Level the Tax-Raising Playing Field

That the government has announced it is cracking down on egregious use of tax minimisation schemes is acknowledgement of a major fault with Australia’s tax system: it is unfair.

Its response, though, confuses the symptoms with the disease.

Australia’s tax system has a problem with the egregious use of tax minimisation schemes. However, dwarfing this abuse are three core problems that together serve to undermine the fairness of the system and skew benefits towards those with means: large tax rate differentials across different types of income (incentives to minimise taxation); exemption from taxation for some types of income (opportunities to do so) and complexity (to the benefit of the flexible and those who can afford to work the system over).

On face value, cracking down on outrageous tax avoidance schemes is good policy. It safeguards our tax system and encourages would-be evaders to think twice before embarking on elaborate schemes.

But in reality that value is limited. Most tax avoidance runs through the system using entirely legal and widely known and understood methods. The root cause is that the methods to minimise tax are embedded part and parcel in the system.

The Australian Federal Police ran a program to reduce bicycle theft – called “Lock it or Lose it”. It’s not a crime to leave your bike unlocked. Similarly, it’s not a crime to leave the tax system open to exploitation. Better, though, to secure it properly.

Large tax rate differentials across different types of income are problem number one. The top personal income tax rate of 47 per cent compares to the small business tax rate of 25 per cent. Work for a salary and pay 47 cents on each additional dollar of income over $180,000. Alternatively, repackage your work into a business that sells to other people and pay just 25 cents on each additional dollar of income.

Those who can have a strong incentive to do so: earn $250,000 through the company and reduce your tax bill by $26,000. (Less the relatively trifling cost of establishing and maintaining a proprietary limited company – less than $800.)

Some endeavours are better suited to operate through a company structure, further undermining the core principle of horizontal equity: that people with equal income are taxed equally.

Trusts exacerbate this problem. A family trust can substitute for a high income earner as per a company and reduce taxable income even further by distributing income among family members in the most tax effective way.

Aged income-free relatives and university-aged children are the primary candidates to, for tax purposes only, receive a distribution from the trust of what would otherwise have been income attributed to the high earning individual. As long as all parties agree to this, no illegality occurs. (Putting an end to discretionary trusts would solve this problem.)

The exemption from taxation of certain types of income is problem number two. Most egregious is owner-occupied housing. Put savings into the stock market and pay tax on dividends received and capital gains. Put it into a house and pay no tax. No capital gains for extra value from improvements and pass it on to the kids tax free. (A broad-based land tax that captures the imputed flow of income from housing would solve this problem.)

Complexity makes it easy to construct vehicles to avoid paying tax and this is problem number three. Complexity is a major factor in washing-machine arrangements, moving money back and forth between trusts and businesses to such an extent that many succeed in never paying any tax on income. The confidentiality of trusts makes them particularly prone to leverage by complexity. (An obligation for all trusts to file electronically with the ATO each year would reveal how much income is flowing through them and be a first step to addressing this problem.)

To reiterate in brief:

• equalise tax rates across different types of income;
• put an end to discretionary trusts;
• ensure all income is taxed (including imputed rent from owner-occupied housing);
• tax all savings income equally irrespective of who receives it or how it is distributed;
• remove complexity.

At first glance what I have said here might seem like “tax gone mad”. But it is not. It is not about raising the level of taxation. It is about levelling the raising of tax.

The government’s commitment to crack down on advisers proffering the most egregious of tax avoidance schemes passes the pub test. It provides a strong disincentive to further such abuses of our system.

On the other hand and closer to home, taxation revenue lost through those most egregious schemes is dwarfed by the amounts whisked away through the perfectly legal means described above. Means available to every reader of this newspaper.

The cookie jar of taxable revenue stands open and unattended on the counter of public finances.

 

First published at the Australian Financial Review on Tuesday 8 August 2023.