‘The tax code, once you get to know it, embodies all of the essence of life: greed, politics, power, goodness, charity. Everything’s in there.’ Sheldon Cohen, Former Commissioner of the IRS.
Tax reform is back on the agenda. Since those who fail to study history risk repeating it (and I was involved in the latter-day history of tax reform) I’m writing this 3 part series as a guide for people who want to become involved in the next phase. I begin with a short history of the dominant tax of the second half the 20th century – personal income tax.
To keep it simple, I’ll focus on some of the big debates over the goals of tax reform and how the system should be restructured to achieve them. Readers with an interest in detail can buy a book, such as Julie Smith’s excellent ‘Taxing Popularity’ (a history of Australian tax policy to 2004) or Slemrod & Bakija’s ‘Taxing ourselves’ (MIT Press 2008 – a beginners guide to tax policy from the US); or turn to the ‘Henry’ Report’s Architecture of the Australian Taxation System . Those wanting to keep up with current Australian tax debates should visit the Tax Watch site.
For most of the second half of the 20th century, the income tax was king. It raised over half of all public revenue in Australia. In the eyes of its supporters it was a benevolent king because it taxed fairly.
Income is a surprisingly slippery concept. The first step in taxing it was to define it. One of the earliest definitions came from Robert Haig:
‘ the money value of one’s net accretion to one’s economic position between two points in time.’ Haig, R (1921) The Federal income tax, New York: Columbia University Press, p27.
In plain language, income is ‘spending power’. A decade and a half later Simons refined Haig’s definition – as the sum of (1) consumption of goods and services in the market and (2) the change in the value of personal wealth in any period. The second part of this equation is the basic difference between a tax on income and a tax on consumption – unlike a consumption tax, an income tax captures the annual returns from that part of income which is saved and invested.
Most people associate income taxes with deductions from their fortnightly pay, yet income has many other guises: interest, dividends, capital gains (the annual change in the value of an investment asset such as shares or property), and ‘imputed rent’ from housing (the annual rental value of the housing ‘services’ you receive when you own your home). A ‘comprehensive income tax’ taxes all of these items at the same rates. All of these items reflect changes in an individual’s ‘spending power’. Note that an income tax is also different from a wealth tax (including taxes on land), which taxes the stock of an individual’s wealth rather than annual changes in its market value.
To illustrate the difference between spending and spending power, let’s compare two people who each spent $50,000 last year. One had an income of $50,000 and spent all of it on regular living costs (as around half of all Australian households do). The other had income of $70,000 and saved $20,000 for a home deposit. She was in a stronger economic position because she had an extra $20,000 and could choose to spend it now or save to improve her future spending power. The difference between income and spending is, of course, saving. It’s all a matter of timing – people either spend their income now or save in order to defer their spending.
Why tax income?
For Haig, the purpose of income tax was to tax people more precisely according to their ability to pay, and their spending power was the best way to measure this. (this is hotly debated by advocates of a shift towards consumption taxes, on which see Part 2). This was the ‘soft’ version of the purpose of income tax. The ‘hard’ version was enunciated by Henry Simons at the tail end of the Great Depression. He argued that its purpose was for:
‘altering or correcting the distribution of wealth and income’. Simons H (1938), ‘Personal income taxation: ‘The definition of Income as
a problem of fiscal policy,’ Chicago: University of Chicago Press, p15.
Despite the sharp political divisions at this time – US President Roosevelt announced at a public rally that he ‘ate capitalists for breakfast’ – the hard version was not the main motive for the dramatic increases in income tax over the next decade. Income taxes were used to fund two world wars.
Income tax and war
As in the US, the first national income tax was introduced in Australia to finance the war effort (the First World War, that is, in 1915). At the time most public revenue came from customs and excise duties – taxes on consumption. These fell on unemployed people and pensioners as well as wage earners, and low paid workers as well as high income earners. Economic divisions were much sharper than than now: unemployment was high and most wages were close to subsistence levels. The vast bulk of private investment income went to a wealthy minority. The new income tax was not consciously used by the Hughes Government to redistribute income, but in financing the war it could not ignore the economic inequalities and social tensions of that era. It was time to shift some of the tax burden to those with higher wages and income from investment.
The first national income tax included investment income, it had steeply progressive marginal tax rates and it wasn’t levied at all on the majority of wage earners. It was accompanied by federal taxes on undistributed company profits, land and inheritances. A country which previously had one of the most regressive tax systems in the western world (that is, one in which effective tax rates are higher for low income earners than for high income earners, in proportion to their incomes) now pioneered an income tax with multiple rates. But to put this in context, Federal and State income taxes together raised less than 10% of all public revenue.
The next step was a dramatic rise in federal income tax revenues in the early 1940s to fund the second (world) war effort and the extension of social security entitlements to unemployed people. There was also a push to centralise income tax in the hands of the Commonwealth to facilitate economic management (State income taxes preceded the national one). Low paid workers were income-taxed for the first time but ‘unearned’ income from property was taxed at higher rates than wages. By the late 1940, income tax raised more than half of all public revenue.
