National Observer Home > No. 62 - Spring 2004 > Article

The Tax Wilderness: How to Restore a Viable Tax System

Professor Geoffrey De Q. Walker

In issue 61 Professor Walker discussed the parlous state of Australian taxation law and administration. In this article he discusses the steps that should be taken to create a satisfactory system.

To have any significant impact on the present morass of disincentives, distortions and non-cooperation, effective reform must include substantial reductions in the personal income tax burden. The modest cuts delivered so far are too small to affect incentives. A good place to start would be the tax-free threshold (T.F.T.) or zero rate step. At present, liability to income tax begins at an income of $6,000 per annum. That is less than half the annual dole of $12,370 (including rent assistance for a single person) or just over a quarter of the federal minimum wage of $22,400. In 1980 the T.F.T. was $4,441, which in today's dollars would be $14,000, and in 1960 a family on average weekly earnings paid no income tax at all. The same was true in 1943, when the government was funding a full share of the greatest war in history. For comparison, the French T.F.T. today is 15,000 euros ($25,000).

The current $6,000 threshold is of course modified by various offsets, but they are of little consequence. The Low Income Tax Offset, for example is worth a maximum of $150 at an income level of $20,701 and tapers off to zero at $24,449. Like all other offsets, it does not apply at all if it would result in a tax refund. The maximum Family Tax Benefit for two children (Part A) raises the threshold only to $6,400, while even for six children, Parts A and B combined increase it to no more than $13,900, or less than the real T.F.T. level in 1980, a derisory concession given the cost of raising and educating six children. Being means-tested, it operates as a disincentive to work, whereas a higher T.F.T. would not.

Although raising the T.F.T. would benefit all taxpayers, not just the lowest earners, it would be hard for the Senate opposition to block it, as public opinion clearly favours such a change. An A.C. Nielsen/Centre for Independent Studies survey of 5,721 Australian residents in March 2003 found that 43 per cent favoured a threshold equal to the basic welfare level ($12,370), while 35 per cent preferred the federal minimum wage level ($22,400). Only 13 per cent were satisfied with the present position.

Next, the rate structure must be overhauled. It must be hard for citizens to feel any respect for a system under which, as now, a worker on close to the average weekly wage pays a marginal rate of 42 per cent. And with the next step starting now at $70,000, an absurdly low figure by world standards, such modestly remunerated people as schoolteachers and nurses are joining Kerry Packer in the top bracket, which now catches one taxpayer in five.

To reverse the brain drain, promote growth and restore the ethic of compliance, the top marginal rate should be cut to 30 per cent and should commence at a much higher level than the present $70,000. Corresponding adjustments to the other rates would be needed. A top rate of 30 per cent would match the company tax rate and would permit substantial administrative simplification. It would make the nation competitive in the race for internationally mobile capital and skilled labour, as a 2002 I.M.F. assessment of the Australian economy argued. It would also help to reduce Australia's high tax enforcement and collection costs.

The need for internationally competitive company tax is now generally accepted. It is time to face reality on personal tax as well. There is no point in comparing Australia with the tax hells of the Old Europe, as the revenue lobby does. Australia's tax rates may not look heavy by that standard, but Europe's high taxes have led to seemingly insuperable stagnation and some governments there are now introducing significant reforms. In any case, our immediate competitors are not in Europe but in the Asia-Pacific region where tax burdens are much lighter.

Because of their effect on incentives, large tax cuts need not lead to the commonly predicted revenue shortfalls. The Reagan administration's 1981 reduction of the top rate from 70 to 50 per cent was denounced by academics and the media as an outrageous handout to the rich. The Internal Revenue Service predicted a $1 billion drop in collections from high earners in 1982. The reverse happened. Money poured out of avoidance schemes into taxable forms of activity. Non-withheld tax receipts, mostly payments by the affluent, rose from $76 billion in 1981 to $85 billion in 1982 and continued to rise in 1983. Instead of a $1 billion drop in tax receipts there was a $9 billion rise. In the midst of an economic downturn, a 20 per cent cut in the top tax bracket had brought an 11 per cent increase in revenues from the rich. The further reduction of the top rate in 1986 from 50 per cent to 28 per cent (plus social security levy), paid for by reducing deductions, was likewise successful. Similar results were reported from rate reductions in Japan, Hong Kong, Singapore, Austria and Britain, while rate increases brought disappointing gains or unexpected losses.

A spectacular recent example is Russia, which in 2001 abandoned its "progressive" rates and adopted a 13 per cent flat tax on personal income. The lower rate, limited deductions and simpler system have produced vastly more revenue, with a 50 per cent real increase in the first two years and overall economic growth of 10 per cent. Over three years, income tax collections as a percentage of G.D.P. have increased from 9 per cent to 16 per cent. Small business has a choice of either paying a 6 per cent flat tax on their revenues or a 15 per cent flat tax on their profits. Russia now has a budget surplus and the best tax laws in Europe. China is reportedly considering copying the Russian model.

