A Civilized Tax Debate

"Taxes are what we pay for a civilized society".

This quote from Oliver Wendell Holmes has survived the assaults of neoliberalism and populist tax cuts because it is carved in the plinth of Washington's Internal Revenue Service Building.

Taxes alone don't buy a civilized society. The way in which taxes are spent reflects collective values which may or may not contribute to a civilized society; different nations spend more or less on defence, welfare, industry subsidies, health care, education and so on. The way in which we collect taxes also reflects our collective values.

Most notably, taxes can be progressive (rising more than proportionately with our means), flat (roughly proportional to our means), or regressive (taking a high proportion of the means of the least well-off). A well-enforced income tax, with higher marginal rates for high income earners, is progressive, most consumption taxes are mildly regressive, and some taxes such as gambling taxes are very regressive.

Malcolm Turnbull has recently raised the question of income tax reform. His work, which draws on modelling by academic economists, is well-researched. His message is that tax rates can be lowered, there can be more integration between tax and welfare policies to eliminate poverty traps, and the tax system can be simplified, without detracting from the government's capacity to provide public services or compromising equity. Most publicity has been about his arguments for cutting or shifting upwards the 48.5 percent tax rate, which cuts in at an income of $95 000 ($125 000 from July 2006) — a move which, in itself, would be regressive.

Many others have since joined the chorus, calling for a reduction in the top tax rate. In context Turnbull's arguments are defensible; he points out that very few people pay tax at the highest rate because the well-off can structure their affairs to avoid this bracket. He also achieved some publicity for taking aim at work-related deductions, which he points out are claimed largely by higher income earners. These are probably the weakest points of his proposals.

Labour market economists and psychologists generally agree that, while high marginal tax rates have a disincentive effect for those on low incomes, they don't have the same effect on those with high incomes. Claims (mainly by the Business Council of Australia) that high marginal tax rates deter skilled immigration and contribute to a brain drain aren't plausible; the decision to immigrate is based on many factors. Table 1 below shows countries ranking on the UN Human Development Index and their top marginal tax rates. Australia's top rate is similar to that in other developed countries. Our top rate cuts in at about 2.5 times average earnings; in Canada, Iceland, Ireland, Netherlands and Sweden it cuts in at lower multiples. Among OECD countries the lowest rates are to be found in Mexico, the Czech Republic and Turkey; low rates don't stem people's desire to emigrate from those countries.

Turnbull's case would have been stronger if he had suggested closing off the mechanisms for people with high incomes to avoid tax — such as using trusts and private companies which exist for the sole purpose of tax reduction. His attacks on work-related deductions were also unfortunate. Employees in state schools and in universities, which have been starved for funds over many years, would be unable to do their work without incurring heavy work-related expenses, such as computers, software, stationery, curriculum materials and self-education. Such expenses would normally be picked up by employers in other industries.

Similarly work-related deductions are necessary for apprentices and many tradespeople who are expected to provide their own tools of trade. Abolishing such expenses, or setting them at a fixed cap, would be grossly inequitable. Other aspects of his proposals are worthy of serious consideration, however. He points to many perverse incentives in our taxation system. We tax income earned from hard work at reasonably high rates, while we have generous tax concessions for those who live off the income from superannuation assets. Following the Ralph 'reforms' of 1999 we reward short term speculation through halving capital gains tax, while imposing capital gains tax on the nominal (inflationary) component of capital-stable businesses. We allow highly-geared property speculators to double-count depreciation and interest payments on their investments — a situation which, along with the capital gains tax concessions, has fuelled a housing bubble, to the detriment of first-home buyers.

There are system-wide consequences of the property bubble. Contrary to election rhetoric, Australia has had to maintain real interest rates well above those in other developed countries to try to check the housing boom. High interest rates have kept our exchange rate high, harming our export industries (particularly agriculture) and our import-competing industries (particularly manufacturing). The property boom has created a massive illusion of increased wealth, encouraging people to spend money they don't have, much of it on imports made temporarily cheaper by the high exchange rate. Our deficit on current account, as a percentage of GDP, is matched only by the USA. In short, the impressive economic performance the Treasurer celebrates is essentially a national pyramid scheme funded by an extended credit card limit.

Turnbull has had the political courage to raise hard issues. Not quite as hard-hitting as Keating's 'banana republic' statement, but Keating was Treasurer at the time; Turnbull is a first term parliamentarian in a party which considers public questioning of government policy to be an act of sedition. I suspect Turnbull is trying to tell us that a country that rewards speculation at the expense of hard work has something wrong with its values and may be losing its claim to being counted as a civilized society. We should listen. Malcolm Turnbull MP's full Tax Reform Paper is available from the downloads section of his website.