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Global trends in tax reform.



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Global Trends in Tax Reform

Thursday, December 15, 2005

In August this year, Jeromey Temple and I published a paper on the subject of tax reform

entitled “Taxation Reform in Australia: Some Alternatives and Indicative Costings” It was

designed to make, or restate, the case for making our tax system simpler, more efficient and

more equitable. This would involve not only reducing rates but also broadening the tax base

and thereby simplifying our personal tax system.

This was hardly radical stuff. While everyone has a different view about the appropriate design

for a tax system, there is no question about what it should seek to achieve.

“A tax system should generate the Government’s required revenue with as little economic

distortion as possible, while distributing tax burdens fairly. It should not discourage work,

saving or entrepreneurship more than is necessary and it should not discourage individuals

from acquiring the skills and education that will increase their productivity. It should not

discourage investment, or favour investments in one asset class over those in another. In

short, an efficient tax system alters economic decision making as little as possible.”[1][1]

In January this year, President George W Bush established a bi-partisan Tax Reform Panel

headed by former Senator Connie Mack and including leading economists including Nobel

Laureate James Poterba to review the US tax system and recommend changes. The leading

figures in economics, government and business contributed to the review and both the

hearings and the report repay careful study.

The President was unequivocal in his charge to the Panel. He recognised that the US Tax Code

was inefficient and inequitable and that it needed drastic reform. It seems unusual for us to

see a Government in office criticising its own tax system, especially when that Government

has been in office for five years, but President Bush actually is following in the footsteps of his

Republican predecessor, Ronald Reagan, who in 1986 effected what was probably the largest

single reform of the US tax system by, in a very small nutshell, broadening the tax base by

removing loopholes, concessions and complexity and at the same time reducing rates.

However since 1986, as the Panel noted nearly 15,000 changes had been made to the Tax

Code.

The Panel reported last month and while its specific policy recommendations are of most

interest to Americans, what struck me most profoundly was the preparedness to speak

bluntly.

“the father of modern economics, Adam Smith, said the free market is the invisible hand

guiding every economic event. In today’s US economy, the tax code is the true force. The tax

code penalises savings, contributes to the ever increasing cost of health insurance and

undermines our global competitiveness. The tax code touches all of our life’s major events. It

tells us the best time to be born, the best time to marry and the best time to retire.”

“In short our tax code is a complicated mess. Instead of clarity we have opacity. Instead of

simplicity we have complexity. Instead of fair principles we have seemingly arbitrary rules.

Instead of contributing to economic growth it detracts from growth.”

The Panel’s chief value, it seems to me, was that it has raised public awareness of the

problems with the current US tax code and reported on it in language that is remarkably

clear and accessible. Both the President and the Panel underline a very important fact of life

(including political life). You cannot begin to address a problem unless and until you recognise

that it exists.

The Panel, in the words of two its members, Stanford Professor Edward Lazear and MIT

Professor James Poterba,

“..endorses two tax reform proposals that would improve economic growth, simplify the tax

code and roughly preserve the current distribution of tax burdens. …The first is the Simplified

Income Tax. It preserves the income tax framework but cuts marginal rates to 15%, 25% and

33%. It provides for a large amount of tax free saving, consolidates credits and rationalises

the system of business taxation.”

“The second reform proposal, the Growth and Investment Tax, builds on the Simplified Tax

System and by allowing full expensing of capital, shifts the tax system toward a consumption

tax base. Similar treatment of all business forms (companies, partnerships etc) would allow

firms to choose their structure for business rather than tax considerations. Non financial

businesses would be taxed on a cash flow basis and financial income or outflows, including

principal and interest, would be ignored for tax purposes. The business tax rate and top

individual income tax rate would be 30%. The Growth and Investment tax would differ from a

pure consumption tax in an important way. Household receipts of interest, dividends and

capital gains would be taxed at a flat 15% rate.

