Over the four decades since Paul Keating’s attempt to introduce a goods and services tax (GST) and cut personal tax rates, the idea that taxes on consumption are inherently superior to taxes on income has hovered ghost-like over every attempt at tax reform in Australia.
I challenged the idea, theoretically and empirically, in a recent report published by the Australian Council of Social Service (ACOSS).
Prompted by the government’s economic reform roundtable, proposals were advanced to increase or broaden the base of the GST and divert the proceeds from state government coffers to the national government to pay for income tax cuts. The case for this ‘tax mix change’ is twofold. The “equity case” holds that it would be fairer since older, wealthier people could no longer avoid paying tax. The “efficiency case” holds that consumption taxes don’t have the same distortionary impact on decisions to work or invest as does income tax.
Consumption taxes aren’t inherently more efficient
A common measure of the efficiency of a tax is its “marginal excess burden” – the extent to which each dollar of tax distorts economic decisions and reduces future wellbeing. The last such modelling from the Treasury – for the Turnbull government in 2015 – repeated the findings of other studies that land taxes were among the most efficient and stamp duties among the least, bolstering the case for replacing the latter with a land tax that includes owner occupied properties.
However, Treasury found little difference in marginal excess burdens between the GST and a tax on labour income (Figure 1):
Our estimate of the marginal excess burden on individuals’ labour income and GST are very similar at around 21 cents and 19 cents respectively. This aligns with the intuition that the taxation of labour income and GST both affect the real purchasing power of wages, with a similar incidence on labour supply.
Figure 1: Marginal excess burden (reduction in economicwelfare) of major Australian taxes
Source: Cao L et al (2015), Understanding the economy-wide efficiency and incidence of major Australian taxes. Treasury Working Paper 2015-1. Canberra. Note: A higher value indicates that a dollar of tax has a greater adverse impact on the efficiency of decisions to work, invest or consume for every dollar collected in tax.
In other words, a consumption tax is likely to have a similar impact on paid work incentives as a labour income tax unless workers ignore the impact of the tax on the purchasing power of their wages.
The Treasury analysis also suggests that personal income taxes have limited impact on investment decisions:
the after-tax rate of return on capital is equal to the global rate of return, which implies the before-tax return on domestic capital is invariant to changes in the personal income tax system.
This argument is weaker. While there is little evidence to suggest that people in the highest 20% of households ranked by income – who undertake most personal saving in Australia – would save more if income taxes were cut, their choice of investment does appear to be influenced by tax. For example, the relatively low rates of tax on capital gains combined with negative gearing strategies have encouraged investment in property over productive investment.
The solution to this problem is to reduce distortions in the personal income tax such as the 50% capital gains tax discount and negative gearing rather than reduce our overall reliance on income tax.
Consumption taxes are an ineffective tool to reduce wealth inequality
There is growing concern that the tax system exacerbates inequalities of wealth – including across generations. This is reflected in the elevation of intergenerational equity as a primary goal of tax reform in the Treasurer’s summary of key themes discussed by participants in the economic reform roundtable.
In public debate on tax, personal income tax is often blamed for entrenching inequality between (younger) ordinary workers who must pay it and (older) wealthier people who don’t. That is, personal income tax is often identified as a tax on labour rather than investment income.
Yet, the key difference between taxes on income and consumption is precisely that the former taxes investment income (returns from saving) while the latter does not. Since people in the highest 20% of households save over a third of their disposable income, they are likely to be the main beneficiaries of any shift from income to consumption taxes. On the other hand, people in the lowest 20%, who rely mainly on public income support and have little or no capacity to save, would prima facie be worse off. The distributional impact of an increase in GST to 15% offset by a revenue neutral cut to all marginal income tax rates is shown in Figure 2.
Figure 2: Distributional impact of increasing the GSTand reducing personal income tax
Source: ACOSS (2015), The effects of a higher GST on households. ACOSS. Sydney. Note: The overall impact of changes to the GST and income tax is equal to the sum of the impact of each. Households were ranked by equivalent disposable income from lowest to highest 20%. Compensation is not modelled here, to gauge the “pure” impact of a change in the tax mix.
To the extent that it taxes investment income, personal income tax suppresses growth in wealth inequality. Since it is a progressive tax, it also reduces inequality of earnings. Over the last 30 years, as the share of earnings going to people under 30 has declined, their share of personal income tax collections has halved – from 20% to under 10%.
While the GST does not directly tax increases in wealth (saving plus returns from investment), it does tax the existing stock of wealth as it is consumed. This is the basis for the argument that a higher GST would reduce wealth inequality between younger and older people. A tax mix change from income to consumption is akin to a one-off tax on current wealth holdings, which it devalues.
This is a very blunt, and ultimately ineffective instrument to contain wealth inequality. It would disproportionately impact people relying on maximum rates of income support (including Age Pensions), who are not wealthy. It would also reduce taxes on the accumulation of wealth through investment, which wealthy older people continue to do throughout retirement, leaving substantial inheritances to their adult children.
The best way to reduce wealth inequality and improve the efficiency of investment at the same time is to tax income more consistently: that is, to close the shelters and loopholes which allow people with substantial incomes and wealth to pay tax at lower rates than the average fulltime wage-earner.
Peter Davidson authored the ACOSS’s Taxing income less and consumption more – the case against report.
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