are often not made aware of the value of fringe benefits they receive, much less of the tax liability those benefits attract (and which they ultimately pay). It is inequitable and regressive, because all fringe benefits are taxed as though the employee is a top marginal rate taxpayer, regardless of their actual ability to pay.

And it is arguably not efficient, because the fact that employers not employees are responsible for remitting taxes means that the scope of Fringe Benefits Tax and the compliance requirements placed on employers go far beyond what could conceivably be imposed on individual employees.

Equity Versus Efficiency

More complex issues arise when there is a trade-off between equity and efficiency, for example, in the states’ exemption of small businesses from payroll tax (see discussion on payroll tax in section 0 on page 11).

Introduction of a broad-based consumption tax

CCI advocates the introduction of a broad-based consumption tax with minimal exemptions at around 15% in order to finance the abolition of a range of indirect taxes and to allow some reductions in the level of income tax. Both State and Commonwealth Government indirect taxes should be abolished, with the highest priority taxes being Wholesale Sales Tax, Payroll Tax, financial transactions taxes (FID/BAD) and stamp duty on financial transactions.

In the survey of CCI members, over 80 per cent supported the introduction of a broad-based consumption tax in order to replace some existing indirect taxes, while 90 per cent supported a shift in the taxation burden away from income and towards consumption.

The primary objective of the introduction of a broad-based consumption tax is to permit the abolition of a range of existing taxes which are distorting, inequitable, complex and damaging to Australia’s economic efficiency. It follows that an improvement in the overall tax structure will be achieved only if a new tax is less distorting, less inequitable and less complex than the taxes it replaces. As one CCI member commented in the survey:

"If a broad-based consumption tax is adopted, it would be important to make it SIMPLE. The current Tax Act is a nightmare & only feeding the lawyers & accountants."

The most effective way to ensure that the a new tax system is equitable and simple is to make the base as broad as possible. As a member commented in the survey:

"a ‘no exemption’ system to reduce compliance/liability costs and govt collection costs"

The secondary objective is to permit a substantial overhaul of the income tax system. While considerable improvements in Australia’s direct tax base could be achieved simply through reform and restructuring of existing taxes, CCI believes than the magnitude of the task required, and the need to reduce marginal tax rates across many income bands, mean that it is not feasible to finance the necessary tax changes from restructuring alone.

A broad-based consumption tax must be set a level sufficient to permit the reduction of the income tax take as well as the elimination of indirect taxes. Along with Payroll Tax, income tax attracted the most comments from members responding to CCI’s survey, for example:

"Both personal & company tax rates must be reduced - no incentive to expand of employ. Tax system encourages business & personal tax payers to stay below the threshold."

A Broad-Based Consumption Tax

Australia's current indirect tax arrangements comprise primarily a Wholesale Sales Tax and a range of additional product-specific excises. The States retain taxes on financial services (FID/BAD) and major transactions (Stamp Duty). The case against Wholesale Sales Tax in particular, and Australia's indirect tax structure in general, has been widely canvassed, but bears repeating as it is central to the case for taxation reform:

  • It causes economic inefficiency by encouraging the consumption of certain goods in preference to others, and of services (not taxed) in preference to goods (which are).
  • It defies "horizontal equity" - the principle that groups of similar people and/or businesses should experience similar tax treatment. Businesses' tax burden depends on their industry purchases; consumers’ tax burden depends on their preferences.
  • It is highly complex, applying different rates to different products and with a wide and anachronistic range of exemptions.
  • It is not transparent - consumers may not even know they are paying it and generally do not know how much they are paying.
  • Because it cascades through the production process and is embedded in business costs, it affects the competitiveness of Australian exports and businesses competing with imports, as imports' prices do not include a residue of tax from the producing country.
  • It is probably regressive (despite attempts to exclude "essential" items), because low income groups spend less of their income on services than the relatively affluent, and very highly taxed items (tobacco, alcohol and fuel) account for a relatively large proportion of low income groups' expenditure.
  • Because the tax base is quite narrow, the rate of tax applied in order to extract a reasonable level of revenue is relatively high compared, for example, to other countries' indirect taxes.
  • Reportedly, the indirect tax base is not expanding as fast as consumption, because a greater proportion of spending is on services and other exempt items (although this has not prevented both the total tax take and the indirect tax take as a percentage of GDP from reaching record levels in 1996-97 - see figures).
  • In part, this rising indirect tax take reflects sharp increases in taxes on specific items - notably States' franchise fees (until recently) and the Commonwealth's excises.
  • In combination, these levies place high effective tax rates on certain goods and services (tobacco, fuel, alcoholic drinks and gambling). While relatively high taxes may in some cases be justified by externalities, the very high levels of tax applied, and their rapid acceleration in recent years, make it unlikely that a purely economic justification exists for such high taxes.

The best way to address these issues is through comprehensive taxation reform, replacing Wholesale Sales tax and other indirect taxes with a single, uniform broad-based consumption tax with minimal exemptions.

Such an approach would have a number of advantages:

  • It would allow some of the most allocatively inefficient taxes to be abolished (eg FID and Stamp Duty).
  • It would make the tax system more transparent, by shifting the tax burden from invisible taxes to a visible one.
  • Broad-based taxes with large numbers of taxpayers are more administratively efficient if they raise large amounts of money than if they raise relatively little (see Section 0 Replacement of Payroll Tax on page 11).
  • It would provide the scope and flexibility to reduce effective marginal income tax rates, and to harmonise and simplify the effective tax rates on different forms of income.
  • It would provide greater flexibility to re-arrange the tax base to address the issue of vertical fiscal imbalance (see page 14).

Replacement of Payroll Tax

Along with Wholesale Sales Tax, the tax businesses would most like to see abolished and replaced by a broad-based consumption tax is Payroll Tax.

Some academics and government officials have argued that payroll tax conforms quite well with the basic tax principles of equity, efficiency and transparency, an argument which CCI would strongly dispute.

For example, a 1996 Commonwealth Treasury Research Paper concludes that "the incidence of a payroll tax is ... similar to the incidence of a consumption tax."

The key problem with this analysis is its assumption that payroll tax is applied at the same rate to everybody (including the self-employed and employees of small businesses). Overseas this is often the case - for example, the social security taxes commonly levied on wages in Western Europe to finance pensions, unemployment benefits etc.

However, Payroll Tax as applied in Australia is neither broad-based nor uniform. Because of exemptions for small businesses, and different tax rates for different levels of payroll in many States, Payroll Tax falls very unevenly across the business sector. The great majority of businesses do not pay it - well over 90 per cent are exempt in most States.

Because different industry sectors and different types of economic activity have different typical employment sizes and average earnings, the initial impact of Payroll Tax falls very unevenly across industries.

Sectors such as mining or electricity, gas and water pay much more than average as a percentage of earnings because typical employment size and earnings are relatively large, so more businesses exceed the minimum tax thresholds (see Table 2).

It seems likely that significant allocative inefficiency results from this uneven incidence of the tax as currently structured, because it falls more heavily on some industries and types of activity than others. The production industries, exporters and businesses trading in national rather than local markets bear the heaviest burden. Such inequity would not be generated by a broad-based and uniform goods and services or similar tax.

If the objective of tax policy was to mirror as closely as possible the impact of a broad-based goods and services tax, then the solution would be simple - eliminate Payroll Tax thresholds and levy Payroll Tax at the same rate on all wages and on the labour income of the self-employed.

However, eliminating allocative inefficiency is not the only objective of tax policy.

One of the key reasons why the current total compliance costs of Payroll Tax are quite low relative to tax collections is that more than 90 per cent of businesses do not pay the tax.