The income tax scale was steeply progressive: for much of the post-war period, the top personal tax rate was over 60% and the company tax rate was over 40%.
Income tax as a leveller
There can be little doubt that the personal income tax redistributed income on a large scale, whether that was its purpose or not. One of Picketty’s main conclusions in his magnum opus Capital in the 21st Century was that the expansion of income taxation in wealthy nations from WW1 on was a major cause of the decline in income inequality over the next 50 years.
This graph shows the typical pattern of income inequality in wealthy countries over the second half of the 20th century, in this case among Australian males (old data are all too often male!), from Andrew Leigh’s research. Inequality moved over this period in a ‘U’ shape curve, higher in the ’40s, falling to a low point around the late ’70s, then rising steadily. [The higher the ‘gini coefficient’, the more unequally distributed income is – if the gini has a value of 0 all income is shared equally, if it has a value of 1 all income is held by one person.]
You can also see from this graph that the income tax system (the only taxes in Leigh’s data) reduced inequality among Australian men by about one quarter between the ’40s and the ’90s. If the same data were available for the first half of the century, they would show a much smaller impact since the income taxes themselves were much smaller. Inequality of private incomes was also greater at the turn of the 20th century.
Another way in which high top tax rates might reduce inequality is through behavioural effects. Picketty argues that confiscatory tax rates on very high incomes after WW2 discouraged employers from paying high wages in the first place, and indeed growth in top wages moderated during and after the war.
Causation also worked in the opposite direction: growth in income taxation was part of a wider push to temper the harsh inequalities and suffering of the great depression and to ‘win the peace’. The rise in Australian income tax in 1944 was to pay for social security for unemployed people and widows. Full employment was enshrined at the centre of economic policy. Minimum wages rose and unions grew stronger. All of these factors contributed to the reduction in inequality from the 1940s to the 1970s. Then public policies began to swing in the opposite direction.
War on income tax
The equalising effect of personal income tax declined from the 1980s as the tax rate scale became less progressive (redistributive), and then as the overall size of the personal income tax was reduced through eight annual tax cuts during the 2000s. This has been the trend across many OECD countries (see graph below, showing the contribution of income taxes to reductions in inequality in different countries at different points in time).
In the 1970s and ’80s, the income tax system fell out of favour with policy makers and sections of the public. This was part of wider shift in the policy zeitgeist from reducing inequality to removing constraints on economic growth. It was also due to serious flaws in the income tax system itself which were exposed at a time when inflation averaged over 10% per year. People were moving rapidly into higher tax brackets, and those in the top brackets were making greater efforts to avoid tax. One prominent national daily newspaper declared a ‘tax revolt’. The king seemed to have lost his clothes!
‘Increased revenue demands are being placed on a system that contains some basic structural flaws and a tax base that has been whittled away through special concessions and tax minimisation arrangements. The system has been criticised by officially commissioned inquiries, (including the Asprey, Mathews, and Campbell Committees), academics, the media and, increasingly, the general public. The system’s basic unfairness, its complexity, and its adverse effects on incentives to work, save, invest and take risks are widely recognised. In short, respect for the system, which is essential for voluntary compliance, has been seriously undermined.’ (Australian Government (1985), Draft White Paper: Reform of the Australian Taxation System, p18)
In the 1970s the Asprey Report diagnosed the problem as an engineering fault: tall tax rates were built on a narrow foundation and the building was at risk of collapse. It advocated a trade-off between a ‘broader tax base’ (the removal of shelters and loopholes) and lower rates. Crucially, this was argued on economic efficiency as much as equity grounds. The tax system was distorting investment decisions (for example the lack of a tax on capital gains encouraged speculation in asset values, especially housing) and labour force participation (due to high marginal tax rates).
Mathews argued that inflation was white-anting the tax system and the best way to bring it back into equilibrium was to adjust income tax thresholds and investment returns for inflation. The latter idea was consistent with the original theory of taxation of investment income, that only ‘real’ (after-inflation) returns should be taxed. Asprey and Mathews didn’t want to bury the income tax, they wanted to save it. Mathews famously argued that the challenge was:
‘not to make the rich pay higher rates of tax, or even more tax, than the poor; it is to make the rich pay any income tax at all.’ Mathews R (1981), ‘The structure of taxation’.
These reports gathered dust until a Royal Commission was established into a very different matter: the activities of the Ship Painters and Docker’s Union. The Fraser Government forgot the first principle of public inquiries – don’t set one up unless you already know the outcome! What started as an inquiry into the nefarious activities of a trade union became a public airing of tax evasion at the top end of town. Investment income and profits were stripped from companies before tax was payable and company records were sent to ‘the bottom of the harbour’. This was the last straw for many ordinary wage earners, whose tax rates rose all too frequently as inflation pushed them into higher tax brackets.