The most recent illustration can be seen here in Australia, where the federal parliament's slashing of the company tax rate from 39 per cent to 30 per cent has been followed by a sharp increase in revenue from that source. Indeed, higher company tax receipts were largely responsible for the $7 billion budget surplus announced in September 2003. While economic growth was a major reason for the higher company tax collections, it is also likely that part of that growth itself stemmed from the incentive effects of the rate cuts.

At present even the modest reforms linked to the introduction of G.S.T. have been largely blocked. The opposition in the Senate has rejected the lifting of the top rate threshold to $75,000. A diluted version of the superannuation surcharge reform was allowed through only because it was cynically understood that the minor tax cut involved would soon be negated by bracket creep. It is perverse that Vladimir Putin, a former head of the K.G.B., has given Russia a liberal, incentive-building revenue law while Australia still suffers under a tax regime based on class warfare ideology.

Some politicians and columnists incorrectly claim that Australians actually want to pay higher taxes so as to expand the welfare state. The Australian Council of Social Service (A.C.O.S.S.) supports high marginal rates. Some believe that this position, which seems to have little to do with the activities of the bodies A.C.O.S.S. represents, is based on the belief that high marginal rates increase the incentive to give money to charity, a doubtful assumption. The advocates of higher taxes usually argue that the additional revenue could be raised by "soaking the rich". The scope for that is limited, however, as the top 30 per cent of earners are already paying 68 per cent of the tax, and capital is highly mobile today.

The public plainly favours lower taxes over higher spending by a ratio of three to one, as even some commentators who favour higher taxes, such as Fred Argy and Peter Saunders (of the Social Policy Research Centre), are forced to admit. Further, in a public opinion poll at the time of the 2001 federal election, twice as many people expressed an unprompted desire to reduce taxes than wanted to tackle inequality, and when respondents were asked what the federal government could do that would most benefit them and their families, tax change - not redistribution - dominated people's answers.

These findings are especially striking when one considers that in recent years there had been virtually no public debate on the possibility of substantial federal tax cuts. It is in the personal interests of politicians to expand government rather than cut taxes because government spending programmes are targeted, while the benefits of tax cuts are smaller and more widely dispersed. Substantial tax cuts are thus not in the platform of any major political party. Many people must have abandoned hope of any significant easing of the fiscal burden as a realistic possibility. Consequently, the underlying potential voter support for serious tax reform could be much stronger than those findings indicate.

There are two developments that may strengthen this public support still further. One would be if housing and other asset values were to deflate significantly. In that event popular opinion could quickly become highly critical of high-taxing governments. As a slump in asset values would be painful for many people, one would not wish to see it occur, let alone make it more likely. But if it happens it will concentrate the public mind.

The other development would be a growing public realisation that there is much more scope for reducing the fiscal burden of government than has previously been thought. This is already happening, in the following way.

Controlling Welfare Spending

As Michael Brooks and John Head point out, controlling public sector growth is a key issue in the tax debate. The largest single head of public spending is social welfare, which accounts for 29 per cent of government outlays, federal, state and local. Federal welfare payments alone swallow 10 per cent of G.D.P.

Since the 1960s the real national wealth, at all levels of income, has doubled. Yet during that period government spending on welfare benefits and services has increased five-fold in real terms, and reliance on welfare support as the sole or principal source of income has increased from 3 per cent to 14 per cent, or one in every seven working-age adults. The welfare state now employs almost one-fifth of the Australian labour force. Probably almost all Australians are willing to pay tax to maintain a welfare safety net, if only out of far-sighted self-interest - financial misfortune could strike almost anyone. But public support for welfare policies should not be confused with support for enforced equality of outcomes. In the 2001 survey, only 2 per cent of respondents listed greater egalitarianism as a preferred government policy, an unsurprising result when 95 per cent of full-time earned incomes already fall below double average weekly earnings. The Australian ideal of equality and the "fair go" has more to do with the idea of equal rights (equality before the law) and equal status (no-one is more worthy than anyone else) than with support for equality of incomes or wealth. It certainly does not mean that those who choose not to work are entitled to live off the earnings of those who do. As Peter Saunders and Kayoko Tsumori put it in a significant recent work, "Willingness to help those who are thought to be in need does not indicate enthusiasm for a general programme of income redistribution."