Those 90 per cent are mostly very small employers whose relative compliance costs for most taxes, including Payroll Tax, are much higher than those of large employers.

Even with simplification of the tax base, taxing all currently exempt businesses would be likely to generate a large increase in total compliance costs associated with the tax. Any gain in allocative efficiency would be at the price of greatly reduced administrative efficiency.

There may not even be gains in allocative efficiency. The proportionate compliance costs faced by very small businesses are so high that including them in the tax net at any level can mean that their relative total costs (tax remitted plus compliance as a percentage of tax raised) are immediately well above those of larger taxpayers. So cost neutrality may not be an option between very small and large businesses. The choice may be between favouring small businesses relative to other businesses by excluding them from the tax net altogether, or penalising them relative to other businesses by imposing proportionately very high compliance costs the moment they are drawn into the tax net.

The key issue in determining whether Payroll Tax thresholds should be applied, and if so at what levels, is to balance the administrative inefficiency generated by taxing small businesses against the allocative inefficiency generated by not taxing them. This balance depends to some extent on the amount of money the tax raises. The dollar cost to a businesses of complying with a given tax is much the same whether payments remitted are large or small.

But other things being equal, compliance costs are lower as a proportion of tax remitted for large taxes than small ones.

In short, broad-based approaches to business taxation may be more appropriate for taxes which raise large sums of money than for taxes which raise relatively little.

On a national scale, no single tax levied by State Governments is particularly large. Payroll Tax is usually the States' largest source of tax revenue, but aggregate revenue is small compared to key Commonwealth Government revenue sources such as income tax, excise tax or sales tax. In 1996 payroll tax raised $7½ billion, while the total Australian tax take (from Commonwealth, State and local governments) was $159 billion. Payroll Tax currently represents less than 3 per cent of its potential tax base (all income from employment and self-employment). No-one has seriously suggested, for example, that a Goods and Services Tax would be efficient if it was levied at 3 per cent of value added.

This has led some observers to argue that payroll taxes in Australia could be increased significantly, especially as the apparent tax take is low relative to overseas countries' social security taxes.

But caution should be exercised here. While payroll tax collections are quite low, the superannuation guarantee charge is virtually identical in both its intent and its effect to some of the social security taxes levied overseas. With employer contributions scheduled to peak at 9 per cent, and States' Payroll Taxes on top, Australia's effective payroll tax rate is already quite high.

Further, direct taxes (mostly income tax) already account for 18 per cent of GDP, the fifth-highest burden of direct tax in the OECD. Payroll tax is a tax on earned income even though it is remitted by employers not employees, and earned income is already taxed heavily in Australia.

In general, substituting a broad-based and uniform tax for a number of narrow and discriminatory pre-existing taxes would probably improve allocative efficiency. It might even reduce compliance costs if the taxes replaced were particularly onerous to comply with. But the theoretical comparability of broad-based payroll and value added taxes appears to have little relevance for existing Australian tax structures.

The danger is that it might become accepted wisdom that payroll taxes as currently applied have the benefits of a broad-based and uniform GST - that they do not apply inequitably, do not generate allocative inefficiency and do not discourage employment or exports.

In fact, the States' current Payroll Taxes do all of these things.

However, the superficially attractive solution of extending payroll taxes to all small businesses and the self-employed would probably make matters worse because of the much larger compliance costs this would generate.

Hypothetically, a much larger payroll tax, levied at a single rate on all earned income without thresholds, replacing some existing State taxes and possibly in association with lower Commonwealth income taxes could achieve the twin objectives of a more efficient tax structure and reduced vertical fiscal imbalance.

However, CCI would not advocate such an approach, for two key reasons.

Firstly, the argument that a (universal and uniform) payroll tax has the same economic impact as a goods and services tax or value added tax is only true (if it is true at all) in the very long run. A substantial hike in payroll tax would be certain to lead to jobs losses in the short term and would distort labour-capital choices for a considerable period of time, until the relative prices of labour and capital finally adjusted to the shock. The transitional social, political and economic costs of such a move would be too great.

Secondly, as discussed previously, the total take from income-related taxes in Australia is already very high, and is even higher if the Superannuation Guarantee Charge is included as a de facto tax. Tax reform should shift some of the tax burden away from taxes on income, not towards it.

Simplicity, Equity and Efficiency

It is worth repeating that businesses do not support a broad-based consumption tax because they want to pay a new tax.

Rather, the strong support which introduction of a broad-based consumption tax enjoys in the business community is founded on an expectation that the revenues raised will allow the abolition or reform of taxes which are complex, inequitable and damaging to economic efficiency.

In particular, businesses would like to see income tax and fuel excise reduced, and the abolition of Wholesale Sales Tax, Payroll Tax, taxes on financial transactions and stamp duty on business transactions.

The extent to which businesses will support any government tax reform agenda which includes a broad-based consumption tax will depend on the extent to which it achieves these aims. The introduction of a broad-based consumption tax is a means to an end, not an end in itself.

Business support for a broad-based tax is also based on an expectation that it will be less complex, less inequitable and less damaging to economic efficiency than the taxes which are abolished or reformed as a result of its introduction.

Again, it follows that ongoing support for tax reform is contingent on these expectations being realised. Simplicity and equity must be given extremely high priority in the design of any new tax.

It is noteworthy that most of the comments in the survey of CCI members’ views on tax reform which expressed opposition to a broad-based consumption tax were not against the tax on principle. Rather, they reflected scepticism that government would in fact abolish existing taxes if a broad-based consumption tax were introduced, or an expectation that the tax rate would rise over time. For example:

"Government should remove taxes. GST is a move to increase taxes. Any new or increase taxes should be by referendum."

"I am wary that if a consumption tax is brought in what kind of guarantee do we have that existing taxes will be replaced."

"I would support a consumption tax if it did away with all indirect taxes with no exemptions."

"No introduction of GST until a guarantee of removal of some indirect existing taxes agreed to by all party sitting of Parliament."

"The big danger with a GST is that any increase in GST percentage needs only a REGULATION - not an Act of Parliament. Might start @ 10% & be 20% within 12 months."

Unfortunately, there is no feasible solution to the concern that government might indeed raise its tax rate over time. The only answer to this argument is that any increase in the tax effort under a broad-based consumption tax would at least be transparent, which would discourage governments from raising taxes without good reason. This would be a substantial improvement on current arrangements, where regular changes in indirect tax rates and the pernicious effects of bracket creep have combined to raise the tax take to record levels as a percentage of GDP without the public being generally aware of this rising tax effort (see Figure 3 on page 10).

The second concern – that a consumption tax would be additional to rather than instead of existing taxes - would of course be allayed if the government’s final tax reform agenda clearly demonstrated an intention to abolish existing taxes as well as introducing a new one.

The tax reform process must give great emphasis to tax simplification. The tortuous processes and modest achievements of the tax simplification process to date indicate that simplification of existing taxes is an extremely difficult task. The aim of tax simplification is achieved in this CCI Policy primarily through the abolition of complex and onerous taxes and their replacement by a more simple and equitable broad-based consumption tax. For this reason, administrative simplicity must be given extremely high priority in the design of a broad-based consumption tax. Such a tax will encompass hundreds of thousands of tax payers, most of them small businesses, many of them entering the indirect tax net for the first time. In order for such a move to enjoy continued support from the business community and to result in a net improvement in businesses’ compliance burden, the new tax must be as simple to administer as possible.

