Australia's tax structure is unsustainable

Australian Treasury Secretary, Dr Martin Parkinson, delivered a speech yesterday claiming that Australia’s tax system is unsustainable and arguing for comprehensive tax reform.

First, Dr Parkinson outlined the medium to long-term pressures facing the Budget, namely the falling terms-of-trade and the ageing population:

…we are now at a critical point in the [mining] boom’s evolution. Prices for commodities peaked in 2011, and we are likely to have just passed the peak in capital investment…

The declining terms of trade will heavily influence the medium term outlook for average incomes…

In addition, the ageing of the population will place downward pressure on income growth from increasing workforce participation…

This chart shows the sources of growth in per capita incomes over the past half century, and two scenarios.

– If we assume labour productivity grows at its long-term average, then incomes will grow on average over the decade ahead by around 1 per cent per year, or less than half of the rates to which Australians have become accustomed.

– To achieve average income growth in line with its long-term average, we will need sustained labour productivity growth of around 3 per cent. This is significantly more than in the past and around double what has been achieved since the turn of the century…

Dr Parkinson then turned his sights to the unsustainable structure of Australia’s tax system, which has become excessively reliant on taxing corporate and personal incomes – a problem that will only worsen over the coming decade:

It is hard to overstate the need for reforming the tax system. If our public finances are not placed on a sustainable footing, tax reform becomes more difficult as time passes.

Our tax mix is heavily weighted toward direct taxes on income — personal and corporate. If we were to leave our tax rates and bases as they are, our reliance on income taxes would grow over time.

We will move even further in this direction if, as we anticipate, the relative share of total indirect taxes continues its long-term decline, including the GST. Part of this effect can be seen in the increase in the share of revenue raised from personal income tax (a result of fiscal drag).

Fiscal drag [bracket creep] will pull someone on average full-time earnings into the 37 per cent tax bracket from 2015-16, and will increase the average tax rate faced by a taxpayer earning the projected average from 23 to 28 per cent by 2024-25 — an increase in their tax burden of almost a quarter.

If fiscal drag is not periodically returned in the form of personal income tax cuts, it can reduce incentives for workforce participation at low levels of income, and increase incentives for tax minimisation at higher levels of income.

There are similar implications for corporate income tax. Over recent decades, the clear international trend has been for countries to lower corporate tax rates and broaden bases…

One of the key issues of the reform debate will be the competitiveness of our corporate tax system and our capacity to attract mobile global investment…

Unfortunately, Dr Parkinson did not offer any concrete tax reform suggestions, but rather an acknowledgement that “reform is difficult” and “without conscious change, the economic cost of raising tax from our current tax mix will increase” over time. He also noted that “for the community to embrace change in this area, the case for reform has to be compelling and well-understood”.

Regular readers will know that I agree wholeheartedly with the themes outlined by Dr Parkinson above, and believe that broad-based tax reform is essential to place the Budget on a sustainable footing and improve the nation’s productivity.

In particular, the increasing tax burden on workers is a particularly deleterious situation, in light of the ageing of the population and rising age-related spending. Without reform, a diminishing pool of workers will essentially be required to pay higher and higher taxes to fund the public investments and programs that we all enjoy.

This is neither equitable, since wealthy older Australians have effectively been cast outside of the tax net, nor efficient, since taxes on productive effort (both labour income and corporations) carry very high “marginal excess burdens” (i.e. a big loss in consumer welfare relative to the net gain in government revenue), according to the Henry Tax Review (see next chart).

By comparison, the Henry Tax Review found that indirect taxes, the GST, and taxes on land and resources have much smaller marginal excess burdens, and would therefore confer productivity gains to the economy if the tax base was shifted away from productive enterprise and onto these sources, along with adequate compensation for the poor (in the case of raising/broadening the GST).

Reform of this nature would also broaden the tax base – since virtually everyone would be captured in the tax net – and would be far more equitable than making the diminishing pool of workers shoulder the lion’s share of the tax burden.

Any tax reform program must also address Australia’s world-beating and poorly targeted tax expenditures – including superannuation concessions and negative gearing – which are starving the Budget of crucial revenue and are broadly inequitable.

In particular, there is a very strong case to limit superannuation concessions, which have increasingly become a mechanism for richer older people to avoid paying tax, rather than a genuine means for Australians to pay for their own retirement and avoid drawing on the Aged Pension.

The cost of superannuation concessions, which overwhelmingly flow to high income earners, as well as the tax free treatment of superannuation once one turns 60, are ripe areas for reform, both on Budget sustainability and equity grounds.

There are also very good reasons to quarantine negative gearing losses, so that they can only be applied against income from the same asset, as well as removing the capital gains tax concession on investments (why should they be taxed at a lower rate than income?).

The key issue is that reform broadens the tax base and shifts it towards more efficient and equitable sources. Again, this requires a shift in sources from productive effort (e.g labour) towards taxes on land, resources, and consumption, along with the closure of generous taxation concessions favouring the old and the asset rich.

But simply relying on never-ending increases in personal income tax via bracket creep, while the base of workers shrinks as the population ages and the proportion of retirees rises, is neither efficient, equitable or sustainable in the longer-term.

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Australia’s tax structure is unsustainable