Opinion & Commentary
Tax reform should include cuts to marginal rates
With the recommendations of the Rudd government’s tax review (the Henry review) completed but still under wraps, we are left to interpret the smoke signals coming out of Canberra. It does not augur well that there is nothing in the signals so far to suggest far-reaching reform of personal income tax involving cuts in marginal rates of tax.
Inaction on this front would be consistent with the government’s retreat from the ‘aspirational’ personal income tax scale it announced as part of the Labor opposition’s 2007 election platform. Without saying when, it aimed for a scale of 15%, 30% and 40%, thereby eliminating the second top rate (at present 38% plus Medicare levies) and cutting the top rate (45% at present).
Although it was only a half-promise, the global financial crisis gave the government an excuse to put it off into the never-never.
Cutting income tax rates was once fashionable in public policy circles, but the crisis has created new policy fashions such as spending up big in the name of economic stimulus, which makes cutting taxes harder to reconcile with fiscal responsibility.
Some countries are even increasing their top marginal tax rates. There is no indication Australia will follow them, nor is there any indication that our government will cut marginal rates. This is unfortunate because the strong case for doing so before the crisis still exists.
The government rightly says that a new wave of reform is needed to expand the economy’s productive capacity in the post-crisis world. Kevin Rudd has set a target of 2% for annual productivity growth.
This is a tall order from where we are now, and reform will be needed in many areas to achieve it. Personal income tax reform can make an important contribution to the task.
Taxes on capital are generally the most harmful to economic growth, followed by taxes on labour, then those on consumption. This ranking puts company income tax and certain state taxes in the front line for reform, but personal income tax should also be there as it is a tax on labour and capital. It also happens to be the largest revenue raiser of all taxes, which makes its effect pervasive.
Of all the ways that personal income tax can be reformed, changes in the rates of tax people face are most effective in influencing their decisions on whether to work at all, the amount and type of work to do, the investment they put into improving their skills, the amount and type of saving they do, the risks they are willing to take for the uncertain prospect of reward, and the effort they put into arranging their affairs to minimise tax.
Present rates of personal income tax are still too much of an obstacle to patterns of behaviour conducive to stronger growth in productivity and the economy.
Australia’s personal income tax system has been reformed and tinkered with for decades by every government, but the job is far from finished. Under the Howard and Rudd governments, there have been huge increases in the thresholds for the various marginal tax rates and in the low income tax offset, but much less by way of across-the-board cuts in the marginal rates themselves. Some of the increase in thresholds has merely compensated for past inflation and the rest gradually will be eaten up by future inflation.
Both governments also have added to the menu of selective tax breaks; deductions, offsets, rebates, credits and concessions number in the dozens and account for much of the complexity in the tax system.
Some of these are justified, but many violate the important tax principle that says equals should be treated equally.
They also distort taxpayer behaviour in favour of acting to take advantage of tax breaks, and they cost billions in foregone revenue and thereby cause marginal rates to be higher than they otherwise could be.
The reform agenda should have as its cornerstone a cut in marginal rates. Labor’s aspirational scale would be a first step, but tax rates should be cut further through time so that most taxpayers face a marginal rate significantly below 30% and the top rate is well below 40%.
Thresholds for marginal rates should be automatically indexed to inflation each year, depriving governments of the proceeds of bracket creep.
On their own, these changes would leave a large hole in the budget. This can be avoided by implementing the changes gradually during a period of years, consistent with the government’s stated 10-year horizon for reform and by keeping the growth of government spending on a tight rein.
Cuts in tax rates also can be paid for in part by cutting back the forest of selective tax breaks, which could save billions. That would be the sting in the tail of this reform package.
Robert Carling is a Senior Fellow at The Centre for Independent Studies. His report The Unfinished Business of Australian Income Tax Reform was released by the CIS.