STATE REVENUES AND VERTICAL FISCAL IMBALANCE

Considerations of which layers of government raise which taxes will inevitably enter the tax reform debate, because any comprehensive tax reform process which introduces or increases some taxes in order to reduce or eliminate others is likely to result in a shift of revenue-raising capacity between the various levels of government.

Depending on which taxes are changed, this in turn may result in an increase or decrease in the degree of vertical fiscal imbalance.

While any review of the taxation system should be comprehensive and have regard for all taxes regardless of jurisdiction, the political and constitutional ramifications of any reform recommendations cannot be ignored.

Of even greater concern is the possibility that the tax reform process will not, in fact, be comprehensive. Both the Commonwealth and the state governments have some incentive to exclude state taxes entirely from the reform process. It now seems possible that only Commonwealth taxes will be subject to reform.

Such an outcome would be highly undesirable, for three reasons.

  1. Many of the taxes most in need of reform in Australia are state taxes. Virtually all of the states’ taxes fail to comply with the basic criteria of equity, efficiency and transparency which should characterise an effective taxation system. Furthermore, the taxes which businesses most often identify as in need of reform include a large number of state taxes, notably payroll tax, financial transactions taxes and stamp duty.
  2. Unless state taxes are included in the reform process, the outcome for Australia’s overall taxation structure can only be far from optimal, and businesses will be left to labour under a taxation burden which imposes an excessive compliance burden and which impedes business and economic efficiency.

  3. The economic impact of a particular tax is not determined in isolation. Taxes across the various levels of government interact with each other, and the negative impact of any single tax can be greatly compounded if it is raised against a tax base also used in raising another tax.
  4. For example, to examine Australia’s taxes on housing only through the Commonwealth tax system, with its favourable Capital Gains Tax treatment, exemption from tax on imputed rent, absence of wealth taxes and the opportunity to negative gear on investment property would all point to a conclusion that housing is lightly taxed. If Land Tax, Stamp Duty, financial transactions taxes and local authority rates were brought into the picture, the conclusion might be somewhat different.

  5. The inadequacy of the states’ tax bases, and their excessive reliance on Commonwealth Grants to finance the delivery of services, is undesirable in itself. Even if tax reform were not on the agenda, a reduction in vertical fiscal imbalance would be desirable.

The current tax reform debate presents an ideal opportunity to achieve the twin objectives of improving Australia’s tax arrangements and reducing vertical fiscal imbalance.

At the very least, when considering tax reform objectives it is important to ensure that any outcomes do not make vertical imbalance worse.

Deficiencies of State Taxes

Financial Transactions Taxes increase the cost of everyday business and household transactions. They distort the flow of capital and fall unevenly across different types of transaction. To an extent, they already distort choices about how financial transactions are organised. With increasing use of electronic and other means of conducting transactions, opportunities for avoidance or evasion are likely to increase.

Stamp Duties are taxes on change and on investment. They impede the flow of capital and certain forms of investment, and distort business decisions about corporate structures. They are effectively taxes on change – one of the most counter-productive forms of tax.

Payroll Taxes are the states’ largest base for own-source revenues. CCI’s concerns about Payroll Taxes are discussed in see Section 0 on page 11.

For all of these reasons, it is essential that abolition of some state taxes be included in the tax reform process.

However, it is equally important that such a process should not entail an increase in vertical fiscal imbalance. Simply replacing these taxes with a Commonwealth-raised broad-based consumption tax, for example, would in fact increase the degree of vertical fiscal imbalance, even if a state share of the new tax base were "guaranteed" (and the states would, with every justification, be sceptical of the solidity of any "guarantee").

If some state taxes are to be abolished without a further deterioration in vertical fiscal imbalance, then the states must have alternative own-source revenues.

Problems With Vertical Fiscal Imbalance

In Australia, the Commonwealth government raises about three quarters of all tax revenues collected, but the states are responsible for about half of government expenditure. As a result, around 40 per cent of states’ general government revenue comes from Commonwealth grants. This disparity between revenue raising and expenditure at different levels of government constitutes "vertical fiscal imbalance".

The issue of vertical fiscal imbalance is broader than simply the appropriate structure and level of taxes. But constitutional and other limitations on the states’ taxing powers, and their consequent reliance on a combination of distorting and inequitable own-source taxes and a significant slice of the Commonwealth’s revenue base, are central issues in both the tax reform debate and broader considerations of the appropriate balance of powers and activities between different jurisdictions. The tax policy and political policy dimensions of vertical fiscal imbalance, are, in reality, inseparable.

The major disadvantages of vertical fiscal imbalance are:

  1. Separation of revenue raising authority from expenditure authority weakens accountability - in particular it is claimed to have encouraged inefficiencies in the delivery of state services as states do not bear the political odium of raising the money they spend. For each dollar spend by state governments, they need to raise 60 cents.
  2. There is no satisfactory priority-setting mechanism between Commonwealth and state functions, giving rise to claims that the Commonwealth is harsher on state grants than its own outlays. The recent decline in state grants - whether as a share of GDP, of Commonwealth revenue and expenditure, or of states’ revenue and expenditure, lends considerable weight to this argument.
  3. A preferred treatment of Commonwealth functions over state functions seems inherently likely in this division of fiscal powers. A consequence of this bias has been that consumption is favoured over investment expenditure because the states are responsible for much public investment while the Commonwealth’s functions are substantially redistributive.
  4. Existing state taxes tend to be volatile, opaque, inefficient and regressive, and severely limit the revenue raising capacity of the states.
  5. There is a basic lack of agreement about the respective roles of the Commonwealth and state governments, resulting in policy conflicts and duplication.

Complete vertical balance is not realistic or desirable if the Commonwealth is to continue to provide the mechanism for fiscal equalisation between the states. All federal systems undertake some income transfers between their various levels of government. However, the degree of vertical imbalance in Australia is much greater than in other democratic federations around the world.

Finally, there is a political dimension to the issue of vertical fiscal imbalance which cannot be ignored in any comprehensive review of taxes.

If tax reform is to embrace state taxes – and it should – then it must be done in a way which is acceptable to the states. The states are extremely unlikely to accept any tax reform proposals which increase the degree of vertical fiscal imbalance, and at the very minimum are likely to require some guaranteed share of Commonwealth revenue if they are to cede parts of their own tax bases. Even this may not be sufficient to persuade them to abolish their own taxes.

It is conceivable that tax reform may be achieved without the active and vocal support of the states, even tax reform which encompasses their own tax bases. But reform of state taxes will be virtually impossible if the states actively oppose it.

Tax Reform Options Which Address Vertical Fiscal Imbalance

Ultimately, issues of the respective revenue-raising and spending roles of different jurisdictions go to the heart of whether Australia should re-define its federation. They go far beyond a tax policy, and rest on whether Australians still want to be governed through a federal system and, if so, what the respective roles of the Commonwealth and states should be.

Yet even if the conflict between state and Commonwealth governments continues unresolved, issues of states’ taxing powers still need to be addressed as a matter of urgency, if only because states’ taxes so clearly fail to meet the objectives of equity, transparency and efficiency.

Centralise Tax and Spending

One way of achieving greater fiscal balance would be to transfer more expenditure responsibility to the Commonwealth. The Commonwealth has already gone some way down this path through its increasing direct involvement in areas of policy and service delivery which were previously under the main or exclusive control of the states.

It has also achieved control of policy and services indirectly, through the use of specific purpose payments. Thus the Commonwealth attaches conditions to the grants it transfers, reducing or eliminating the states' freedom to determine policy or establish priorities in service delivery. Service delivery is effectively contracted out to the states.

