Decisions already taken and difficult to reverse have unfortunately resulted in an Australian tax system being overly reliant on personal income tax to raise the largest part of its revenue. With both an ageing population and continuing pressure to increase expenditures, the prospects of even short-term income tax relief for our working-age population are at best dismal.
The introduction of compulsory super contributions now at a 12% rate has closed off options to fund social welfare outlays by taxes on employers. Similarly, the decisions to transfer payroll tax and GST indirect tax collections to the States has reduced the scope to lower income tax burdens by increasing indirect taxes.
Earlier Chapter 9 explained in detail the importance of the imputation credit system to the efficient functioning of our economy and encouraging investment. Abolishing it and returning to the double taxation of dividends system applying in other comparable countries would certainly help reduce the pressure on personal income tax collections.
Offsetting this, the resulting fall in capital values and share prices would present major problems for both investors and the economy, ruling out any possibility of this way of helping personal income taxpayers.
Against this background, also recognizing the need for close control and monitoring of expenditure commitments, the only remaining option is a major restructuring of the personal income tax system. Broadening the base and focusing on special needs and the capacity to pay will improve the chances of long-term acceptance of the system.
Turning initially to taxation theory, the widely accepted Haig-Simons personal income tax base includes both gambling income and gifts, including inheritances. Both historical and practical considerations convince me that including these important sources of income in our personal income tax base is not currently politically possible.
From both an equity and revenue perspective, changing our approach to both the taxation and social security system treatment of the owner-occupied home offers major benefits. Owning a home provides an imputed income in the form of not having to pay rent and appreciation in the capital value of the asset. Just how significant this income is depends very much upon the non-tax-deductible debt on the property and the extent of the capital appreciation in value.
The Australian system, unlike that in many other countries, does not provide any tax deductions for the interest cost of buying an owner-occupied home. However, once the taxpayer owns the home outright or even when there is some debt, it does allow tax deductions on interest expenses when the house provides collateral for an investment loan.
Indeed, a rewarding gearing strategy is to pay off an owner-occupied home with non-deductible debt as quickly as possible and then use the house as collateral for investment or business debt. The tax system grants a full deduction for the interest cost of that debt and under the recent changes only taxes capital gains after allowing for indexation of the purchase price (including the debt part).
Even if administrative difficulties prevent including the value of imputed rent saved by owning a house, there are no obstacles to following the practice of many overseas countries and taxing the capital gains on owner-occupied homes. Not to do so both distorts investment decisions and provides disproportionate benefits to wealthier and/or better-informed investors able to fund purchases of owner-occupied homes with tax-deductible debt.
The Australian system adds to the benefits of investing in the family home by totally ignoring its value in applying the age pension and other social security assets test. Changes to both capital gains and age pension rules would improve both the equity and efficiency of our tax and social security arrangements.
To date, no government has dared to even raise the possibility of including the family home in the age pension and other assets test. Similarly, neither the Treasury nor successive Treasurers have focused on improving the equity and efficiency of the capital gains tax by including it in the capital gains tax base.
These suggested changes would create major administrative challenges, particularly with valuation and recording of improvement expenses. Concentrating on the larger transactions through major exemptions, such as those applying in the USA of, say, an indexed lifetime $1 million tax-free per taxpayer or $2 million combined per couple, would reduce these problems by only encompassing people actively participating in the housing market and/or investing larger amounts in their home.
The combined impact of including the value of the home in the age pension assets test and subjecting larger capital gains to tax would reduce the current incentives to over-invest in the family home. Lowering capital gains tax rates now set as high as 47% on other investments would also help. Reducing the top marginal rates of personal income tax or even introducing a flat-rate tax at a 25 or 30 per cent rate, funded by expanding the base and using non-refundable tax rebates to help lower-income earners, could aid this restructuring.
The current bleak budgetary situation and the latest dismal intergenerational equity projections about our future budgetary situation highlight a need for major structural changes to improve productivity and economic growth. Achieving a lower 25% flat-rate income tax would require major changes to the tax base and restricted access to the tax-free area. For example, the current taxation system harshly overtaxes fixed-interest income at high marginal tax rates with no allowance for inflation, while imputed rent, capital gains and the expenses of borrowing receive much more favourable treatment.
As it now works, our tax system grossly distorts investment decisions, altering both the incentive to earn income and where and how taxpayers invest. Similarly, a flat-rate system would remove the current huge incentive for fully tax-deductible borrowing for investment purposes and income splitting via trust structures.
Given that wealth contributes enormously to the ability but not necessarily the incentive to earn income, applying an assets test to determine eligibility for a tax-free amount would improve both the equity and incentive to earn income of the current system. Reducing effective tax rates, moreover, will increase the incentives of taxpayers to earn more income and reduce the efforts taken to avoid and otherwise reduce their tax liabilities.
A 25% flat tax rate will also reduce the attractions of investing in and keeping money in super by significantly reducing the potential benefits from the current accumulation 15% rate. Similarly, a 25% or 30% flat-rate income tax would remove the current tax advantages to higher marginal-rate taxpayers when companies opt to reinvest their earnings.
Lowering the company tax rate to 25% to match a flat-rate tax at the same rate would not affect the taxation paid by residents but would lower the nonresident tax rate by 5% at a large direct cost to revenue. Thus, even though the corporate sector would object to a company tax rate higher than the personal tax rate, the imputation system ensures that residents would pay only the personal tax rate on dividends.
Turning now to ways of assisting taxpayers deserving of special help, particularly lower-income earners, private-market renters and home purchasers with high mortgage commitments, a 25% flat-rate tax structure without any tax-free area provided by way of a rebate would collect $11,250 in tax from a taxpayer earning $45,000 annually, approximately $7,000 more annually than now (ignoring the Medicare levy). As annual income rises above $45,000, the 5% reduction in the marginal tax rate from the current level kicks in, reducing the added tax burden gradually so that taxpayers with an annual income of $140,000 would pay the same tax as currently.
Above this income level, a flat-rate tax reduces the tax payable below that payable currently, increasing as income rises. By increasing the incentive to receive more taxable income, a flat-rate tax helps higher-income earners further by levying significantly less tax on more income than currently.
Broadening the beneficiaries of the tax rate change would help gain acceptance of this major taxation restructuring. The social security system already distributes cash payments to selected people using both an income and assets test. In the same way as the sole parent rebate works, the tax system could provide similar non-refundable rebates to selected categories such as resident renters in the private market, subject to both an asset and income test.
Selectively applying a non-refundable rebate of, say, up to $8,000, indexed annually and reducing by 5% of income above an indexed $45,000, distributed selectively to taxpayers with assets less than $1 million, would ensure that the selected individuals paid no more tax than currently. The basic aim would be to broaden the tax base and limit eligibility for rebates to selected categories of resident taxpayers.
Given that both an assets and income test decide eligibility for the age pension, denying all pension recipients access to special income tax rebates will simplify arrangements and reduce budgetary costs. Not taxing the pension income could be part of this arrangement. Similarly, confining access to rebates to residents and permanent visa holders would help control costs and concentrate the special rebate aid on the categories of taxpayers most needing help.
Without detailed number crunching, this Domain cannot confirm that a 25% flat-rate income tax accompanied by base broadening and limited access to non-refundable rebates would raise sufficient revenue to meet expenditures. Nevertheless, even with a higher 30% flat-rate tax, action to reduce the huge cost of tax-free areas and lower tax rates in the current system would markedly help lower marginal tax rate increases, especially those occurring through bracket creep.