Prepared For : Steven Kemp

Prepared By   : Chow Tai Wei, David

Student No.     : 977438B

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            TABLE OF CONTENT

1. INTRODUCTION *

2. THE PRESENT TAXATION SYSTEM *

The WST and Other Indirect Taxes *

Income Taxes (Direct Taxes) *

An Unfair System *

A Complex System *

An Inefficient Taxation System *

High Level of Vertical Fiscal Imbalance (VFI) *

The Need for Taxation Reform *

3. THE TAX REFORM PACKAGE - AN ASSESSMENT *

The GST *

The Income Taxes *

Business Taxes and Tax Administration *

4. CONCLUSION *

LIST OF REFERENCES *

 

1. INTRODUCTION

In the Federal election held on 3^rd October, the Howard led coalition was returned to power with a majority of 13 seats. The Prime Minister interpreted his victory as a mandate for implementing his proposed new tax system that includes a 10% goods and services tax (GST), a proposal the Liberal-National coalition put forward as their election platform. Although the ALP rejected the introduction of a GST and ran a scare campaign against it, John Howard had repeatedly claimed that deep down, the Labour camp would agree that Australia needed a GST to cope with its shrinking revenue from sales taxes. He also claimed that the present tax system is unfair, complex and outdated, incapable of serving Australia today and into the future.

So how bad exactly is Australia's present taxation system? Some textbooks cite equity or fairness, simplicity and efficiency as the criteria by which a tax system should be tested. This essay shall attempt to assess the present taxation system, and the tax reform package proposed by the Howard Government along these criterions. In this essay, we shall limit the scope of assessment of the tax reform package to improving Australia's taxation system.

 

2. THE PRESENT TAXATION SYSTEM

In the widely circulated brochures to households by the Treasurer, it reinstated that the present taxation system is unfair as there is no incentive to work harder because of the high tax rates imposed on incomes, and that extra income will reduce the benefits handed out by the government (Costello, 1998a). The loopholes for tax avoidance are attributed to the complexity of the present system. It also labelled the present system as being outdated. It cited the wholesale sales tax (WST) as one of the main inefficient indirect taxes introduced since 1930, when the fundamental economic structure was different then. We shall examine these claims below.

The WST and Other Indirect Taxes

The WST is levied on a narrow base, has complex multiple classification rates and is difficult for business to comply with (Costello, 1998b, pg. 71). It also taxes exports indirectly as more than half the revenue raised from it come from taxing business inputs (ibid.). The main problem is that the WST unfairly taxes products (which sector is in relative decline) and not the growing service sector, which now forms more than two-thirds of the economic activity (ibid.). Because of its increasing narrow base, the revenue collected from the WST can only be maintained by raising the rate of tax over the years by past governments from a single rate of 2.5% in the 1930s, to a general rate of 22% today (see Table 1 overleaf).

The WST taxed at six different rates can lead to confusion and provide scope for tax avoidance where large businesses structure their operations to minimise their WST. Mark Paterson, the Chief Executive of ACCI, added that the volume of tax legislation has "doubled in less a decade, and is now five and a half thousand pages in length", much of which is devoted in great detail to "combating perceived or actual rorting" (Paterson, 1998, pg.2). He added that the WST "adds 5% on average to the cost of Australian goods, affecting those exported to, as well as those competing against imports from, the many OECD and Asian countries with VAT-style indirect tax system" (ibid., pg. 1). He also pointed out that the current higher effective tax rate on investment has made Australia losing its competitiveness in soliciting investment funds internationally.

Income Taxes (Direct Taxes)

Income tax is a dominant tax in Australia, contributing 56% of revenues, which is high by international standards (Abelson, 1998). The personal income marginal tax rate ranges from 0%, to 20%, to a maximum of 47% (see table 2 overleaf). The corporate tax rate at 36% is also relatively high.