“Productivity growth depends on investment in human and physical capital. Investment in

human capital means acquiring skills through formal education and learning on the job.

Investment in physical capital means adding to the stock of plant, equipment, technological

know-how and other intangibles that make workers productive. Both proposals encourage

investment in skills by reducing marginal tax rates on labour supply for most earners. They

encourage investment in physical capital by reducing taxes on business investment. Treasury

estimates that moving from the current structure of the Growth and Investment Tax would

lower the average tax burden on all investment from 17% to 6%. This would encourage new

investment and significantly increase productivity and wage growth.”

The two panel members conclude their summary of the Report with a very telling comment, as

applicable to Australia as it is to their own country.

“Tax reform, as distinct from tax reduction, inevitably involves curtailing some entrenched tax

benefits. If reform proposals are dissected by politicians in an attempt to promote provisions

that reduce their constituents tax liabilities while excising those that increase constituents tax

liabilities, reform will inevitably fail. But if reform proposal are viewed instead as a collection of

provisions that leave most families in a position not very different from their current one,

while also shifting the tax system toward a structure that will promote long term economic

growth and reduce the burden of tax compliance then these proposals can command broad

popular support and even enthusiasm. Tax reform is a difficult process that requires

commitment to the goal of creating a more efficient, simpler and fairer tax system.”

A good example of the political difficulties these reforms will face in the US is the proposal to

replace the deduction for home mortgage interest with a tax credit equal to 15% of interest

paid on a principal residence. Almost as heretical as proposing limits to negative gearing in

this country.

We will see what comes of these proposals. It is not unreasonable to be sceptical, although it

is worth remembering that the Reagan reforms of 1986 were given no chance of passing the

Congress…until they did.

Elsewhere in the world, including Australia, there has been over the last two decades a wave

of tax reform.

The goal of all of these reforms, including our own, has been to promote simplicity by

broadening the tax base thereby enabling a lowering of rates.

Our own Treasurer, Mr Costello has not only been a practitioner of tax reform - what else was

the A New Tax System in 2000 if not far reaching tax reform - he has also made the

principled case for tax reform on many occasions.

Speaking in 1998 in Queensland as he promoted the merits of the GST, the Treasurer said:

“We’d have a much better designed tax system if we had a broader base with lower rates. This

is the point you’ve got to bear in mind: the broader the base, the lower the rate….. So

anybody anywhere in the world will tell you whether it’s the indirect tax system, whether it’s a

personal income tax system, whether it’s a business income tax system - broad base, low

rate. That would be the best kind of design.” [Address to the Griffith/Moreton Electorate

Lunch, 18 May 1998]

There is a wide consensus around the world that tax systems should, in the Treasurer’s words,

have broader bases and lower rates. The OECD, for example, proposes that efficiency in

personal income taxation can be obtained through broadening of the tax base, flattening tax

schedules and aligning rate structures across different taxation systems (eg. Personal /

Company tax) to reduce arbitrage opportunities (van der Noord and Heady, 2001). This would

mean in our context that we would reduce the top two marginal tax rates which

notwithstanding the recent changes are still high relative to comparable OECD countries.

In the last decade and at an accelerating pace nine European countries have moved to flat tax

regimes; all with great success in terms of improved economic activity and, as a consequence,

government revenues. The largest of these economies is Russia and to date only small

economies like Estonia, Latvia, Lithuania and Slovakia have a flat tax within the EU. Slovenia

is likely to follow suit and despite the messy election results in Poland and Germany flat, or at

least flatter, tax will remain on the agenda in those countries.

In an excellent coverage of the flat tax revolution in its April 14 edition, The Economist

Magazine began its editorial with this observation:

“The more complicated a country’s tax system becomes, the easier it is for governments to

make it more complicated still, in an accelerating process of proliferating insanity - until,

perhaps, a limit of madness is reached and a spasm of radical simplification is demanded.”

