Image by QuinceMedia CC0 via Pixabay

Australia’s tax system is facing a crisis. The tax system is not well-positioned to deliver well-being for our future. The system is antiquated, unsustainable, overly complex and unfair. Will cuts to personal income tax rates as laid out in the 2018-19 Budget help?

Reasons to reduce personal income taxes

There are some reasons to like personal income tax cuts.

Taxes on direct economic activity, such as corporate taxes or personal income taxes, create disincentives for productive activity and, perhaps more importantly, promote unproductive activity to minimize tax burden. Unfortunately, the complexity[1] of the Australian tax system creates a large number of opportunities to legally avoid paying tax.

One example of this is the creation of corporate structures which shift income from the more highly taxed personal income tax system (taxed at 47 per cent including the Medicare Levy of 2 per cent) to the lower rates of the corporate tax system (27.5 to 30 per cent depending upon the size and structure). There are also more complex structures that can be legally employed to achieve even larger reductions in tax. Cutting personal income taxes reduces the incentive for individuals to shift their income to these other forms.

Since tax thresholds are not indexed to inflation, the typical Australian pays more tax each year even when real income (adjusted for inflation) stays constant. Personal income tax cuts are a way of giving some of this money back. The policy however, is poorly targeted since people pay different amounts of tax in different years. A retiree today who was subject to bracket creep while working will not be getting the money back.

The 2018-19 budget makes a half-hearted attempt to address bracket creep through increasing the top of the 32.5 per cent tax bracket.

Cutting personal income taxes should also stimulate economic activity and produce a small amount of additional growth. Small amounts of additional growth are often underappreciated. Growth and well-being are intimately linked and small additions to the GDP growth rate have large impacts over long time horizons due to compounding.

Finally, Australia is increasingly out of line with other countries in our very heavy reliance on direct taxation. 56 per cent of total tax revenue is collected through direct taxation in Australia compared to an average of 33 per cent across OECD countries in 2015. In this respect, our tax system looks like something from the last century. Other countries have already moved to more efficient taxation approaches, through an increased reliance on indirect taxes like goods and services tax (GST), which are more difficult for people to avoid.

But personal income tax cuts don’t pay for themselves

However, be suspicious of arguments suggesting that lower income taxes will pay for themselves through higher government revenue in the short run. There is simply no evidence for this. Research from the Tax and Transfer Policy Institute suggests that achieving an increase in declared, taxable income of one per cent by taxpayers on the top marginal rate in Australia would require decreasing the marginal tax rate by six percentage points (from 47 to 41 per cent, for example).

If we only consider the self-employed at the top marginal rate, a three percentage point reduction in the marginal tax rate (from 47 to 44 per cent, for example) would generate about one percent more declared, taxable income. So Australia is a long way from the top of the Laffer curve (the point beyond which taxes are so high that reducing taxes generates more tax revenue).

And alone, personal income tax cuts are fiscally irresponsible and a piecemeal approach to tax reform

This brings us to my main concern about the repercussions of income tax cuts in isolation. They will bring less revenue to a country in deficit with a mounting debt burden. We are a long way from being Spain or Greece, but the trajectory is bad and the slope is a slippery one.

The justification for Australia being able to afford personal income tax cuts is based on a short-term positive blip in revenue, rather than long-term trends in positive revenue growth (the trends do not look good and the blip may or may not be a lasting one). The corporate tax is threatened by base erosion and profit shifting. The casualisation of salaried work, including the growing ability to offshore bits and pieces of many jobs in the knowledge economy, could lead to the rise of base erosion of the personal income tax base. There is not much evidence of this happening yet, but it remains a risk which high personal income tax rates only exacerbate. So our two main tax bases are shrinking or at risk.

Other tax bases are at risk too. GST applies to an ever-shrinking amount of consumption, mostly because prices of goods that are exempt from GST have gone up faster than prices of those goods which attract GST. Excise taxes on fuel are also likely to fall as electric cars become more common.

Meanwhile, expenditure is growing in ways that neither side of politics seems interested in addressing. An ageing population and their associated pension costs, an expensive National Disability Insurance Scheme and a health system, with costs growing faster than inflation, will all need to be funded.

So cutting taxes, but retaining the compassionate and generous Australian society we cherish, while our main sources of tax revenue keep slipping through our hands like jello as they are squeezed even tighter, this does not add up for me.

Some will run a “starve the beast” argument that cutting taxes leads to higher deficits which forces expenditure cuts but the evidence around the OECD seems weak for this. We either see dizzying debt burdens with little attempt to balance expenditure and revenue (the United States; France; Japan) or total collapse (think of Greece) where pensions and support for basic public transportation are slashed in the face of disaster. I am not sure that is the cliff that we want to drive the country off of.

Decreasing personal income tax rates, bearing in mind the country’s reliance on direct taxation, will only be good for Australia if they are accompanied by serious broad reform including:

  • Simplification of the system to reduce unfairness and burden on taxpayers
  • Reduction in the number of taxes
  • Removal of complicated and unfair exemptions, complex deduction rules and a myriad of tax offsets
  • Increased indirect taxation by broadening the base and increasing the rate of GST
  • Increased taxes on “bad things” like pollution and congestion
  • Increased taxes on land and natural resources
  • Reform of the corporate tax system

So where to from here?

In the absence of a comprehensive re-think of our tax system, we are left with a choice between silent, increased taxation through bracket creep to keep up with unrestrained expenditure or a short-sighted cut to personal income taxes.

If pushed to choose between these two (far less than best) options, I think I would pick the personal income tax cuts based on the arguments for growth and reducing the burden of direct taxation. But we simultaneously need to continue to push for comprehensive tax reform as outlined above. We will also need expenditure restraint to move towards a sustainable fiscal position. Both of these look difficult in the current political environment.

[1] This complexity is partially reflected by the substantial number of Australians that hire a tax agent to file their taxes (73 per cent of residents in 2015-16).


*This podcast was presented and produced by Austaxpolicy editorial intern Cherry Zheng.


More from our Budget Forum 2018 series:

Budget Forum 2018: This is not a Genuine or Equitable Way to Simplify the Personal Income Tax System by Andrew Podger

Budget Forum 2018: A Missed Opportunity for Enhancing Australia’s Budget Transparency on Distributional Information by Teck Chi Wong

Budget Forum 2018: Targeting the Black Economy by Joel Emery

Budget Forum 2018: Tax Caps and Tax Cuts: Good for Australia? by Miranda Stewart

Budget Forum 2018: Risks Greater Than I Can Recall in My Working Life by John Hewson

Budget Forum 2018: Should Australia Produce a Citizen’s Climate Budget? by Usman W Chohan

Budget Forum 2018: The Future of Corporate Taxation by David Ingles

Budget Forum 2018: A Political Budget Unlikely to Work Politically by John Hewson

Budget Forum 2018: The Government Could Be Boosting the Budget Bottom Line with a Change to How It Taxes Gas by Diane Kraal