While this may resolve in part the problems of the separation of revenue raising and service delivery roles, it is inefficient and inconsistent with the principles of federation. It also leaves some ambiguity about responsibility. For example, it is difficult to determine whether the increasing problems evident in the public health system are due primarily to inadequate Commonwealth (or state) funding, inappropriate state (or Commonwealth) policy, or inefficient state service delivery.

States objected strongly to the increased use of special purpose payments over the 1980s and early 1990s, and in recent years there has been something of a reversal of the previous trend to "tie" a growing proportion of grants.

Further centralisation of spending responsibilities to match revenue-raising powers would reduce the degree of political decentralisation and state Government autonomy in Australia, and further weaken the federation. Taken to extreme, it might see the abolition of the states.

Such a wholesale shift of responsibility for spending and service delivery from the states to the Commonwealth would require a shift in the balance of governmental power in Australia which would have major political implications and would probably require constitutional change. It would, of course, require a far more compelling justification than the existence of vertical fiscal imbalance.

Australia’s tax structure should reflect and support the jurisdictional and spending powers and responsibilities Australians want from their different levels of government. The tax system should be shaped by the political system, not the other way round.

Tax Sharing

A less extreme centralist scenario which would permit fairly substantial tax reform might see the Commonwealth raise a new tax, replacing part of its own tax base (Wholesale Sales Tax, maybe some income tax and possibly some excise duties) and some state taxes (probably stamp duties and possibly payroll taxes and financial transactions taxes).

States would almost certainly demand a guaranteed share of revenue from the new tax or existing tax base in return for ceding their own revenue-raising powers. This option has a number of weaknesses.

It would increase the extent of vertical fiscal imbalance.

Although a guaranteed share of the Commonwealth’s tax base might make the states’ interests in the new tax relatively transparent, taxpayers would probably hold the Commonwealth responsible for its application.

It would not allow different states to apply different levels of tax effort in order to provide different levels of service. Even if the Commonwealth were inclined to apply, for example, different rates of goods and services tax in different states and remit revenues accordingly, it is constitutionally constrained from doing so.

There would still be a gap between states’ responsibility for service delivery and their service priorities, and their flexibility to achieve those objectives by adjusting revenues.

History shows that the size and use of taxes can change markedly over time. For example, payroll tax was originally introduced (at 3½ per cent, by the Commonwealth) to pay for child endowment. The previous Labor Government’s second tranche "LAW" tax cut has transformed successively into a deferred income tax cut, a superannuation co-contribution, and now a promised tax incentive for savings. It has still not been paid.

In tax policy, especially in the long run, there is no such thing as a "guarantee".

However, guaranteeing the states a share of Commonwealth revenue has a number of advantages which have tended to make it the most widely canvassed tax option which addresses the problems of the states’ tax bases (along with the fact that it closely corresponds to the "Fightback!" proposals).

Perhaps the most obvious are that it is simple, constitutional and need not entail serious soul-searching or re-vamping of vertical fiscal imbalance.

A "guaranteed" share of Commonwealth tax revenues has a number of advantages for the states. It might help to halt the persistent erosion of their share of Commonwealth revenues in recent years (though this is questionable, as the Commonwealth is certain to retain some discretion in its spending commitments to the states).

It would also allow the states to share in the gains of tax reform and continue to take the political credit for delivery of services without the associated pain of holding primary responsibility for what is likely, because of its transparency, to be an unpopular tax.

This "centralist compromise" option is preferable to a tax reform process which excludes state taxes entirely.

But a better reform process will not only see damaging state taxes removed, it will also see the extent of vertical fiscal imbalance reduced.

Raise Existing State Taxes

If tax reform is to achieve a lesser degree of vertical fiscal imbalance without transferring spending powers from the states to the Commonwealth, it must allow states to increase their own-source revenues.

There are three broad options for tax reform which would achieve the dual objectives of improving the overall tax mix by abolishing some state taxes while at the same time reducing vertical fiscal imbalance:

  1. raising existing state taxes,
  2. introducing new state taxes, or
  3. passing tax powers from the Commonwealth to the states

Probably the only state tax which has the theoretical potential to conform to the key taxation principles of equity, transparency and efficiency is Payroll Tax. Yet, as discussed above, the academic arguments suggesting that the economic impact of payroll tax is relatively benign, (or at least, it would be if only it were raised on a broader base) are open to question.

Furthermore, an increase in the payroll tax burden sufficient to raise the revenue to eliminate other state taxes, (let alone to replace some Commonwealth grants), would lead to a sharp increase in the cost of labour. Again, economists argue that prices and the exchange rate might eventually adjust to eliminate any negative employment effects in the long term, but the transitional costs of loss of employment could be substantial.

Finally, payroll tax is effectively a tax on earned income even though (like PAYE income tax and Fringe Benefits Tax) it is remitted by employers. Australia already raises a much greater proportion of its government revenue from taxes on income than almost any other OECD country. Increasing payroll tax to eliminate indirect taxes would effectively switch the tax burden further from consumption to income.

Ideally, any change in Australia’s tax mix arising from the reform process should be the other way around.

In short, increasing payroll tax to finance the abolition of some other state taxes and possibly some reduction in Commonwealth grants is a reform option, but it is probably the worst option.

Introduce A New State Tax

An alternative might be to give the states new tax powers and allow them to abolish existing taxes. Such a new tax would be most likely to be a broad-based consumption tax. Given the practical difficulties associated with collecting a state-based tax throughout the production chain, an end-point retail sales tax would be the most feasible practical option for a state-based tax.

This approach would have a number of substantial advantages.

  1. It could reduce vertical fiscal imbalance if the revenue raised were sufficient to finance a reduction in Commonwealth Grants as well as the elimination of some state taxes (for example, if the Commonwealth were to abolish Wholesale Sales Tax and reduce grants by an equivalent amount).
  2. It would improve Australia’s overall tax structure by allowing the abolition of some of its worst taxes and replacement by a more efficient, equitable and transparent consumption tax.
  3. It would give states more power to determine their preferred balance between revenue and expenditure.
  4. Overall compliance costs would be somewhat lower than with a GST or VAT, because there would be fewer tax payers.
  5. It would also increase transparency and accountability by establishing a clearer link between the level of states’ service provision and the cost of providing those services.

A state consumption tax does have some disadvantages, however:

  1. A retail sales tax would have a somewhat narrower base than a GST or VAT, and the potential for evasion would be greater.
  2. Compliance costs would be greater for a tax levied separately in each state jurisdiction, though this effect could be largely ameliorated if states’ agreed to a common tax base and differed only on rates. However, such agreement would in itself lessen states’ control of their revenue raising capacity to some extent.

If the only concern of the tax reform process were to devise a more efficient, equitable and transparent tax structure while simultaneously reducing vertical fiscal imbalance, then this would probably be the optimal outcome.

However, there are other constraints. Successive High Court interpretations of the constitution have greatly narrowed the taxes which the states can raise. In the light of the High Court’s recent decision that franchise fees are excises, it is widely perceived than any broader state consumption tax would similarly be deemed unconstitutional.

This does not mean that replacement taxes are impossible, but it means they may be achievable only through constitutional change. And the likelihood of a constitutional change to give the states new tax powers being proposed (much less accepted), seems remote at present.

Whatever the theoretical appeal of this reform, the political and constitutional barriers may prove insurmountable.

Passing Tax Powers From The Commonwealth To The States

The third possibility is to shift some existing revenue-raising powers from the Commonwealth to the states.

The most obvious candidate for such a shift is income tax. Indeed, income taxes used to be state taxes until they were ceded to the Commonwealth during the second world war.

