Over many years, myriads of proposals purporting to increase the progression in the distribution of the tax burden have never ceased to amaze me, especially those wanting to fiddle with the income tax rate structures. Anyone thinking this is an easy task has never read William Vickrey’s 1947 masterpiece Agenda for Progressive Taxation.
Designing a progressive tax structure not only requires decisions on the most suitable tax base, e.g. income (Henry Simons), expenditure (Lord Kaldor), and potential income (earnings if human capital and assets used to best advantage). Next on the list is choosing the relevant time to allow/adjust for volatility over time in the income/expenditure and finally the most proper definition of the tax unit (individual, couple or family allowing for dependents).
Australia has opted to levy tax on individual annual incomes with only modest and limited adjustments for those with fluctuating incomes and differing family structures. Distributing the tax burden ignores key differences such as the number of children, disabilities etc and housing situations. The ability of partners and adult children to obtain separate income streams play a more significant role in distributing the tax burden.
Successive governments have opted to increase tax payable as annual income increases by applying higher tax rates in steps (brackets) as measured income rises. Often, they have opted to increase effective rates of tax by not or only partially adjusting the starting bracket levels for inflation, preferring in many cases to make discretionary changes in the brackets or applicable tax rates.
This approach penalises people with fluctuating annual incomes and those with increasing or decreasing incomes over an extended period. It also increases the advantages of income splitting within the family unit. The system as it currently works does not provide a correct or reliable indicator of individual family structures to pay more tax. Just as important to ensuring a fair distribution of the tax burden is the differing ability of taxpayers to vary the timing and/or size of their annual incomes.
Specific taxation provisions, e.g. the ability to prepay expenses or delay expenses, also provide opportunities to defer or neutralize the impact of rigid progression in rate structures.
Naturally the larger the progression in the rate scale the greater are the benefits of restructuring the flow of income over time. The higher the rate of progression, the greater are the benefits of manipulating the flow of income and income splitting with family members or utilising other investment structures including companies and superannuation are.
Inevitability the harshest impact of a steeply progressive rate structure falls on taxpayers such as wage and salary investments with no or extraordinarily little ability to control/adjust how and when they receive their income. During the high inflation period of the Whitlam government, for example, not indexing the tax brackets for inflation quickly resulted in average income workers facing marginal rates approaching 50% on their wage increases and overtime earnings.
For the above reasons and a desire to limit the advantages of income splitting, levying personal income taxes at a uniform rate sufficient to raise the required revenue has considerable appeal especially when there are other ways to achieve progression in distributing the final burden. These options include using refundable or non-refundable rebates with varying values depending on the assessed needs of distinct categories of taxpayers.
In terms of achieving progression in the tax system rebates are much more effective instruments than the tax-free area and bracket steps currently in use. The $18,200 tax-free area has for example a value of $8,554 for a top marginal rate taxpayer and only $5,824 for taxpayers earning between $45,000 and $135,000 annually.
The first tax bracket at an 18% rate (including Medicare levy) up to an income of $45,000 similarly provides a benefit of $7,772 to a top marginal rate payer and only $3,752 to most taxpayers paying a 32% marginal rate. Their combined impact of these two steps in the rate scale provides a benefit of $16,326 for top marginal rate payers and only $9,576 for the vast majority on the 32% marginal tax rate.
Switching to a flat tax rate of 32% up to the current $135,000 income at which the 32% rate cuts out and offering every taxpayer a non-refundable tax rebate of up to $9,576 annually would substantially reduce the tax levied on lower income taxpayers and increase that payable on higher income taxpayers (if higher marginal rates apply to incomes over $135,000 annually).
For example, this change would increase the tax-free area to $29,925 compared with current $18,200. Importantly also, the benefit would extend up to an annual income of $45,000 where the current 32% tax rate begins. Furthermore, increasing the annual rebate to the current maximum concession currently offered to highest rate payers of $16,326 would raise the annual tax-free area to $51,019 and extend the tax benefits up to an annual income of $152,307.
Compared with the proposals to increase progression floated recently, these changes would help a redistribution of the tax burden focused solely on lower income taxpayers. Critics of this style of restructuring will at once focus on the huge added cost of rebates pitched at these elevated levels.