A flat tax is not, of course, truly flat. Flat tax systems impose a single tax on income with the

broadest possible definition and with very few deductions. Progressivity, or vertical equity, is

maintained by having a tax free threshold which can be adjusted for family size. There is no

need whatsoever for a flat tax to be regressive.

The greatest economic benefit claimed for so called flat taxes is that income is taxed only

once: either at the business level or at the household (or wage earner) level. This means that

income from investments be it interest or capital gains is not taxed in the hands of the

recipient, although of course when it is spent it is taxed because it becomes income in the

hands of the business or individual who receives it. This reduces the bias against savings and

investment which slows capital formation and as a consequence wage growth.

It is important to bear in mind that while there have been substantial tax reforms around the

world, and particularly as noted in Eastern Europe, this has not resulted in a diminution in

Government revenues. Experience is that tax reform, including tax cuts, can not only result in

an improvement in Government revenues but that the highest income groups which pay the

vast bulk of all income tax will actually pay a larger share.

Reagan’s tax cuts controversially slashed high marginal rates. Yet the bottom 50% of

taxpayers’ share of tax collection was 8.3% less in 1984 than it had been in 1981 before the

cuts. Similarly the top 5% of taxpayers paid 35.3% of tax in 1981, but in 1984 paid 38.9%

(Teather, 2004). Mitchell’s (2001) study for the Heritage Foundation found that for every

major period of personal income reduction in the US (during the 1920s, 1960s and 1980s),

“the economy prospers, tax revenues grow, and lower income citizens bear a lower share of

the tax burden” (p. 4). A similar experience was observed in the UK when Thatcher cut the top

rate of tax from 83% to 40% where it remains today. In 1979 the top 10% of earners paid

35% of total revenues. In 1990, they were paying 42% (Teather, 2004).

In these examples, the key question is: did the tax cuts promote increased economic activity

or was the outcome due to other factors? It is difficult to provide empirical support for either

proposition because of the complexities involved, although it is obvious that a tax cut cannot

be detrimental to economic activity; the only controversy is the extent to which it is a

stimulant.

Federal Reserve Board Chairman Alan Greenspan spoke to the Tax Reform Panel about the

deadweight costs of taxation, or excess burden as he described it. He said that this excess

burden grows more than proportionately as tax rates are increased. “In fact economic theory

suggests that if you double the tax rate you quadruple the excess burden. This means that

high tax rates have disproportionately high economic costs associated with them.”

The Panel went on to observe:

“A recent study estimated that the excess burden associated with increasing the individual

income tax by $1.00 is between 30 and 50 cents so the total cost of collection $1 in additional

tax revenue is between $1.30 and $1.50 before taking into account compliance or

administrative costs. All else being equal, a tax with a lower excess burden is preferable to

one with a higher excess burden. The size of the economic pie will be larger for example if it

costs only $1.05 to raise a dollar of revenue instead of $1.30. To put this into perspective,

some studies have suggested that a tax system that removes the penalty against savings by

switching the current structure to a progressive consumption tax could potentially increase the

size of the economic pie by between 3 and 7%.”

It should be noted that support for the stimulant effect of tax cuts is not limited to politicians

and economists of a conservative hue. It was President John F Kennedy who said in 1963 “It

is a paradoxical truth that tax rates are too high today and tax revenues are too low and the

soundest way to raise the revenues in the long run is to cut the rates now.”

We may be witnessing a similar phenomenon in the United States today where the

Congressional Budget Office reports fiscal revenues are running well above estimates and

substantially reducing the United States’ fiscal deficit. This surge in income tax receipts follows

the Bush tax cuts in 2003. The Wall Street Journal argues “…the 2003 reductions in the tax

rates on dividends and capital gains seem to be resulting in much higher tax revenues

on…dividends and capital gains.”

In summary what are the trends overseas?

- generally flattening, as the OECD observes, of the personal income rates, especially in

Eastern Europe where flat taxes have been introduced.

- Reducing taxes on investment income and capital gains (see the US especially of late)

- Base broadening by removing concessions as an aid to simplification and lower rates.