Such a proposal has a number of advantages:

  1. It would be constitutional, and may not even require the Commonwealth’s agreement.
  2. It could be done without changing the existing range of taxes raised (although this is arguably a disadvantage).
  3. Income tax revenues are more stable than many of the states’ own taxes, and it is a "growth tax" whose revenues tend to increase automatically as the economy expands.

However, there are disadvantages, too.

  1. The key role of the Commonwealth is redistributive - most of its revenue is derived from progressive income taxes; most of its expenditure is directed to transfers either to individuals (through benefit payments) or to other levels of government. Ceding some of its income tax powers to the states might undermine its ability to control the degree of progressivity in the income tax system.
  2. It could also impede its ability to determine the overall process of redistribution by coordinating the cumulative impacts of progressive income taxes, unemployment and other benefits and social spending. This coordination should be enhanced by tax reform, not diminished by it.
  3. Tax reform should be directed not only at the balance of taxes between the states and the Commonwealth, but also the balance of taxes between income, expenditure and wealth. Shifting income taxing powers in itself only addresses jurisdictional issues.
  4. Income tax is by far the Commonwealth’s largest single source of revenue. It may not concede the loss of even part of that revenue willingly.
  5. There appears to be no satisfactory mechanism by which the states could share the business income tax base (company tax). They would be limited to tax on individuals.
  6. If the states were to set different tax bases, "progressive" rates etc, the complexity of the income tax system, compliance costs and the potential for evasion would increase.
  7. If the states agreed to align their income tax bases with the Commonwealth’s, each set single tax rates and compete only on those rates, then these problems would be largely ameliorated. However, this would again reduce their flexibility to design their own revenue-raising mechanisms, and might provide the Commonwealth with a powerful incentive to contract the income tax base over time, or change its structure so that income was generated in activities only taxed by the Commonwealth (eg by encouraging incorporation).

Yet for all these reservations, if a state consumption tax is politically impractical then state income taxes represent the next best option. If the state taxes "piggy back" the Commonwealth’s tax base, varying only on rates, then compliance and evasion complications will be lessened. Such a solution would also permit the Commonwealth to maintain general control of the overall progressivity of the income tax structure (for which it need control only marginal rates), and hence to improve integration with the benefits structure to reduce poverty trap effects. Above all, it would be constitutional.

Summary and Conclusions

A comprehensive and effective tax reform process must encompass the whole of Australia’s tax structure regardless of the jurisdiction which raises any particular tax. In encompassing state taxes, it must address issues of vertical fiscal imbalance to ensure that, at the very least, this problem is made no worse. The key reasons for including state taxes in the reform process are:

  1. Some of Australia’s worst taxes are state taxes. Tax reform cannot be judged a success unless they are addressed.
  2. A comprehensive review of the appropriate structure of taxes on income, on capital or expenditure would be meaningless unless it encompassed the comprehensive range of taxes applied to those tax bases. Changing the tax structure in one jurisdiction without regard to the taxes raised in other jurisdictions could make the overall tax structure worse.
  3. Vertical fiscal imbalance of the degree currently evident in Australia is in itself undesirable, and undermines government efficiency, accountability and ultimately Australia’s economic performance. It is an issue which needs to be addressed in its own right.

There are various options which would address the problems in the states’ tax arrangements without worsening vertical fiscal imbalance.

Of these, a state-based consumption tax would provide the solution which most closely addresses the need to improve the tax structure, provide the states with a "growth" tax and reduces state reliance on Commonwealth grants.

However, the constitutional constraints on such a proposal will probably prove insurmountable.

A state-based "piggy back" income tax, levied on the same base as Commonwealth income tax and at a single rate in each state (through possibly different rates between states), represents the most attractive of the options guaranteed to be constitutional.

In order that the states do not lose net revenue as a result of reforms, and to reduce the degree of vertical fiscal imbalance, the states should receive a guaranteed share of revenues from the broad-based consumption tax, and also raise their own income taxes. State income tax would be levied at a single rate by each state on a personal income tax base identical to that of the Commonwealth. States might apply different rates in order to achieve their own budgetary and spending objectives, but would not vary the tax base. The Commonwealth Government would act as a central collection agency in order to minimise compliance costs. Initially, the Commonwealth would reduce its own income tax rates in order that the new state income taxes do not lead to an increase in the total tax take.

A "piggy back" income tax of sufficient magnitude to both replace existing state indirect taxes and reduce vertical fiscal imbalance would consume a large slice of income tax revenues, to the extent that the problems outlined on page 19 could prove significant. Rather than relying solely on income tax, therefore, CCI proposes that the States should also be given a guaranteed share of the revenue from the Commonwealth’s broad-based consumption tax.

taxes on Income

In principle income tax conforms well with the criteria for an effective tax - it is equitable (indeed, it is the tax most suited to achieving progressivity), transparent and could be relatively efficient. Every major industrialised country has income taxes as the major, or one of the major, sources of government revenue.

The problems associated with income taxes in Australia relate to their application in practice, rather than in theory.

Australia has nine different methods of collecting income tax. In addition, a further five taxes are levied against remuneration or other income.

The complexity of the income tax system, the potential for avoidance and the range of taxes against similar tax bases greatly increase the compliance and administrative cost of the tax system. Australian PAYE taxpayers are amongst the most likely in the world to seek professional advice in completing their tax returns.

Marginal income tax rates for higher income earners are much greater in Australia than in many other countries, and high rates cut in at relatively low income levels. Yet because of the complexity of the system and the wide range of exemptions etc, high income earners have a range of opportunities to minimise their tax payments. This undermines the objective of progressivity and increases compliance and administrative costs.

Australia’s income tax thresholds have not changed since 1993. Since then, earnings growth has pushed first male average full-time weekly earnings (in 1995) and, more recently, total adult full-time average earnings above the $38,000 threshold at which a marginal income tax rate of 43 per cent kicks in. A man on full-time total average earnings would be paying 25.5 per cent of his gross wages in income tax in November 1997, compared to 23.0 per cent when the current rates and thresholds were introduced four years previously. Put another way, if he still paid 23 per cent of earnings his tax bill would be over $1,000 less.

One of the features of this phenomenon of "bracket creep" which is not always understood is that it is not necessary to move into a higher tax bracket in order to carry a higher average tax burden. For example total full-time female earnings, at $33,700 in November 1997, have not yet pushed into the 43 per cent marginal tax bracket. Nonetheless a woman on average female total full-time earnings would be paying 22.2 per cent of her income in tax in November 1997, compared to 20.1 per cent four years previously. As nominal earnings rise, a diminishing proportion of total income is either tax-exempt (the first $5,400) or taxed at the relatively favourable rate of 20 per cent (the next $15,500). So the average tax bill rises even though the marginal rate remains unchanged.

Employers report that high marginal tax rates are acting as a disincentive for employees, especially when offered overtime.

CCI advocates that Government should in future index all income tax thresholds to the Treasury’s estimate of the underlying Consumer Price Index.

This will act as a brake on the inherent tendency of income tax revenue to rise over time in real terms (although to the extent that wages are growing in real terms, so will tax revenues). This is the only measure in CCI’s tax reform policy which is not revenue neutral, and is proposed as a matter of sound fiscal policy. It should be matched by a parallel commitment to constrain the real growth of outlays.

