Whither tax?

Iris Murdoch and her very literary husband John Bayley had a term for going to literary festivals and talking on panels with names like “whither the novel”. They called it ‘whithering’. The Sydney Morning Herald asked for 1,500 words of withering on the tax system, which I structured around what I liked and  didn’t about the Henry Review. Unfortunately, it turns out, they didn’t, in the end, want 1,500 words.  Of  the 1,000 odd words on Fairfax websites, even fewer made it into the paper and, as is the way with such things some things got garbled.

But that’s the game with papers, so there you go.  At least I get to post it up here.  So here it is below the fold in its full 1,500 word glory.

It seems first term governments can’t help themselves. Hawke, Howard and now Rudd made big tax reform announcements in their first term. This cruelled Hawke and Rudd’s honeymoon popularity and nearly lost Howard what should have been a ‘honeymoon’ election.

Rudd’s dance with death was a study in fecklessness. We’re forever being seduced by the idea of approaching the tax system afresh and, thus emboldened and enlightened, sweeping away its maddening perversities. If only! Wresting over twenty five cents in every dollar people earn is no picnic. Volumes of legislation go into preventing people from wriggling out of the net. And when taxpayers aren’t individually wriggling, they’re kicking and screaming to prevent the community getting hold of their money. Ask the miners.

Against that background what chance is there of even giving a comprehensive review a clean sheet of paper? It took about five minutes for the Government to go tree doctor. The ‘root and branch’ review of taxation ended up with progressively more roots ripped and branches lopped. And whoever suggested giving the panel eighteen months so their report could suppurate in the Government’s in-tray in the run-up to the next election has surely already received the Godwin Gretch medal for services to the Opposition in some secret hideout somewhere.

Still Henry provides excellent broad benchmarks for reform which are of sufficient ambition that the review itself contemplates their influence over years rather than in a single package. There are also ideas the panel liked, but which it thought the government wouldn’t like. These ideas surface, but often ‘between the lines’ – as we’ll see. Then there are some places where I think Henry gets it wrong, which I raise below in conclusion.

The economics of taxation revolves around raising sufficient revenue to fund modern governments’ myriad functions whilst doing as little economic damage as possible. Taxes harm an economy when people change their behaviour, either deliberately to avoid tax or in response to the way taxes change their incentives. If someone can earn $1,000 per week working but it costs them $250 to drive their car to and from work, the tax on their income and their transport consumption might make the difference between them wanting a job and sitting at home on welfare.

The panel spent lots of time trying to better integrate our tax and family payments system to minimise this kind of thing, leading for instance to proposals to increase the tax free threshold from six to twenty five thousand dollars.

Business taxes also change behaviour. The capital that businesses invest is more mobile than labour. So taxing it is more costly. International studies show a strong negative correlation between company tax rates and economic growth. Quoting this, Henry wanted our company tax rate cut from 30 to 25 percent. But he left a way of being much more ambitious sitting there between the lines – to which we’ll return.

The review also made a big play for expanding taxes where they didn’t change behaviour or, better still, where they could actually change behaviour for the better. Taxing resources falls into the first category. The resources can’t move. So, we can tax our little heads off so long as we leave miners with sufficient remaining returns to get that dirt out of the ground and to minimise the cost of doing so.

Henry’s proposed resource rent tax met those requirements admirably as does its replacement (though less so roughly in proportion to the revenue disgorged in securing political peace in our time with Big Mining). Henry also wants to switch taxation towards annual taxes on land and away from stamp duty on property transactions. (Land isn’t going anywhere, but hefty stamp duty charges obstruct people changing their home to suit changing circumstances).

And if we tax resource and land rents without distorting behaviour, there are some ways to raise revenue whilst actually changing behaviour for the better. Henry’s proposal to restructure registration as road user charges fits this bill as road charges help push people towards more efficient and environmentally friendly use of our transport infrastructure for instance by greater use of car-pooling and public transport.