Since the 1970s, however, the welfare industry has manoeuvered the public into acquiescing in a colossal expansion of the social welfare budget by building a massive structure of unexamined claims on a foundation of dubious premises and fallacious arguments. The main source of misconceptions and false logic has been the welfare industry's definition of "poverty" itself. Most Australians (over three-quarters in fact) define "poverty" as a lifestyle below subsistence level, an inability to acquire the basics of food, clothing and shelter. That state is what is known as "absolute poverty". Australians will strongly support any domestic programme that is presented as being needed to remove "poverty" in that sense, especially child poverty. But as it is agreed on all sides that absolute poverty scarcely exists in Australia, the welfare lobby since the 1970s has instead focussed on poverty defined in a relative way, that is, inequality rather than poverty.

The conditions now exist for a fundamental reappraisal of the welfare system. Recent scholarly re-evaluation of the concept of poverty and other issues shows great potential and support for slimming the public sector and reducing the tax burden. But any reform proposals face determined opposition from vested interests, especially the welfare industry. That group is also in denial about the spectacular success of the Clinton administration's 1996 legislation aimed at reducing the number of lone parents living on welfare, which cut numbers on the welfare rolls by 58 per cent in the first three years, while the critics' predictions of a humanitarian disaster were falsified. The 1996 U.S. legislation stands as one of the few examples of a social reform that has actually achieved its objectives.

The Australian welfare lobby is strongly opposed to learning from the United States' success, arguing among other things that Australia's unconditional welfare approach helps to prevent crime and foster social cohesion. Yet since 1996 American crime rates have been falling sharply while Australia's have continued to rise. Crime rates in the United States are now lower than Australia's for all crimes except murder, and even for murder the difference, on a true comparison, is small. Classic sociological indicators of social malaise (crime, divorce, drug abuse, mental illness and so on) were all much lower before the welfare state expanded. The experience of receiving government aid is widely recognised as alienating, stigmatising and disempowering, while the experience of being forced to pay into the system promotes, not altruism, but suspicion of others and anger at being exploited by "bludgers".

Conclusion: Where to from here?

In the realm of federal taxation the rule of law has all but been replaced by a system of direct bureaucratic rule. The separation of powers has broken down and key institutions have been compromised. The legislation has become unmanageable, unintelligible and unpredictable, the executive exercises legislative and quasi-judicial powers, the judiciary exercises policy-making powers and, in a variety of ways, the law is changed at the point of application. Major taxpayers increasingly treat the enacted law as irrelevant and acquiesce in the A.T.O.'s assumption of the role of supreme deciding authority. None of this was inevitable: in Britain and the United States the rule of law still largely applies to the tax system.

On current indications the chasm between Australian federal taxation and the rule of law is likely to widen. The Integrated Tax Design concept currently being trialled by the A.T.O. for possible general adoption contemplates that the law should no longer attempt to deal with complex situations. These would instead be directly regulated through administrative rulings. Specific anti-avoidance provisions binding on all taxpayers would be replaced by "compliance strategies" targeted to the "risk profile" of various "users". It does not take much legal imagination to see where that approach is likely to lead.

It is well understood today that the rule of law and healthy institutions of government are essential for long-term economic growth. Failure to uphold those ideals in the tax arena is producing major disincentives and distortions, including a massive and flourishing underground economy, a brain drain and a tax-driven property bubble that has given Australia the world's highest housing prices relative to income and is deterring overseas capital inflows.

Perverse incentives pervade the present system, which creates disincentives to work, learn, save, risk, innovate, create wealth, support charity and procreate - in short, most worthwhile human activities. It deters skilled people from moving to Australia and deters skilled Australians from staying here. It handicaps workers who have to compete internationally and rewards the devious and the indolent. There is an old saying, and a true one, that people will work not to pay taxes but will not work to pay taxes. "They no longer do what is useful to others and hence profitable to themselves," writes Professor Kasper, "but are instead guided by avoiding government-made obstacles, bending rules, seeking preferments, bribing officials and dissimulating their wealth". According to the O.E.C.D., Australia's tax system is the fourth worst in the developed world for rewarding effort.

In a global economy nations have no choice but to compete for highly mobile capital and skilled labour, and tax law is an important part of that competitive market. "Tax competition is a healthy and natural economic process that weeds out stupid or inefficient taxes", writes A.N.U.'s Dr Terry Dwyer: "There is nothing wrong or immoral about sovereign countries competing for investment by offering differing legal and economic regulatory systems. That is how human beings learn from each other. That is how the world discovered that communism was not such a good economic system." The Commonwealth has faced the reality of tax competition in relation to company tax, but not personal scales; it would be hard to find a tax structure more "stupid or inefficient" than one that taxes a worker on average weekly wages at a marginal rate of 42 per cent. As the I.M.F. recently reported, "Lower personal income tax rates would boost work incentives and foster the development of a higher skilled work force by increasing returns to human capital ... [I]n an increasingly globalized economy, Australia will have to remain competitive to retain the services of its best and brightest people."