However, the key objectives of reform of taxes against income are much broader, and should include:

  • To adjust marginal income tax rates so that they provide less of a disincentive to work, either through "poverty trap" effects on low to middle income earners or high marginal rates on those on higher, but not very high, incomes.
  • To simplify the system by reducing the number of taxes paid against income, harmonising tax bases (and in some cases, tax rates) and eliminating unjustified exemptions and opportunities for avoidance. Broadly, all types of income should be taxed in a similar way at similar rates.
  • To maintain equity across the whole tax system and progressivity in the income tax system including, if appropriate, adjustments to compensate for any regressive effects of increasing the indirect tax burden.

Poverty Traps and Disincentives

The extent to which these objectives are achieved will depend crucially on whether the tax reform process entails a shift in the overall tax burden from income to consumption, or merely rearrangement of the income tax structure.

Reducing marginal tax rates across middle income ranges, and eliminating poverty traps for low to middle income earners, will almost certainly require more money than can be raised through measures to broaden the income tax base. If Australia’s income tax structure is to be reformed as it should be, that money will have to come from elsewhere. The obvious answer is to set the rate of broad-based consumption tax at a level sufficient to allow reductions in the income tax burden as well as abolition of some indirect taxes.

In its survey of members, 90 per cent of respondents indicated that they would support a shift in the burden of taxation away from income and towards consumption – even stronger support than the 87 per cent of businesses which supported introduction of a broad-based consumption tax. Along with Payroll Tax, income tax attracted more comments than any other tax. The most common comments complained about high average and marginal tax rates and their disincentive effects.

Comments included:

"Both personal & company tax rates must be reduced - no incentive to expand of employ. Tax system encourages business & personal tax payers to stay below the threshold."

"consumption taxes must go hand in hand with a reduction in personal tax"

"PAYE tax thresholds need to be adjusted upwards and marginal rates reduced."

"Reduce direct income tax - Give PAYE employees greater income and choice to spend (to pay tax) or to save."

The precise magnitude of the financing task will depend on how reform of the income tax structure is addressed, how much compensation is necessary for low/fixed income earners if the tax mix shifts from income to expenditure, and how much is raised through measures to broaden the direct tax base. CCI is not in a position to make detailed recommendations on these issues. For this reason, we propose a broad-based consumption tax of approximately 15 per cent, although it may be a little higher or lower depending on the revenue necessary to achieve income tax reform.

Table 4

Range of Indirect Tax Rates

Minimum

Maximum

Either

% Not Answering Question

6.5%

6.6%

5.9%

% Responding "0"

1.0%

1.4%

0.9%

% Responding >0

92.5%

92.0%

93.2%

Analysis of responses other than "0" or blank

Minimum

Maximum

Average

Average

10.17

14.50

12.34

Lower Quartile

8

12

10.5

Median

10

15

12.5

Upper Quartile

12

15

13.5

Maximum

30

35

32.5

Minimum

1

1

1

Mode

10

15

12.5

Count

748

752

758

A tax of 15 per cent would be towards the top end of the acceptable range of a broad-based consumption tax reported by CCI members, but nonetheless within that range. Respondents were asked to specify the range of tax rates (minimum and maximum) they believed would be acceptable. The most commonly cited range was between a minimum of 10 and a maximum of 15 per cent (24% of all respondents specified both a minimum of 10% and a maximum of 15%). Some 41.2 per cent indicated a preferred tax range minimum of 10%, while 37.8 per cent selected a tax range maximum of 15%. Overall, the lowest (non-zero) rate cited was 1% and the highest was 35%.

Table 4 above shows the ranges and averages of "acceptable" rates of a broad based consumption tax reported by members in the survey.

Direct Tax Base Broadening

Some of the money to finance reductions in marginal income tax rates must be raised through a broad-based consumption tax. Broadening the existing indirect tax base is also likely to make a significant contribution.

Measures to broaden the direct tax base which could be considered by government include:

  • Reducing the opportunity for tax minimisation through income splitting, favourable taxation of trusts etc.
  • Increasing efforts to expose the black economy (it is likely that opportunities for tax evasion will anyway reduce somewhat if a broad-based consumption tax is introduced).
  • Restricting work-related deductions.
  • Reviewing other exemptions and deductions.

In addition, the government should consider using the $2 billion earmarked for the Savings Rebate Scheme to finance general income tax reductions (this was, after all, its original intent) and reviewing the payment of benefits and allowances for mid to high income earners – a process which in any event should form part of the process of reviewing marginal rates and poverty trap effects.

Company Tax

The survey of CCI members also revealed very strong support for equalisation of the top personal tax rate with the company tax rate, with over half ranking this as the direct tax reform they would most like to see achieved.

The difference in these rates encourages income-splitting and sheltering and other avoidance mechanisms, and means that the marginal rates faced by small business may be substantially higher than for large ones. The legal structure of a business will tend to be determined primarily by tax considerations rather than business fundamentals.

Reducing the top marginal rate of personal taxation is also consistent with the broader aim of reducing disincentives inherent in the income tax structure.

This aligned rate should apply to all economic entities regardless of legal structure.

Abolition of Company Tax

Remitted company profits are simply another form of income. The government should explore the possibility of abolishing company tax and dividend imputation and taxing profits in the same way as other income in the hands of the recipient at their appropriate marginal tax rate. This would be a simpler and fairer system than at present and would eliminate compliance costs on company tax.

However, the treatment of earnings remitted overseas would need careful consideration, as would Australia’s international and bilateral agreements for the tax treatment of dividends. It will not be possible to address these issues quickly, and so there is probably not time for the abolition of company tax to be included in the tax reform policy being developed currently.

Nonetheless, it deserves consideration over the longer term.

Tax Simplification

In addition to reform of income tax structures and rates, the tax base should be made simpler and more equitable. This should be achieved through the elimination of unfair, distorting or overly complex taxes and simplification of remaining taxes.

Payroll Tax

Although Payroll Tax is generally perceived as an inputs tax, it is raised against a base determined by employees earnings. This tax should be abolished (see Section 0 Replacement of Payroll Tax on page 11).

Fringe Benefits Tax

Fringe Benefits Tax probably ranks as Australia’s most administratively inefficient tax - the compliance costs it imposes on employers are massive, while the revenue raised is relatively small and largely offset against company tax.

In the survey of CCI members’ priorities for tax reform, Fringe Benefits Tax attracted as many comments as Wholesale Sales Tax as an impost businesses would like to be reduced. Given their relative values (WST raises around $13 billion, FBT just $3 billion) the fact that they are equally loathed is indicative of the unacceptably high compliance burden which Fringe Benefits Tax imposes.

There is a very strong equity case for taxing payment in kind as well as payment in cash, but the structure of taxation against fringe benefits in Australia defies any logic, including equity.

Australia and new Zealand are the only OECD countries in which tax on fringe benefits is raised from the employer, not the recipient.

In 1994 CCI published a review of Fringe Benefits Tax. It concluded that Australia's current arrangements for taxing fringe benefits breach virtually every established tax principle.

They are not horizontally equitable because they fall more heavily on some groups of employers and employees than others. The most obvious example is the travel and accommodation "benefits" of mining and some government employees in remote areas, which employers could not reasonably fail to provide.

They are regressive. Perhaps the most glaring example of regressivity is the salary-related allowances for travel benefits, but the most pervasive and pernicious effect derives from effectively taxing the fringe benefits component of low-paid employees' remuneration at the top personal tax rate.

They are not transparent, as the tax component of employees' remuneration is split between employer and employee, generating the illusion that fringe benefits are taxless for the employee.

Perhaps more important, the lack of transparency has allowed Fringe Benefits Tax to be applied to goods and services which employees probably do not regard as "perks", or which they value less highly than the taxation office.

They distort consumption patterns leading to allocative and dynamic inefficiency. Goods and services which could be provided to mutual benefit - for example because of employers' bulk purchasing power - are not tax-efficient except for high rate taxpayers.