Totally correct if you ignore equity in the distribution of the tax burden which our governments certainly have. First what is the justification for every income recipient having access to a tax-free area. Let me start with the most glaring gross inequity in the current system. Currently the superannuation pension tax arrangements set (unbelievably) a tax-free area for funded annual pension payments of $125,000 even though the accumulation of funds has already received generous tax subsidies.
The tax laws also give them another tax-free area of at least $22,000 on top of the maximum $125,000 tax- free pension payment, up to $147,000 annually free-of tax before we even consider the benefits of imputation credits to many of these taxpayers. What is even more galling is that when ordinary taxpayers have not received inflation adjustment the $125,000 limit is now 25% higher than the original starting point of $100,000
Such have been the priorities of governments suggesting that the motivation for this indexation priority is that by doing so they also indexed a special 10% rebate for taxable public servant unfunded pensions at the same time.
Enough about this gross distortion of tax equity. Let us look at another big tax and social security shelter for homeowners. Traditional tax theory correctly recognises that investing in a family home generates an imputed income (equal to the value of the rent that would be payable less the costs of home ownership). Put simply by investing in the family home, you do not generate a taxable income on the money invested and instead receive the benefit of not paying rent.
Unlike many other countries, Australia further increases the benefits of homeownership by ignoring all appreciation in value for capital gains taxes and totally ignoring this asset under the social security assets test. As a pragmatist, I would not dare suggest Australia tries to include imputed rent estimates in defining the income tax base (but the unlimited exemption from capital gains and social security arrangements is another matter).
Instead, we can address the benefits of home ownership in other ways especially in assessing eligibility for non-refundable tax rebates in the personal income tax system. To go further ahead we also need to address a major inequity in our superannuation laws. The superannuation tax provisions do not adequately or equitably address situations where retirees do not have their superannuation equally split or are not owner occupiers.
If upper limits are to be set on the maximum superannuation tax concessions, these limits need to recognize two key factors. First not all superannuation fund members have been able to split their benefits equally with their partners and the rules need to remedy this. Second non-homeowners do not have the advantage of tax-free imputed rent in securing their accommodation. Where possible the legislation also needs to recognise this.
One conceivable way to address these issues is to vary the size of the non-refundable tax rebate available to various categories of taxpayers. There is a wide range of options to choose from including the following:
- No rebate for homeowners with more than $2 million (single) or $3 million (couple) in equity in their home (to deal with imputed rent benefit)
- No rebates for individuals/ couples with equity in their/home and superannuation funds exceeding $3million (single) and $5 million (couple).
- No rebate for recipients of government funded social security payments. Instead like current disability pension payments, all pensions should be tax-free with adjustments to the applicable eligibility income tests.
- No rebates for temporary visa, foreign students, and tourists with working visas
- No rebates for recipients of tax-free superannuation pension payments which exceed the maximum available tax rebate (with phasing in provisions)
- Largest annual rebate of $16,326 for sole parents, orphans, renters, and home-purchasers with say less than 30% equity in their home
- Standard rebate of up to $9,576 for other eligible homeowners.
These options show the flexibility that using rebates instead of tax-free areas and rate steps can give in achieving progression in the tax system. As highlighted previously, annual income is only a rough and approximate measure of the capacity to pay tax. Family structure and size, health and accommodation status are crucial factors needing careful consideration.
I do not have the conceptual and statistical support available to me in the 1970s and 1980s where brilliant number crunchers were only too keen to be given difficult but meaningful tasks (such as actuarially costing the age pension in 1983 and helping the Gang of 3 restructure the tax system in 1975).
Nevertheless, based on my experience seeing the massive unnecessary cost of the superannuation tax concessions, the huge incentive for income splitting to avoid the top marginal rates (greatly reduced if access to the basic tax rebate is reduced/removed) I am sure that a major restructuring of the personal income tax system along the above lines would work and help many struggling taxpayers.
A later Chapter explores the costs and benefits of a flat rate system (say at a 32% rate) incorporating highly selective tax rebates as suggested in this Chapter accompanied by a major restructuring of the tax shelters now distorting our tax system. Legislation to set a minimum tax rate of 30% for trust and capital gains tax appears to be the best thing since sliced bread in the latest budget. Focussing on a tax structure that does not encourage the use of structures including superannuation, companies, and trusts may well be a superior avenue to pursue.