Even more so for environmental taxation like a carbon tax which raises revenue whilst reducing pollution. Henry also wants to tax congestion (for instance by rebalancing tolls to charge more at peak hour). That would raise revenue and reduce congestion as some people rearranged their transport to avoid peak tolls. Congestion costs Australia around ten billion and Sydney nearly four billion dollars a year a figure that’s set to double within the decade.

Then there’s Henry between the lines.

Dividend imputation passes the company tax to company’s shareholders who can use ‘imputation credits’ to pay their own income tax. It’s a nice idea, which reduces ‘double taxation’ of shareholders’ investments. But most tax concessions sound like a good idea, especially to the beneficiaries. The question is, are they cost effective? In this case despite it’s truly monumental cost – around $25 billion next financial year – it achieves next to nothing for the economy.

It’s not available to foreigners, since they don’t pay Australian income tax. Yet they’re the ones with the real money. Where most Australians’ money will stay in the country with or without company tax breaks, a tiny fraction of global capital finds its way to Australia. If we did what numerous countries have now done and recirculated imputation as company tax cuts we could get the rate to around 19 percent. That one third cut in the tax rate would increase the share of global portfolios we received. If it rose from – say 2 percent to just 2.5 percent of global portfolios – foreign investment would surge by a quarter, reduce Australian businesses’ cost of capital and boost investment in Australia’s factories, mines, tourist resorts, privately run infrastructure etc.

Lateral Economics helped put this idea on the national agenda with a discussion paper for a business forum in 2006 and I presented it to a Treasury seminar last year. Some early somewhat sympathetic comments from Dr Henry thereafter produced a campaign by Australia’s investors to keep imputation, leading Treasurer Swan to publicly support them. In the upshot the Henry panel supported limited reductions in company tax and seemed very lukewarm on imputation. Their final report even contemplates a partial move towards what I’ve outlined, presumably on the grounds that if a job’s worth doing it’s worth half doing.

In any event, if we half do it, like we half did the resource rent tax, it would generate gains of a similar magnitude. (Australian shareholders would even get compensation for the return of double taxation – not only because company tax would be lower, but also because their shares would surge in value as foreigners bid for them. If only all reform came with its own building compensation package.)

The Henry panel also thought death duties were a good idea. They don’t distort behaviour much. And they’re the acme of fairness. Why should your chances in life depend on your skill in choosing your parents? Of course the very expression ‘death duties’ strikes as much fear into politicians’ hearts as it strikes loathing into the denizens of Bellevue Hill and Toorak. But need it worry the rest of us? What if we only collected death duties from estates worth over $2 million (OK $5 million for the political chickens) and recirculated the revenue raised in lower tax elsewhere.

But though I didn’t see them explicitly ruled out by the Treasurer, the panel recommended not that we do it, but . . . that we discuss it. So dear reader, here I am discussing away as instructed. You can do the same – on the train, at work. Anywhere! Remember, it’s Recommendation 25.

Finally, a complaint. The virtue of Henry’s simplicity and elegance is that it keeps the fundamental issues clear as the ideas navigate the messy world of political compromise. But simplicity can be overdone. Often a good idea can’t be introduced holus-bolus, but can be kept in play in some partial form. Generous tax free thresholds like the one I proposed above for death duties could be used more widely to begin the process of normalising good taxes that are currently political no-go zones. And caps on entitlements can be used to scale down access to unjustified tax concessions where abolition is politically taboo.

Your family home is exempt from various taxes including capital gains tax. It makes little economic sense but would be electorally impossible to overturn. But why should the concession be extended to the very wealthy few who live in houses worth more than – say – $4 million. By the same token, we could cap the extent to which we allow landlords to claim negative gearing against their other income – to say 20 percent of the value of their interest payments. By dint of such makeshifts we could save plenty of revenue, and keep the issues more properly in play for continuing community deliberation.

Nicholas Gruen is Founding CEO of Lateral Economics and Peach Financial.