And the favourable treatment of a few benefits - such as cars - encourages their use.

The one redeeming feature which Australia's system should have - administrative efficiency because of the relatively small number of business as opposed to personal taxpayers - is undermined by the complexity of some of the rules, especially relating to employee declarations, small value benefits and to car parking.

Fringe Benefits Tax arrangements should be substantially overhauled to address these problems. In devising a new structure, the following principles should be adhered to:

  • Taxes on all forms of remuneration - whether in cash or in goods and services - should be as near as possible identical regardless of the form of remuneration and regardless of whether goods and/or services are purchased by the employer or employee. Under the current system taxes on certain goods and services (such as motor vehicle use) are lower when provided by the employer than the employee, while taxes on other goods and services (such as medical insurance) are higher for the employer than the employee.

For example, Worsley Alumina Pty Ltd provides medical benefits for its 900 employees and their families at a total cost of $3.3 million, comprising $1.7 million in medical insurance costs plus $1.6 million in Fringe Benefits Tax. If its employees instead purchased their own medical insurance the tax cost would be much lower, both because many are not top rate taxpayers and because they would be entitled to tax concessions. Even so, it is likely that if Worsley did not offer this benefit, far fewer of its employees and their families would choose to purchase medical insurance. Not surprisingly, Worsley has expressed concern at the high FBT impost imposed on this benefit.

  • The taxation of fringe benefits should be transparent.
  • It should be born in mind that a fringe benefit's cost to the employer or its value to the employee might be significantly less than its market price. Where this is so, and where it is practicable to do so, the taxable value of the benefit should be discounted.
  • Goods and services should not be regarded as fringe benefits unless the employer could reasonably fail to provide them, or could reasonably remunerate the employee in cash instead of benefits.
  • Proper recognition must be made of the work-related uses of any "fringe benefit", such as cars, phones, computers etc.
  • Taxes should be applied in a manner which is efficient, and especially in a manner which is administratively efficient. That is, the cost of complying with the legislation should not be disproportionately high relative to the revenue collected.

Applying these principles, tax on fringe benefits should be paid by the employee not the employer, and should be taxed as part of that employee's remuneration - that is, it should be paid at the employee's personal marginal income tax rate. Any tax concessions available to individuals purchasing goods and services (such as medical insurance) should apply equally if the employer provides that good or service as part of their remuneration package.

This would have the advantage of making the tax system progressive and equitable in the relative treatment of different forms of remuneration, and also increase transparency. Compliance costs would be shared more fairly between employer and employee.

Other things being equal it should decrease rather than increase the tax on employees' remuneration, because employees on other than the top personal income tax rate would have a lower tax liability than is currently imposed on their employers.

However, any loss of revenue could be offset by increasing the effective tax rate on those few items which are currently treated relatively favourably (notably motor vehicle use).

Its key disadvantage could be that it might increase administrative complexity by increasing the number of taxpayers. However, this should be offset by substantial simplification of arrangements for taxing benefits.

Indeed, the fact that employers not employees are responsible for remitting Fringe Benefits Tax might well have been a cause of administrative inefficiency, as it appears to have encouraged the government and the tax office to broaden the FBT base and apply compliance requirements far beyond what could conceivably be imposed on individual employees.

Fringe benefits should be more tightly defined to include only those things which can be legitimately regarded as remuneration. This should encompass the following principles defining fringe benefits:

  • they entail a significant and measurable benefit to the employee, and the basis for tax payments should be a realistic approximation of the actual value of the benefit to the employee. Goods and services which are not convertible may be of limited value to the employee, and that value may be hard to ascertain;
  • they entail a significant and measurable cost to the employer;
  • they are goods and services which are not necessary for the conduct of an employee's work, and not used exclusively in the course of employment; and
  • they are goods and services which an employer could reasonably not provide, ie they are convertible within the remuneration package to cash rather than goods and services.

If these principles were applied then it is likely that several currently taxable items would drop out of the tax net, notably the accommodation and travel "benefits" provided for employees working in remote areas, car parking, travel benefits etc.

Medicare Levy

The Medicare Levy raises only a small proportion of the Government’s health costs. It is not tied to particular health expenditures. Although levied at a relatively low average and general rate, it cuts in at extremely high marginal rates for some low income earners as their taxable incomes increase. Because it is levied at a flat rate and cuts in at relatively low earnings, it diminishes the progressivity of the income tax system.

In some circumstances, hypothecated taxation is justified as a means of effectively imposing user charges on consumers, or to finance programs aimed at compensating for the effects of consumption (for example, the links between some State governments’ tobacco franchise revenues and spending on health promotion).

In the case of health, there is no such justification. The government’s spending on health is not, and should not be, directly and proportionately linked to changes in the size of the income tax base.

Access to public health services is not, and should not be, linked to the amount of Medicare Levy which individuals pay.

The current levy encourages taxpayers to under-estimate the actual cost of health spending, because it is notionally charged to meet health costs but in reality covers only a small percentage of those costs.

The Medicare Levy should be abolished and rolled into the income tax base.

Superannuation Surcharge

The Superannuation surcharge has proven a nightmare to administer and will raise very little revenue, in part because many of its intended targets will avoid it through tax minimisation mechanisms such as salary sacrifice. It should be abolished.

Lodging of Tax Returns

In some European countries a system of interest withholding taxes and standard revenue and deduction profiles is used, under which individuals and small businesses are not required to lodge a tax return. Such a system would greatly reduce compliance costs, and should be introduced unless the likely loss of revenues proves unsupportable.

FISCAL POLICIES

After many years of persistent government deficits, there is now a real prospect that the Commonwealth will return to underlying surplus next year, with surpluses projected to rise over the next few years according to the forward estimates (see Figure 6 below). This has prompted some interest in the notion that the government might use some of these anticipated surpluses to finance tax cuts.

CCI would strongly oppose such a move.

The current financial year is the seventh successive year in which the Commonwealth Government has been in underlying deficit. This represents the longest phase of underlying deficit in modern economic history. Since 1990 Commonwealth general government debt has risen from $30 billion to over $100 billion, or from 8% to 20% of GDP. The interest bill on Commonwealth government debt in the current financial year is estimated to be $9.6 billion, compared, for example, to outlays on education of $10.8 billion and outlays on defence of $10.5 billion.

The government is fortunate that this rapid expansion of debt occurred over a period when interest rates in Australia and worldwide were at historically low levels. Had interest rates remained at their levels of the late 1980s – or if they were to return to those levels in future – the task of servicing government debt would be considerably harder.

By domestic standards the growth in government debt in recent years looks dramatic, but it is worth bearing in mind that, by international standards, Australia’s government debt still looks quite modest. Many European governments have run persistent deficits for far longer, and have hence accumulated a much greater stock of debt, than is the case in Australia. As a result, their debt servicing costs are much higher.

This does not mean that Australia’s recent fiscal performance is no cause for concern.

As discussed in section 0, one of the reasons why Australia raises less in tax as a percentage of GDP than other OECD countries is that its debt servicing costs are lower. This is an advantage which Australia should be anxious to keep.

CCI has three key concerns with the accumulation of debt over recent years.