The fact that the corporate tax rate is lower than the marginal tax rate of higher income bracket gives rise to the misuse of trusts and private companies to minimise tax. Also, the disincentive for many Australians on average income to work harder is attributed to the current personal income tax system having high marginal rates and low thresholds.

 

According to Costello (1998c), the tax mix in the Australian economy has been moving over the past two decades towards a higher share of direct taxation and a lower share of indirect taxation. The declining share of revenue collected from indirect taxes must be compensated by putting a heavier burden on the income tax system, which will ultimately carried by wage and income earners.

An Unfair System

The equity criterion means that tax payments should be related to a person's ability to pay the tax. There are two dimensions of equity: horizontal and vertical. Abelson (1998) highlighted that within the current taxation system, there are significant vertical and horizontal inequities. He cited the use of "corporate structures, superannuation funds, setting up trust companies and negative gearing" by many high income individuals to minimise tax payment; workers increasingly avoiding the PAYE system; and individuals operating in the black or cash economy, as the sources of vertical inequities (ibid. pg. 18). These may also lead to horizontal inequities, as individuals with similar income are not paying similar taxes if their income comes from different sources.

In addition, Abelson also pointed out that the narrow indirect tax base and the differential indirect taxes are "unfair to producers and consumers of the highly taxed goods, generous to consumers of services, and inconsistent with horizontal equity" (ibid. pg. 18)

A Complex System

As mentioned in Mark Paterson's earlier remark, the tax legislation has grown as a result of patching and filling. It seems that in striving for equity we have sacrificed simplicity. The income support system has become equally complex, with 30 major different types under the tax and social security regimes. As quoted from Costello (1998c, pg. 6), the complexity of the tax system has resulted in over 70% of tax returns being handled by tax agents. It also "imposes high compliance costs on business and distorts investment decision-making by encouraging investment on the basis of tax effects rather than economic merit", which makes the current taxation system inefficient.

An Inefficient Taxation System

On the allocative efficiency criterion, a tax is judged by the extent to which it affect individual and firm's decisions. The existing tax system was criticised to be inefficient where the supply of labour, supply of capital, intertemporal consumption, investment choices, production methods, production and consumption decisions are bias towards minimising and avoiding the present direct and indirect taxes (Abelson, 1998, pg. 15-17).

High Level of Vertical Fiscal Imbalance (VFI)

Presently, the Commonwealth accounts for about 80% of all revenues raised but is directly responsible for only 57% of total expenditures. This imbalance requires the Commonwealth to provide nearly $30 billion in grants to the States annually (WA Treasury, 1998) as they do not collect enough tax revenue to finance the expenditures for which they are responsible. To address this imbalance, the Commonwealth-State financial relations must undergo reform to provide revenue security to the States so that they are not forced to rely on narrowly based, distorting taxes.

The Need for Taxation Reform

The existing tax system needed to reform because the tax system was distorted, unfair, complex and costly to comply with. Broadening the direct tax base would theoretically cut tax avoidance, while broadening the indirect tax base would remove distortions. We have to address the problem of poverty traps created by the link between the tax and social security systems, which were a disincentive for low-income earners to increase earnings. Finally, the Commonwealth-State financial relations had to be reformed for the effective operation of the Federation.

Given the call for taxation reform, Prime Minister Howard, on 13 August 1997, announced five core principles that will guide the reform. They are:

                    1.     No increase in overall tax burden;

                    2.     Major reductions in personal income tax;

                    3.     Consideration of a broad-based indirect tax;

                    4.     Compensation for low-income earners, pensioners and the like;

                    5.     Reform of Commonwealth-State financial relations.

Exactly a year later, the Howard government released the long awaited package, amongst other highlights, a 10% GST to be introduced in July 2000. We shall examine this package in next part of the essay.

 

3. THE TAX REFORM PACKAGE - AN ASSESSMENT

The new package announced on the 13 August 1998 promises greater assistance for families; income tax cuts; increases in pensions and benefits; abolition of distorting indirect taxes and replaced by a GST; close tax loopholes so that everyone pays their fair share; more secure revenue for States; lower tax compliance costs; lower industry costs; and a fairer business tax system (Costello, 1998d). Some important aspects of this new tax package are discussed below.

