Insights
Our tax system our future: The need for a national tax reform roadmap
24/09/2023
Why reform to the Australian tax system is critical
The Australian tax system is not only the fundamental revenue source for governments but also a critical driver for decision-making around economic policy and growth, income equality, job creation, and many other issues that impact society as a whole. In environments of constant change and upheaval, we must have a robust and dynamic tax system that can help address our society's most significant challenges and position us for a productive future.
In the past 50 years, there have been a handful of successful tax reforms. Paul Keating's introduction of Capital Gains Tax (1985), Fringe Benefits Tax (1986), and the Foreign Tax Credit System (1986); and John Dawkins’ introduction of the Superannuation Guarantee (1992) are examples of significant reforms that have endured. Many commentators see Howard/Costello's introduction of the GST (2000) as defying conventional wisdom about tax reform and the short-term nature of the electoral cycle that prevents reform from happening.
Other attempts at tax reform have failed, and it's easy to see why. Piecemeal tax reform creates winners and losers - the losers tend to be concentrated among a small number of groups who advocate loudly and derail the reform. While significant in number, the winners gain little individual benefit from reform and typically do not offer their political support. These dynamics (coupled with institutional inertia, unwanted vested interests, high levels of complexity, blame avoidance, and risk aversion) typically abort ideas about tax reform before they gain momentum.
The last comprehensive review of the Australian tax system was by the Treasury Secretary in 2010. Few, if any, of its 138 recommendations have been implemented (especially not in full). Reforming the Australian tax system can evoke profound change in areas fundamental to the positive transformation of society. Assuming the system is fair and efficient, it will increase the economy’s productivity and long-term growth rate, improve incentives to work, save and invest, provide incentives for state and territory governments (states) to deliver services more effectively, increase sustainable revenue for Commonwealth and state governments, and reduce the public debt burden.
Reframing the four pillars of tax reform
With large spending pressures looming over the next few decades – particularly when it comes to health, child and aged care, the NDIS, AUKUS and the energy transition - a robust tax system is critical. The revenue to pay for this spending can only be provided by a tax system that is efficient, sustainable, and consistent with high productivity levels.
All four essential components of the Australian tax system - Commonwealth taxes, State taxes, Commonwealth-State financial relations, and GST revenue (collected by the Commonwealth and distributed to the states), need substantial reform.
1. Commonwealth taxes
The income tax system does not promote incentives to work, save and invest. The GST has too many exemptions, and resource taxes don’t work.
2. State taxes
Reliance on inefficient stamp duty and payroll tax - which could be an efficient tax, but with small business thresholds, is not.
3. Commonwealth - state financial relations (reduce vertical fiscal imbalance) states are excessively reliant on GST and Commonwealth grants.
4. Distribution of GST between states (improve horizontal fiscal equalisation)
Formulas for distributing GST between states reduce incentives for states to introduce efficient taxes and deliver services effectively.
Our rationale for why these areas need substantial and integrated reform is outlined below.
First, Commonwealth taxes suffer from two significant problems. There is an excessive reliance on the taxation of personal income in the system. This creates disincentives to work and save and incentives to shift income to structures for no reason other than to avoid tax. Commonwealth taxes also offer sub-optimal ways of taxing consumption and natural resources. The GST (our broad-based consumption tax) suffers from carveouts and exclusions that make little economic or social sense but lead to substantially less revenue being raised. Natural resources are not taxed in a way that delivers an adequate dividend to the nation.
Second, state taxes have distortionary impacts. Stamp duties on property transactions, insurance levies, and poorly designed payroll taxes distort the behaviour of individuals, businesses and markets seeking to transact economically and effectively. They provide the wrong incentives to invest in property markets, re-invest, take risks, and for labour and capital to be mobile.
Third, the current state of Commonwealth-state financial relations (vertical fiscal imbalance - VFI) means that the states and Territories rely on the Commonwealth for a large part of their revenue, which is principally derived from the GST (anticipated to be $86.6 billion in 2023-24). Direct payments from the Commonwealth to the states have the effect of reducing the states’ incentives to deliver their services effectively and efficiently and ties them to national programs that might not suit their geographic and demographic circumstances.
Fourth, the distribution of GST between states and territories (horizontal fiscal equalisation, HFE) is the process by which the Commonwealth Grants Commission (CGC) distributes GST among the states according to complex, opaque, and contested formulas that only some understand. These formulas estimate states’ relative ease in raising different taxes and providing different services according to what the CGC judges as the states’ inherent characteristics. For example, Western Australia can raise considerable mining-related revenue because it has vast mineral deposits compared to other states. while it is relatively expensive for Queensland to provide some services because it has a dispersed population.
HFE is meant to uphold the principle that all state governments should be in a position to deliver the same quantity and quality of services to their residents and should be funded accordingly, but it doesn’t. The current system is unnecessarily complex. It rewards inefficient service delivery by states, penalises them for improving service delivery and interacts perversely with Commonwealth direct payments. (See Jerome Fahrer and Vince FitzGerald, Aspects of Australia’s System of HFE, Submission to the Productivity Commission inquiry into Horizontal Fiscal Equalisation, November 2017.)
The Australian tax system road map to reform
A feasible roadmap for tax reform should aim to:
1. ensure the national tax system (Commonwealth and states) is on a secure and stable footing
2. add to productivity and economic growth
3. be simpler, fairer, and more transparent than the current system
4. be politically achievable.
A possible set of reforms
We believe the reforms underpinning this roadmap should focus on the Commonwealth rationalising income tax rates while consolidating and simplifying deductions and special tax breaks. It could also include broadening the GST base, increasing the GST rate, and reforming resource taxes.
These reforms need to be accompanied by reform of state taxes in the form of land tax (stamp duty) reforms, reformed payroll taxes and insurance charges, and the introduction of well-calibrated congestion charges for our largest cities.
These reforms must also be underpinned by a system that reduces the states’ need for direct Commonwealth payments. This system could provide states access to a portion of the income tax (though still collected by the Commonwealth) and include a reformed process for distributing the GST. This would allow for an HFE system where all Australians can potentially receive services from their states at (at least) a nationally determined minimum level. If some states lack the fiscal capacity to provide this minimum, they should receive sufficient horizontal transfers to provide them with the necessary capacity. Assuming these transfers continue to be financed out of the GST pool, any remaining GST revenue can be distributed to the states on an equal per capita basis.
These reforms would make the system simpler and more transparent and would give the states incentives to improve the efficiency and effectiveness of their service delivery. Comprehensive tax reform is technically and politically difficult, which is why it happens so rarely. But the need to raise living standards and pay for the things the community wants governments to provide means the time for a new round of tax reform has arrived.
For further information or discussion on this topic, please contact:
Jerome Fahrer, Director
Alex Gash, Executive Director, Canberra