Policy Monographs
The Unfinished Business of Australian Income Tax Reform
Tax reform is once again squarely on the Australian policy agenda, with the review of Australia’s Future Tax System (the Henry Review or the review) now under consideration. Although personal income tax has been reshaped over many years and undoubtedly lightened over the past 10 years, those changes have left some of the major failings of the personal income tax system in place. Personal income tax reform should be a result of the Henry Review along with the other policy areas it is targeting.
A look back at the cumulative effect of changes since 2000 reveals that although tax brackets have been adjusted through large increases in thresholds and low income tax offset (LITO), marginal rates have not been cut by much, while selective tax breaks have proliferated. The reform agenda is clear: cut marginal rates; implement automatic indexation of thresholds for inflation; scale back the selective breaks; and simplify.
While the economic and budget landscape has changed dramatically since the review was launched, the global financial crisis has strengthened the case for reform instead of weakening it. Amidst calls for a more robust framework for future growth, tax reform should be used as a microeconomic policy tool to boost productivity growth and expand the economy’s productive capacity. Personal income tax reform has an important role to play in this effort, as do reforms in other parts of the tax system such as business and state taxation.
Tax reform can have any effect on budget revenue that policymakers choose, but there is a strong economic case to further lighten the personal income tax load. If, as seems likely and realistic, this cost to the budget cannot be fully offset elsewhere in the tax system, there are ways to manage the cost through phased implementation of reform and slower growth in government spending over the next several years.
The case for personal income tax reform rests on the heavy economic costs of high marginal tax rates, abundant selective tax breaks, and system complexity. Those who would reshape personal income tax to make after-tax income more equally distributed need to explain why those economic costs should be tolerated or increased further, and why the total tax/transfer system should be made even more redistributive when it is already one of the most redistributive in the world.
The cornerstone of the major reforms proposed here is a new marginal rate scale with a top rate of 35%, most taxpayers facing a rate of 27%, and no Medicare or other levies. Serious consideration should also be given to a dual system, under which the above scale would apply to labour income but a flat rate equivalent to a reduced company tax rate (say 25%) would apply to capital income.
LITO has created an effective tax-free threshold of $16,000 (from July 2010), with the amount between $6,000 and $16,000 clawed back through a 4 percentage point surcharge on headline marginal rates above $30,000. This is a clumsy arrangement that adds to complexity and obfuscates the marginal rate scale. LITO should be converted to a conventional tax-free threshold of $16,000 with no claw-back. This can be funded partly by reducing government cash benefits above a certain income level. Otherwise, the existing thresholds for the various tax brackets do not need to change, only subject to automatic indexation.
Elimination of the Medicare levy and LITO would achieve some simplification, as would a flat rate capital income tax under a dual system, but greater simplification would require a major cutback in selective tax breaks. This would also advance horizontal equity (equal treatment of equals), reduce tax-induced distortion of private sector decisions, and help fund cuts in marginal rates.
Australia last saw personal income tax reform of the base broadening/rate cutting kind in the 1980s. Since then, reform has concentrated on adjusting bracket thresholds, while selective breaks have crept back into the system. It is time to cut rates and broaden the base again.
Robert Carling is a Senior Fellow at The Centre for Independent Studies. He was Executive Director, Economic and Fiscal at the NSW Treasury from 1998 to 2006, and a Commonwealth Treasury official before that. He holds academic qualifications in economics and finance from the London School of Economics and Political Science, Georgetown University, and the University of Queensland.
