Real Reform

I’ve been looking at a recently published paper by Allen Consulting on tax reform. Tax reform has become the New Thing To Do. The paper was commissioned by the Victorian Government and, given that I don’t know what the brief was, I’m not being critical of the consultants.

The report proposes base broadening suggesting government choose from a menu of $12 billion worth of base broadening measures ie removing CGT concessions (nothing so brave as suggesting that we remove CGT concessions on housing that I can see). Allen Consulting then argue that governments need to choose about half of these base broadening options to fund the reduction of the top marginal rate from 47.5% to 40%.

As I’ve indicated in several posts and columns I’m very suss on reducing the top marginal rates. It’s not that I wouldn’t like those of us on the top rate to enjoy a lower rate. It’s that from an efficiency perspective, I just don’t think it’s as high a priority as lower rates further down the income scale where incentives to work are already much worse with high effective marginal tax rates (EMTRs) produced by the combination of tax and benefit withdrawal and this is where the supply responsiveness of labour is higher than it is further up the scale.

Even where we are not targeting high EMTRs from welfare withdrawl as a priority, I think what the government has done since it’s come into office namely lifting thresholds makes much more sense than cutting the top rate. But it’s now pretty much accepted that cutting the top rate is a priority.

And various arguments are rolled out about ‘competitiveness’ of the tax system (a very seductive idea which is mostly wrong – but that’s another story pursued a little here). We’re told that we should be cutting tax if not to encourage the wealthy to work harder, then at least to attract highly paid skilled workers to our shores. But that argument doesn’t wash either. If we want to pursue this line of argument then we should be lifting the top threshold as far as we can afford rather than cutting the top rate. I make that assertion on the grounds that we’ll get larger tax cuts to more people in our target zone (high income earners) by lifting thresholds than by cutting rates.

If we want to lift it to $200,000, $250,000 or further well and good. Indeed, with the money we save not lowering the top rate we could lower the second top rate a little and so ‘incentivise’ more of those skilled people that are supposedly at the heart of ‘real reform’. But lowering the rate and creating a windfall for the very rich is mostly revenue down the drain for little GDP return (maybe you’ll get a few fewer sports exiles, but why shouldn’t they keep heading off to the Cayman Islands anyway.)

Anyway, as I was reading the Allens report I came upon this statement. “[W]ith more savings, more fundamental reform could be achieved”. That’s when it struck me that there’s something funny going on in this debate. I can accept that it’s a reasonable ‘rule of thumb’ to say that broadening the base is ‘real reform’ whether it’s fundamental or not I’m not sure. But given that the report is speaking of the rates side of the tax system, what is “more fundamental’ reform? Well to be charitable to its authors, perhaps the idea of reshaping the welfare and tax systems into a fully blown negative income tax system.

But I think something else is going on. I think these tag lines like ‘real reform’ (as opposed to ‘just tinkering’) are forms of unspeak the function of which is to do the thinking in advance for us by framing debate. In the tax debate we now have a strong rhetorical tendency to equate ‘real reform’ with cutting rates and lifting thresholds as ‘just tinkering’. This also goes on within a larger political drama in which Malcolm Turnbull, Craig Emerson and Lindsay Tanner are for ‘real reform’ and the establishment – John Howard and Peter Costello – are ‘just tinkering’.

Now though I think lifting thresholds is generally preferable as I’ve explained above, even if I held the opposite view on the merits (and I’d be happy to be persuaded that I’m wrong) I’d still think this language is deeply misleading. Because the choice between cutting rates and lifting thresholds is one of tradeoffs, and so one of degree not of kind. This is generally true of debates about tax they’re about choices between costly alternatives.

In the GST debate we had much talk of how our indirect tax system was ‘broken’. Well the GST certainly was much more broadly based, and on those grounds it was a big improvement. But it got to be the ‘real reform’ and that meant that two things were sidelined in the debate. They’re not unimportant.

1) Transactions costs. WST was collected by of the order of 100,000 businesses. The GST adds another entry to every invoice of every one of over one million businesses in the country. What’s the cost of that? We didn’t really debate it but I don’t think it’s trivial.
2) I think I recall reading at around the time of the GST (please let me know in comments below if you can recall where you saw it if you did) that the allocative distortions involved in exempting medicine, education and finance from the GST were approximately the same as the allocative distortions generated by the different categories of WST and the resulting different rates of tax between specific goods and between those goods and services. That got virtually no discussion at all. After all the GST was real reform. Extending WST to services (as was happening in NSW in an ad hoc way) or harmonising WST rates was just tinkering.

Tax is about tradeoffs. So finding that there are difficulties and problems in a tax system isn’t an argument for replacing it before you’ve given the alternative however attractive it might be in removing those problems the ‘once over’ and you’re confident that it has fewer problems that the thing it is replacing.

Sloganeering about ‘real reform’ is very effectively preventing us from debating the issues sensibly.

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Andrew Leigh
15 years ago
15 years ago

real reform would change the EMTRs for people (especially low or no income people) as this changes the incentives.

i would define real reform as something that addressed marginal rates, and the unnecessary complexity in the tax system. there also shouldnt be major jumps in marginal rates at arbitrarily defined incomes.

Matt Canavan
15 years ago

When the government have barely raised income thresholds in line with growth in nominal incomes, you can hardly blame people for calling ‘just tinkering’. If they raise the threshold to $200 thousand then, sure that’s real reform. But they haven’t done that have they.