  • It reduces the Government's ability to deliver services, and introduces greater uncertainty into the fiscal outlook. As noted above, if it did not have to pay interest on outstanding debt, the Government could roughly double its education or defence spending. Further, it leaves the Government more vulnerable to shifts in the financial environment. Domestic and overseas interest rates are at historically low levels. If rates return to their average levels of the 1980s, then the Commonwealth Government's interest bill would be significantly higher. There are good reasons to believe that inflation and interest rates will remain relatively low worldwide, but no guarantees.
  • Borrowing to finance recurrent expenditure forces future taxpayers to pay for services which were delivered to previous generations in the community. This is both inequitable and regressive, as the future beneficiaries of current government borrowing (those who own government securities in their own right or hold shares in the financial institutions which buy them) tend to be fewer in number and more affluent that the population of taxpayers or the community at large.

The Government does not use accrual accounting, so it is difficult to measure precisely how its overall balance of assets and liabilities have changed in recent years. But the overall pattern of its spending - strong growth in current expenditures, accelerating debt and a decline in capital spending - suggest that its accumulation of liabilities has far outstripped its accumulation of assets.

  • By far the most important reason is the need to raise national savings. The level of private savings and the level of Australia's net foreign liabilities are worse than they were 12 years ago, when then Treasurer Paul Keating made his famous speech on the dangers of Australia becoming a "banana republic". Low private savings persist despite the record of consistent economic growth in recent years, and measures such as the Superannuation Guarantee Charge designed to increase private savings.

If Australia is to be able to afford adequate investment levels without further accumulation of substantial foreign liabilities, the public sector will have to make a positive contribution to national savings.

For these reasons, the tax changes outlined in this document are designed to be broadly revenue neutral, with the exception of indexation of income tax thresholds which is a matter of sound fiscal management and should be matched by a parallel commitment to constrain real growth in outlays. CCI views the objective of achieving and sustaining a positive contribution to national savings from the Commonwealth Government to be too important to sacrifice for tax cuts.

It is also worth pointing out that, while rising surpluses are projected on current forwards estimates, these are not forecasts. Recent history demonstrates that budget outcomes can differ markedly from forecasts even over a relatively short period of time, and the margin of error rises the further out you get. It is utterly unrealistic to expect no change in government revenue policies or expenditure programs, yet this is the key assumption which underpins forward estimates. The Budget for the current financial year is likely to be in underlying deficit.

At the very least, the government should wait until underlying budget surpluses actually materialise before spending them. A more prudent course would be for the government to adopt an explicit policy of the restoration of structural surpluses (that is, an underlying surplus averaged over the course of the business cycle).

The government should not compromise its policy of fiscal responsibility in order to finance taxation reform. Debt reduction should remain a high priority. Substantial reductions in the total tax take should be considered only when a structural budget surplus has clearly been restored and/or if accompanied by corresponding reductions in outlays. The cyclical surpluses indicated in current forward estimates have not yet materialised and, if they do, they may not persist in less favourable economic conditions. They should not be used to finance taxation cuts.

OTHER TAX REFORMS

This section outlines other reforms which CCI would like to see included on the tax reform agenda.

Fuel Excise

Fuel typically attracts effective rates of taxation in excess of 100 per cent, making it the second most highly taxed substance in Australia after tobacco, and significantly more highly taxed than other goods and services subject to high taxes such as luxury cars, alcoholic drinks or gambling.

As discussed in section 0, relatively high rates of taxation on particular goods and services can be justified on economic grounds if they are associated with "externalities". In the case of fuel use, these externalities comprise the costs to the community associated with fuel use, and in particular, motorised transport. This encompasses both the direct costs to governments of building and maintaining roads and related infrastructure, and the indirect costs to the community as a whole arising from environmental impacts and pollution, health effects, road accidents etc.

Other features of the tax structure also recognise this cost-related aspect of fuel taxes. For example, the differential rates of tax on leaded and unleaded petrol are designed to reflect the claimed contribution of leaded petrol to environmental pollution.

To the extent that these externalities exist, they justify the imposition of a higher rate of tax on fuel than on other goods and services.

However, they do not justify arbitrary or excessive tax levels on fuel. The extent to which fuel taxes are higher than the general rate of tax on goods and services should at least approximately reflect the externality costs which fuel users actually impose on governments and the community.

CCI urges the government to conduct a review of the direct and indirect externality costs associated with fuel use, and to use the findings as the basis for establishing a defensible level of fuel excise.

If externality costs provide the justification for relatively high taxes on fuel, it follows that fuel users who do not impose those externalities should not be subject to penal rates of tax.

This is the justification for the current diesel fuel rebate, which recognises that primary producers mainly use diesel for powering vehicles not operated on public roads, or to fuel other equipment. The environmental and, especially, road construction and maintenance costs they impose on the community are lower than for other users.

This process of exempting users who generate relatively small externality costs should also feature in any revised fuel tax structure, and should be extended to other, similar, users. In particular, the Government’s decision to tax light fuel oil used in electricity generation has had a substantial impact in regional Western Australia and added $20 million to the cost of generating electricity in remote areas and small population centres.

The case for exempting light fuel oil used by Western Power to generate electricity for remote communities is identical to the case for exempting diesel fuel used by mining companies to generate electricity on remote mine sites.

Capital Gains Tax

Capital gains tax is a tax on investment. It draws no distinction between short-tem speculative gains and longer-term investment, and is overly complex.

The Government should retain Capital Gains Tax for speculative gains (say, held for 5 years or less) but taper the rate of tax downwards towards zero over time for non-speculative assets. Such a move would also have the considerable advantage of harmonising the tax treatment of pre and post 1985 assets.

Superannuation and Saving

Different forms of saving and investment attract different types and levels of taxation in Australia. These differences make the tax system highly complex, encourage saving and investment decisions driven primarily by the desire to minimise tax, and generally create inequity between different savers. It is particularly notable than the most tax efficient forms of saving and investment (superannuation, home ownership, negative gearing etc) tend to be most intensively used by relatively high income earners, while savings vehicles readily available to those on low incomes (such as savings accounts) are taxed relatively highly.

Superannuation is now a key savings vehicle in Australia, and likely to increase in importance. The Government should move over time towards restoring superannuation taxation towards tax on payments out rather than on contributions.

More generally, the Government should adopt similar taxation levels and processes for all savings and investment vehicles. Many of the complexities embedded in the current tax system arise from efforts to treat different forms of saving and investment differently for tax purposes, and to control potential abuses of the relatively favourable tax treatment of some saving/investment vehicles.

APPENDIX: WELFARE EFFECTS OF TAXES

The illustrations below show the impact of two forms of taxes. In the first, the initial (untaxed) market equilibrium has a consumer spending all of her income ($400pw). With the existing supply curve, the market equilibriates at demand of 10 units and a price of $40.

If the government imposes a tax on the consumer's income which raises $160, the consumer has disposable income of $240 and can now afford to buy only 6 units at the initial market price of $40. At a price of $40 supply exceeds demand. The market equilibriates at a price of $30 and supply and demand of 8 units. In real terms the consumer is worse off by 2 units, while producers' revenue falls from $400 to $240 (equal to the fall in the consumer's disposable income).

Now suppose that the government wants the tax "burden" to fall on business, not consumers, so it applies a tax of $20 a unit on businesses rather than consumers. Producers attempt to pass on the higher cost as higher prices, but at the old price plus the tax ($60), demand is less than supply.

The market equilibriates at a new market price (including tax) of $50. Consumption falls by 2 units to 8 units. Businesses collect gross revenue of $400, but of this $160 (8 x $20) is remitted to government in tax, so net revenue falls to $240 (8 x $30).

The effects of a tax on consumption are identical to those of a tax on production.

This simple economic analysis is central to the concept that there are few if any net welfare benefits from manipulating the tax base to reduce the number of taxpayers. Whether a tax is collected from all producers, from some producers or from consumers, consumers and businesses ultimately share the costs.