The GST

Levied at a rate of 10%, the GST is an important element of the new tax system. Its implementation enables the abolishment of the WST and nine indirect State taxes; remove more than $10 billion a year of indirect tax burden on business input costs; reduce exporters' costs by $4.5 billion a year; and reduce income taxes and increase family benefits etc. (Costello, 1998b). These could lead to better business results with lower costs, increased exports and employment, and encourage greater efforts by businesses and employees benefiting the whole economy. Other benefits (which may be vague) of a GST claimed by the Howard government are:

Encourage savings

Tax on consumption would encourage saving, leading to further investment and benefits for the whole economy. However, figures published by the OECD revealed that there is no evidence at all of higher savings rates in countries which have had a broadly-based consumption tax for some years (Donnelly, 1998, pg. 48). This may be because increased savings as the result of GST could only be expected if the tax was limited to items on which there is real discretion as to whether to make such expenditure.

Tax evaders would be caught

People who operate in the cash economy and avoid taxes by not disclosing their income, have to contribute to tax revenues by the tax on consumption and on business inputs, recovering an estimated $3 billion (Costello, 1998a). For businesses, there is an incentive for operators in the cash economy to be registered. But where business inputs such as materials may not be a big proportion of the revenue received (for eg. service industries), the fact that not recording a transaction would prevent obtaining a credit for GST paid on inputs, may not be significant encouragement for evaders to record sales.

An Efficient, Simpler and Fairer System

The new package labels itself a better, simpler, and more equitable system. On its efficiency front, it claimed that the uniform rate of GST could minimise distortions in consumption and production choices. This may not be totally true as business decision could still be made on grounds other than economic efficiency due to the fact that GST allows for tax credit to be claimed against liabilities for the GST on sales of goods and services.

The simplicity of the GST is largely derived from the abolishment of the WST (and nine other indirect taxes). However, businesses would find themselves having to cope with the complex task of keeping track of GST on business inputs as well as on sales, and effectively become tax collectors! Also, the GST is estimated to affect 900,000 businesses, while the current WST affects only 75,000 businesses (Switzer, 1998).

On equity grounds, the GST is widely criticised to be grossly unfair because it ignores the important essential of a fair taxation system, namely, the capacity to pay. This is because of its broad-base nature, applying to essentials such as food, clothing, heating, transport and even funeral expenses (a favourite quote of Kim Beazley!). This means that very low income-earners buying food, or other essentials pays exactly the same rate of tax as very high-income earners, but effectively the rate is much higher for low-income people because they would pay the GST on a very high proportion of their income, with little or no scope of reducing their expenditure on essentials items. Thus, it is not surprising that there are calls for exemptions on at least food from the GST by welfare groups and some political parties.

Locking In the GST Rate

According to Costello (1998b), the government has taken careful note of concerns expressed that future Commonwealth government could increase the GST rate. As GST revenue will be directed to the States, the Commonwealth government would not only have to agree to introduce legislation to increase the GST rate, but the request for such a change would have to be unanimous among State Premiers and Territory Chief Ministers. Legislation would then need to be passed by both Houses of the Federal Parliament. However, most countries with some form of GST have increased their rates after introduction (principally to increase government spending). Although the States have to be consulted for rate increase, they possess the incentive to do so as the GST revenues are directed to them. Together with calls by the government of the day, the possibility of a rise in GST rates will not be as remote as it may seems.

The Income Taxes

Another important aspect of the taxation reform is providing income tax cuts across the board, with reductions in marginal tax rates for about 95% of all taxpayers (Costello, 1998b). The new rates are presented in table 3 overleaf. The new package will benefit low income taxpayers with an increase in the tax free threshold from $5,400 to $6,000; and a reduction in the lowest marginal tax rate from 20% to 17% (ibid., pg. 47). With the reduction from 34% and 43% marginal rate to 30% from those earning between $20,001 and $50,000 a year, this means that 81% (cf. 30% currently) of taxpayers then will have a top rate of 30% or less (ibid., pg.47).