This is particularly apparent in the UK and New Zealand where the majority of taxpayers do

not have to file a tax return. Also note in NZ how fringe benefits are simply added to the

income of a taxpayer and therefore taxed at his or her marginal rate instead of at the top rate

and payable by the employer.

- Especially in Europe a greater emphasis on consumption taxes by increasing the rate of

VAT.

Comparing these trends with Australia it is clear there are similarities and differences. We

have certainly favoured some kinds of savings with concessional treatment of superannuation,

although the most preferred savings are probably the family home which is CGT free and

investment real estate which benefits both from very generous negative gearing and the

concessional rate of CGT.

We have introduced a GST, leaving the US as the only major OECD country without a VAT.

The rate of GST is low relative to other VAT levying nations. But we have not been successful

in reducing the higher rates of income tax (they remain relatively high) although we have

mitigated their impact by raising thresholds.

Base broadening was effective in the field of company tax; there was a very effective trade off

between concessions (principally accelerated depreciation) and a lower rate. But in the

personal income tax area, the tax base continues to be diminished by concessions which grow

apace.

In conclusion, there is a world wide move for tax reform and we have been part of it, although

our reforms have been effected at different times and in different ways.

The theme is consistent: simplicity, equity, efficiency. The technique is consistent: broaden

the base, lower the rates. The politics: uniformly difficult.

The challenge of tax reform is a continuing one, no different from other types of economic

reform. The PM talks about the continually receding horizon, no matter how fast you run the

race of economic reform, the finishing line is always beyond you.

Most enterprises, be they nations or businesses, undertake reform when they have fallen into

hard times. Nothing promotes an efficiency drive more than the threat of receivership! But

there is a paradox. Just as hard economic times create the greatest incentive or motivation to

effect reform, those hard times also mean that there are limited means available to pay for it.

On the other hand when revenues are strong, there is plenty of capacity to restructure and

reform, but in days of plenty many of us tend to take our eye off the ball.

The Howard Government is a rare exception. We have enjoyed more than a decade of

sustained economic growth. The Howard years have seen real wages rise by nearly 16%,

more than ten times the increase that 13 years of Labor achieved. Yet John Howard has

pressed on with economic reform, most recently the reforms to Industrial Relations.

I was at a conference in Melbourne earlier this year when I heard Kim Beazley say that the

economic gains from labor market reform were “exhausted”. He was the first political leader to

complain of reform fatigue while still in opposition.

Leaders, whether in government or business, who can maintain as keen a focus on efficiency

and productivity in good times as they do in tough times are rare indeed. We have had that

quality of leadership in Australia these last ten years.

Because of our strong economy, our Government is enjoying very substantial surpluses. The

latest estimates are to be announced today, I believe. It is clear that there is ample scope to

fund reductions in tax, indeed so much is widely acknowledged. But these strong surpluses

also mean that we can afford to tackle real tax reform. As I noted earlier this involves tough

decisions; base broadening means removing concessions. This can be compensated entirely by

a reduction in rates: across the system. $5 billion of concessions can be compensated with $5

billion of rate cuts. But there will inevitably be some losers as well as some winners. A strong

surplus enables us better to ensure that the number of losers is as small as possible.

Ronald Reagan once asked “If not us, who? If not now, when?”

The same questions may be asked today.

There is a global move to simpler, more efficient and fairer tax systems.

We have already achieved a great deal in tax reform, and we have been leaders in some

respects.

Yet we know there is work to be done to make our tax system simpler and more competitive.

I believe we have the means and the will to tackle a new round of tax reform in Australia. If

we cannot afford tax reform today, when will we be able to afford it? And if a Government

with a proven and trusted track record of economic reform is not qualified to take it on, who

else would have the courage, let alone the public trust, to do so?

[1][1] Edward Lazear and James Poterba “A Golden Opportunity” WSJ 1/11/2005