RATS save the ship
The income tax was finally patched up in 1985 following the Hawke Government’s Tax Summit. This was a time when different sectors of the community – unions represented by the ACTU, the community sector by ACOSS, and major business organisations – were encouraged by Government to come together to tackle the big problems of the day. It was no coincidence that this was also a period of sweeping economic and social reform.
The Treasury released a Draft White Paper called ‘Reform of the Australian Tax System’ (RATS). Thus began the tradition of applying animal names to tax reforms. This one may have been borne of frustration – Treasurer Keating’s preferred ‘Option C’ which included a ‘broad based consumption tax’ (another recommendation of the Asprey report) was dropped (more on this in Part 2).
The RATS package attempted to seal the four main ‘cracks’ in the income tax system (see Rick Krever’s summary of the package and its origins).
First, the different tax treatment of capital gains (which were largely untaxed) and other investment income: A Capital Gains Tax was introduced on increases in the value of assets such as shares and property (but not the main residence), after taking account of the effects of inflation (but inflation adjustment was not extended to other investments as Mathews proposed so investments were still taxed inconsistently).
The second problem was related to the first: the mismatch between income and deductions in ‘negatively geared’ property investments. Real estate investors structured their affairs so that annual investment expenses (e.g. interest payments on debt) exceeded returns (e.g. rents) for a number of years before the property was sold, yielding a low-taxed capital gain. The problem for the fisc was that these ‘losses’ were deducted against other income (e.g. wages) which were taxed every year at higher rates than capital gains. There was a mismatch between the timing and the level of income tax and related deductions.
Third, a Fringe Benefits Tax was introduced to capture income in the form of goods and services provided in lieu of wages, such as company cars (but not discounted shares and options).
Fourth, inconsistencies in tax rates applying to individuals who used different business and investment structures were tackled. It was argued that as long as the company income tax rate was less than the top personal tax rate, high income-earners could shelter their income in a private company. This problem was resolved a few years later when the company tax rate was increased to the same as the (lowered) top personal tax rate, but this alignment of the two tax rates only lasted a few years.
The tax bias in favour of diverting income into private discretionary trusts also attracted attention. This problem would be partly resolved by reducing the value of the tax breaks (such as building depreciation) that flowed through to the beneficiaries of these trusts. This reform, which brought their tax treatment more closely into line with that of companies and fixed trusts, was later reversed on a legal technicality and the use of private discretionary trusts to avoid tax continued apace.
The RATS reforms were vigorously opposed amid warnings that the sky would fall in on business lunches, the car industry and rental property investment. While it’s true that the ‘abolition of negative gearing’ for rental property introduced a tax bias against borrowing for housing investment relative to other investments (e.g. borrowing to buy shares), the claim that it decimated rental property investment was false – investment only declined in Sydney and Perth and the main reasons for this were interest rate increases and a sharemarket boom (see Badcock & Browett (1996), ‘The responsiveness of the private rental sector in Australia to changes in Commonwealth taxation policy’). Despite this, this federal tax reform was reversed during a hard fought NSW election campaign, to avert a scare campaign over rent increases.
As it turned out, the sky remained in its place, the restaurant industry prospered and the car industry continued to post losses as it had for some time. The reforms were widely accepted because the the majority of taxpayers received tax cuts at the expense of the minority who previously benefited from tax shelters. The top tax rate fell from 60% to 49% but more high income-earners would at least pay the 49%. In one swoop, RATS attacked the two main public complaints about the income tax.
A startling fact about the RATS reforms was that their logic – to ‘broaden’ the tax base and lower rates – was identical to a simultaneous tax reform in the US authored by the Reagan administration. Like Keating, Reagan was determined to cut income tax rates, including the top rate. His problem was that after he cut tax rates dramatically in 1981 the US budget fell into deficit (contrary to the theory that lower tax rates might increase revenues, promoted by economist Arthur Laffer). If he was to cut income tax further he would have to find a way to pay for it. The solution proffered by the US Treasury was the same as its Australian counterpart: close or restrict tax shelters. The US Capital Gains Tax was increased, negative gearing was restricted, and depreciation allowances for business were cut. Reagan’s political strategy was the same as Keating’s – those who opposed the removal of tax shelters would be accused of standing in the way of tax cuts for the majority. The story of this hard-fought battle for tax reform in the US is detailed in Birnbaum & Murray’s entertaining and informative ‘Showdown at Gucci Gulch’ [Gucci Gulch was the area outside a certain Senate Committee room where tax lobbyists gathered].
The king faces a challenger
While many gaps remained in the income tax – including those that were re-opened following the retreats on negative gearing and discretionary trusts – it remained the pre-eminent Australian tax. Yet by the end of the 1980s the income tax still faced challenges on two fronts. It was under siege politically due to its high visibility and the general retreat from inequality-reducing policies. It was also threatened intellectually by a new challenger, the broad based consumption tax. The battle of ideas often precedes the political one, and so it was with tax policy. The idea that the income tax should be replaced by a tax on expenditure was first advanced in the 1940s. This is the topic of Part 2 of the Brief History of Tax, the Clash of the Titans.