Also, the top marginal rate of 47% will then apply to those earning $75,001 and above, an increase of $25,000 from the current top tax bracket.

Table 3: New Income Tax Scale wef 1 July 2000 [Source: Costello, 1998b, pg. 47]

These income tax cuts, totalling $13 billion a year, provide a 14% reduction in personal income tax collections (ibid.). Under the new system, the need for the historical practice of increasing tax rate will cease (given the revenues collected by the GST).

The income tax reform will see the low and middle income earners in particular, keeping a higher proportion of the earnings they receive after tax, thus "providing them with greater rewards for their work efforts and improved incentives to better their financial position through overtime, promotion and training" (ibid, pg. 48). Also helping the lower income individuals and families to "offset" the GST, especially those who do not pay income tax (such as age pensioners and students) and thus cannot benefit from tax cuts, the new package proposed increasing pensions and benefits for them. These increased rates of assistance, according to Costello (1998b, pg. 56), will raise the maximum level of all income support payments "by more than the impact of tax reform on prices (as measured by the CPI), overcompensating recipients for the cost of living effects of the changes to indirect taxation arrangements".

Business Taxes and Tax Administration

The other two aspects of the new tax package are reforms to business taxes and tax administration. These includes reforming the taxation of business entities and investments, improving the business registration system, introducing one tax instalment system for all taxpayers, simplifying tax returns, and reforming customs administration (Costello, 1998b).

 

4. CONCLUSION

The discussions above demonstrated the difficulties in striking a balance between the three criterions of equity, simplicity and efficiency in a taxation system. Often the promotion of one erodes another. From the perspective of businesses and households, it seems that the new taxation package fairs better, addressing most, if not all of the more pressing problems of the existing system. By offering the States the proceeds of the GST in return for scrapping some banking and stamp duties, the new system also improves the Commonwealth-State financial relations.

On the political front, the implementation of the proposed tax package will eventually lies on the hands of the Senate, and we will expect to see many debates on this bill, majority of them trying to make the present state of the proposal more equitable.

 

 

            LIST OF REFERENCES

Abelson, P. ed. (1998) The Tax Reform Debate: The economics of the options, Allen & Unwin, NSW.

Costello, P. (1998a) Tax Reform: not a new tax, a new tax system, Aug., Canberra Press, Victoria.

Costello, P. (1998b) A New Tax System, [Online] available at www.taxreform.gov.au/whitepap/whitpap.pdf

Costello, P. (1998c) Tax Reform: not a new tax, a new tax system, [Online] available at www.taxreform.gov.au/exover.pdf

Costello, P. (1998d) The new tax system – at a glance, [Online] available at www.taxreform.gov.au/001.pdf

Donnelly, A. (1998) GST : The winners and the losers, Wrightbooks Pty Ltd, Victoria.

Lewis, P., Garnett, A., Drake, P., Juttner, J., Norris, K. and Treadgold, M. (1998) Issues, Indicators and Ideas: a guide to the Australian economy, 2^nd ed., Addison Wesley Longman Australia, South Melbourne.

Paterson, M. (1998) "Taxation Reform Priorities" Pen: Political and economic newsletter, CEDA Research publication No. 38, Mar.

Raper, M. (1998) "ACOSS and Tax Reform" Pen: Political and economic newsletter, CEDA Research publication No. 38, Mar.

Switzer, P. (1998) Who’s afraid of the GST? Prentice Hall Australia, Sydney.

Western Australia Treasury (1998) Revenue Sharing or Tax Base Sharing? Directions for Financial Reform of Australia’s Federation, Discussion Paper, Intergovernmental Relations Division, Jun.

 

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