In a paper marking the 50th anniversary of the seminal 1975 Asprey Tax Review, I asked the question whether Haig-Simons style comprehensiveness was still relevant to tax reform in Australia, or whether developments in optimal tax theory had qualified its role.
The early 20th-century work of Haig and Simons on an income tax approach, alongside Fisher, Kaldor and Meade on an expenditure tax approach, established comprehensiveness as a cornerstone of tax policy design. The premise is simple: to achieve an equitable measure of a taxpayer’s ability to pay tax, a comprehensive measure of income (or consumption) is required. All income, regardless of its source, form or use, needs to be included in the tax base.
The mantra to ‘broaden the base, lower the rate’ informed tax base broadening around the world in the second half of the 20th Century. In Australia, the introduction of the Capital Gains Tax (CGT), Fringe Benefits Tax (FBT), and the Goods and Services Tax (GST) were stand-out reforms. Similarly, the lowering of the company tax rate to 30 percent, in conjunction with the removal of accelerated depreciation, followed this blueprint.
The Challenge of Optimal Tax Theory
However, this presumption in favour of comprehensiveness has been challenged by optimal tax theory. It has been demonstrated that, on economic efficiency grounds, it is not always optimal to tax all income (or consumption) equally.
Most obviously, if practical constraints prevent the comprehensive taxation of one form of income, the argument in favour of taxing everything else comprehensively weakens. Further, where different forms of income have different price elasticities, it may be economically efficient to tax the more elastic forms lighter.
The confused state of tax reforms in 21st-century Australia partly reflects the muddled thinking about the merits of comprehensiveness in tax design versus a more selective optimal tax theory approach. While fully ‘unmuddling’ tax policy thinking is too great a task, my paper sought to provide some clarity about the role of each approach.
Equity vs Efficiency
To begin that task, we need to understand the different conceptual frameworks of the two approaches. Comprehensiveness begins with an equity framework (the ability to pay tax), giving the taxing of all income equally an intuitive fairness appeal. Conversely, optimal tax theory comes from an efficiency framework, where economic distortion arguments resonate more strongly. Of course, real-world tax policy considerations always involve balancing trade-offs between equity, efficiency and simplicity. Therefore, the two frameworks need not be viewed as strictly incompatible.
An important area where these two frameworks diverge is the taxation of capital income versus labour income. With capital allocations increasingly determined in a mobile international market, the elasticity of capital income is higher than that of labour income. This provides strong economic efficiency arguments for taxing capital income differently—and probably more lightly. Weighed against that is the equity consideration that capital income disproportionally accrues to higher-income earners.
Corporate Tax and Domestic Savings
The world-wide trend to lower company income tax rates is consistent with this optimal tax theory view. At 30 per cent for larger companies, Australia’s corporate tax rate sits at the higher end internationally, creating pressure to lower it. But the domestic gap with the top personal tax rate acts as a constraint on that. A further challenge is that our dividend imputation system only provides franking credits to domestic shareholders. Since the cost of capital is determined by the after-tax return in international markets, this system skews domestic investors towards domestic shares and distorts the system against foreign investors in Australian shares.
A somewhat different set of considerations arises in regard to the taxation of domestic savings more broadly. A comprehensive income tax would fully tax the returns from savings, while a comprehensive expenditure tax would fully exempt them. While there are arguments in favour of each approach, the reality is that savings in aggregate are relatively price-inelastic. Of concern, though, the choice of savings vehicle appears to be quite elastic, meaning people are responsive to tax rates. As such, Australians invest heavily in the most tax-favoured forms of savings: owner-occupied housing and superannuation.
The Henry Review’s Balancing Act
Australia’s major tax review this century, the 2009 Henry Review, maintained a general presumption in favour of comprehensiveness, but was influenced by optimal tax theory in some respects.
Most notably, it argued that a shift away from taxing mobile capital income towards less mobile factors could improve economic growth. It recommended a reduction in the company income tax rate to 25 per cent to attract foreign direct investment, in conjunction with a uniform resource rent tax to ensure a fair community return for natural resource extraction. A rent tax, by taxing only above-normal returns, should be economically neutral.
In regard to the taxation of domestic savings, the Henry Review proposed a more uniform tax treatment of the different forms of savings. It recommended a hybrid income/expenditure tax approach that provided a uniform 40 per cent discount for net returns on bank deposits, bonds, rental properties and capital gains.
The review also targeted stamp duties on property conveyances, labelling them as inefficient and inequitable because they discourage people from changing residence as their personal and work circumstances change, penalising those who do need to move more frequently. Instead, the AFTS proposed a greater reliance on land taxes, as their immobile tax base makes them a relatively efficient means of raising revenue.
In framing these recommendations, the Henry Review sought to find a balance between a general presumption in favour of comprehensiveness, but with some specific departures for optimal tax theory where there was strong evidence to support that. It remains to guide future tax reform considerations.
Conclusion
In conclusion, comprehensiveness remains a sensible starting point for tax reform considerations, but it is not an adequate endpoint. Where there is strong information about economic efficiency effects, departures are warranted, perhaps most obviously in regard to the taxation of capital income.
Tax policy design requires constant assessment against some accepted criteria such as equity, efficiency, simplicity and revenue adequacy, with trade-offs inevitably required. Tax reform was never meant to be easy, but we should take courage, for the rewards can be great.
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