To be effective, any programme to restore the rule of law in the tax field must therefore start from these propositions:

1. Reviving the rule of law in the tax field requires positive incentives

Tinkering with tax legislation and procedures will not revive the rule of law or restore government institutions to their proper roles. Curtailing discretionary powers, rewriting the legislation or other symptom-oriented solutions that do not tackle the underlying enforcement versus resistance dynamic will only cause the confronting pressures to break out elsewhere in the system. True reform will need to be substantial enough to change the pattern of incentives so that, as in the 1950s and 1960s, most people will voluntarily meet their obligations and enforcement pressure is needed only to deal with the greedy few. The rule of law can operate only where most people are willing to obey the law voluntarily most of the time. That proposition has been promoted for decades by the political-intellectual elite in such contexts as drug law, pornography and abortion; it is time to recognise that it applies at least as well to revenue law.

2. Changing the pattern of incentives will entail substantial tax rate cuts

The personal tax cuts of recent years have been too small to affect the pattern of incentives, which is why they are seen as so "costly" from the Commonwealth's viewpoint. They make only trivial inroads into the effects of the massive bracket creep caused by the inflation of the 1970s and 1980s. To be internationally competitive, Australia needs, for example, to raise the tax-free threshold to $14,000 (its 1980 level, in real terms) and cut its maximum rate to the 30 per cent level recommended by the I.M.F.

3. Large rate cuts need not cause revenue loss

Experience shows that such large reductions need not cause a loss of revenue and usually lead to increased collections (as has happened in Australia following the substantial cut in the company tax rate). That observation long antedates the insights of supply-side economics. The 14th century Arab philosopher-statesman Ibn Khaldun stated it in 1377 in his pioneering work of scientific historiography, The Muqaddimah. "At the beginning of the dynasty," he wrote, "taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments".

The Australian revenue lobby persists in treating rate cuts as a zero sum process in which a gain to the taxpayer constitutes an equal loss or "cost" to the government. But revitalisation of the economy, with more income to divide between the big earners and the rest, is the point of the tax reform. It is better achieved via cuts in personal rates than through special tax packages for business, which share some of the weaknesses of other special interest wealth transfers.

Stronger growth, and thus larger tax collections, will result whether tax cuts apply to the top brackets or across the board. The former approach favours high incomes, on the basis that entrepreneurs in that bracket are the ones who will create new jobs. The latter, more politically acceptable approach should benefit all wage earners, moderate wage demands and generally lower business costs.

4. Tax indexation must be restored

A vital part of any reform programme must be the immediate restoration of tax indexation, the lack of which is the main cause of our current misfortunes. Even the present cumulative inflation rate of 3 per cent, while low by the standards of recent decades, is high by those of history and, if not compensated for in tax scale adjustments, will over time effect a substantial transfer of resources from the people to the government. Leviathan must not be allowed to profit from his own wrong, silently debasing the currency so as to drive lower-paid workers into higher brackets. This reform also has the advantages of having little immediate impact on budgeting and of being almost impossible for the opposition in the Senate to reject. Research shows that tax indexation, even on its own, measurably reduces non-compliance.

Tax indexation should be a statutory, automatic mechanism similar to that introduced by the Fraser government, rather than a "manual" process as in the United Kingdom, where thresholds are raised each year in the budget as a matter of practice and convention.

5. Welfare reform should accompany tax reform

At the same time, recent research has uncovered wide scope for reforming the social welfare system, which is the largest single head of public spending. As currently structured it is producing a steady increase in welfare spending that is unsustainable, especially in a country with an ageing population. "With the astounding rate of growth achieved across all Western countries over the last 60 years", Saunders and Tsumori conclude, "most of the population is now in a situation where it could cope more-or-less unaided if only taxation levels were not so crippling."

Surveys show that a large majority of Australians favour tax reform and a welfare system that is based on mutual obligation and caters for genuine need, not one based on fallacious, ideologically-driven definitions and assumptions. The potential is there for substantial improvements in Australia's institutional structure and competitive position if the reform process can be shifted from its present narrow focus on purely technical improvements to a broader, more principled perspective. For, as the Thomson A.T.P. tax writer Terry Hayes comments, "reform never really got started in a meaningful way for the vast majority of taxpayers."

Now, however, the beginnings of a public debate can be heard. There is talk of a higher tax-free threshold, flat rates and abolishing returns for most workers. We are hearing less of the notion that Qantas flight attendants earning $65,000 or Holden night-shift assembly workers on $72,000 are plutocrats who deserve outright fiscal punishment. "The incentive system is all wrong," complains Mark Latham. "The hard workers are being punished while the rorters are being rewarded . . . For the people who do the right thing in our society, the system is crook." Australia faces a once in a generation opportunity to opt for fairness and growth. It must not be allowed to pass us by.

Complete footnotes to this article are available from National Observer.

National Observer No. 62 - Spring 2004