This is a quick off the cuff analysis of CPA Australia’s report: Tax reform in Australia, the facts, a day after its release. In the absence of time to study the report more closely, and critical details of the modelling and presentation of data, I raise as many questions as answers. But they are important questions – including how a revenue neutral change in the tax system leaves all households better off. There are efficiency gains from good tax reform but the magic pudding remains elusive!
The CPA proposals are a welcome change from standard ‘tax mix shift’ reform proposals which trade off a higher GST for lower income taxes. Instead, most of the revenue gained from higher GST would be used to remove some of the most inefficient (and unfair) State taxes such as Stamp Duties on insurance. Aside from the proposed income tax cuts, most of the taxes to be replaced fall mainly on household consumption, so the implications for the distribution of spending power among households are less clear cut than a straight consumption tax for income tax switch, which is strongly regressive. See my previous blog ‘Who’s the fairest of them all’ and ACOSS analysis ‘Paying our fair share’.
The CPA advances four reform options:
- A 10% GST with health, education and fresh food exemptions removed to raise $12B in 2015 to replace stamp duties on insurance & motor vehicles ($8B) and modestly reduce property Stamp duties and other indirect taxes ($2B), with the remaining $2B used for income tax cuts and an increase in income support payments.
- A 15% GST off the existing base to raise $26B to replace stamp duties on insurance & motor vehicles ($8B), substantially reduce property Stamp Duties ($10B) and other indirect taxes ($2B), with the remaining $6B used for income tax cuts and an increase in income support
- A 15% GST with health and education in the base to raise $37B to replace stamp duties on insurance & motor vehicles ($8B), abolish property Stamp Duties ($13B) and other indirect taxes ($2B), with the remaining $14B used for income tax cuts and an increase in income support
- 15% GST with health education and fresh food in the existing base to raise $42B to replace stamp duties on insurance & motor vehicles ($8B), abolish property Stamp Duties ($13B) and other indirect taxes ($2B), with the remaining $19B used for income tax cuts and an increase in income support.
Using a model developed by KPMG, the report estimates the impact of these options on economic growth and on households (divided into groups of 20% by household ‘equivalent’ income). It also makes a number of claims about the inefficiency of the current tax ‘mix’. This blog is in two parts: ‘what’s clear’ (some obvious points) and ‘what’s not clear’ (questions that need to be clarified).
1. Australia does not rely a lot more on income taxes (broadly defined) and a lot less on consumption taxes, than the OECD average.
The international tax revenue data in the report shows that, when social insurance contributions in other OECD countries are added in, 58% of tax revenue in Australia comes from taxes on income compared with an OECD average of 60% – or 63% compared with 61% if Payroll taxes are included (figure 2-8)
The share of tax revenue raised from consumption taxes is 27% in Australia compared with an OECD average of 33%. There’s much more to consumption taxes than GSTs and VATs, including State taxes such as Stamp Duties that fall on consumption.
2. The increases in the GST modelled for the report by KPMG would reduce economic growth for the first three years after the reform.
It is well known that one of the short term effects of an overall rise in consumption taxes is that the economy slows, due to the impact of higher prices (just ask the Japanese). To be precise, it increases household consumption in the years between announcement of the reform and implementation as people rush to buy good at existing prices, then reduces it).
3. Abolishing inefficient State taxes would boost growth in the long run
It’s not surprising the modelling finds that GDP would grow faster over the long term if these taxes were abolished. Taxes such as Stamp Duties have well known negative impacts on investment and growth. Taxing business ‘inputs’ rather than final income or consumption or assets such as land and mineral wealth is inefficient as it distorts household and business investment decisions (for example by discouraging people who need it from taking out insurance, and penalising decisions to move house).
The $27.5 billion dollar question is: by how much? This is notoriously difficult to estimate. As with all macro-economic modelling, results depend on assumptions. The report appears to take this a step further by assigning the projected economic efficiency gains to households (which no Government would be brave or foolish enough to do).
4. Low income households don’t usually benefit from tax cuts
One quarter of households, including the vast majority of those in the bottom 20%, pay no income tax (but they do pay consumption taxes), so they would be worse of in the absence of social security payment increases if consumption taxes increased.
As the above ACOSS report argues, relying on social security payment increases to sustain spending power is risky in an environment when these payments are under threat (see last year’s Budget)
What’s not clear
1. Why do all households gain from revenue-neutral tax reforms?
All four proposals are revenue neutral. They neither increase nor reduce taxes overall. So in the short term, reform is a zero sum game with winners and losers. Yet all households appear to win in the modelling.
A close look at Appendix ‘C’ shows that his happens because of a line item called ‘increase in income before tax’. Why would income increase before tax (apart from social security payments increases which are accounted for separately)?
One possible reason is the claimed ‘efficiency dividend’ from the reform. That is, the economy grows more quickly because taxes are less distortionary. But that’s a long term impact. As indicated, the model shows that GDP growth slows for the first three years and household consumption is projected to fall for the first five years.
If ‘input taxes’ (such as Stamp Duties) are replaced by a tax on consumption (like the GST) we would expect households to be slightly worse off in the short term, in the absence of compensation. This is because in the short term, some of the gains from abolition of input taxes would ‘leak’ to sectors other than Australian households (especially exports).
2. What happens of we exclude ‘increases in income before tax’ and focus on the impact of the tax changes?
If we separate out the effects of tax and social security changes (higher GST, lower Stamp Duties, and income tax cuts and social security increases) from the projected ‘increases in income before tax’ we find that the first reform option (removal of GST exemptions, abolition of some Stamp Duties, a reduction in the first marginal tax rate from 19% to 18.5%, and modest social security increases) reduces household spending power for the bottom 2 quintiles and raises it for others.
This is the pattern of short-term winners and losers we would expect from such a change (red bars), though the average losses at the bottom end are much larger than expected:
- Low income households are disproportionately affected by the consumption tax changes
- Since only the lowest marginal income tax rate is cut, middle income households gain the most, but high income earners also gain because the tax cuts flow through to them as well.
When the ‘increases in income before tax’ are added in (blue bars) everyone wins and the reform is distributionally neutral (see Figure 3-4 in the report).
But where do these income increases come from? The report refers to ‘increased incomes as a result of improved efficiency in the economy’ (p14). If this is where they come from (and these look like brave assumptions), how would these efficiency gains flow through to households in the first year of the reform (2015-16)?
3. What is the effect of the consumption tax changes on their own?
It would be worth knowing what the effect of replacing Stamp Duties with a higher GST has on the spending power of households at different income levels, since this kind of reform is rarely modelled. The impacts are not obvious since Stamp Duties themselves largely fall on household consumption – so the reform would replace one set of regressive taxes with another. Its effects would depend on the spending patterns of different households (e.g. on food, home purchases, car purchases, insurance, etc).
It’s good to see more information out there on the impact of different tax reforms, and it would be even better if some of the results in the report were explained more fully.