There were no new tax ideas in the 2019 Budget, which I guess is to be expected from a six-year-old government ready to pull the trigger on an election campaign the betting markets indicate it will likely lose. Instead what we got was some casual rearranging of a few actually-pretty-big tax ideas introduced in last year’s budget: the planned elimination of the 37-percent tax bracket, the expansion of the Low-Income Tax Offset to the middle class, and immediate expensing of investments for businesses.
But given the looming election, it’s worth taking another look at those big ideas and perhaps we’ll even learn a bit along the way about how to design a better tax system. This is the first of a three-part series, beginning with the Government’s plan to flatten the tax schedule. The key takeaway of this first part is that simplifying the tax system is great in principle, but it comes at a cost so we’d better be sure we get what we pay for. Sadly, this proposal doesn’t do what it says on the tin.
In last year’s budget, the Government set out a plan six years hence to “flatten and simplify” the tax schedule by removing the 37-percent tax bracket (the schedule currently has 0, 19, 32.5, 37, and 45 percent brackets). This time around, they modified the plan by lowering the 32.5-percent rate to 30 percent, but it still lies out beyond the four-year forward estimates. It’s worth noting that the 2010 Henry Tax Review recommended a similar flattening of the tax schedule.
Real simplicity is what really matters
If you think about the tax schedule like a staircase, periodically stepping higher and higher, the plan amounts to removing one of the steps. That leaves a much bigger gap between two of the steps that remain.
In doing so, the Government says its goal is to simplify the tax system. Simplicity certainly sounds like a desirable feature and a tax system with fewer tax brackets certainly looks simpler. But give it just a little more thought and you’ll be left wanting. If you ask yourself why exactly does simplicity matter—what are its concrete benefits—and then how might we reform the tax system to that end, I guarantee you won’t end up at “we need to get rid of tax brackets”.
Setting aside political considerations, simplicity only matters to the extent that it lowers the cost to the economy of the Government raising revenue. For every dollar it raises, the tax system imposes compliance costs on taxpayers and others like employers and banks required to keep records and report information to the Australian Tax Office (ATO). And the ATO—and we taxpayers who foot their bill—also bears a cost in administering the tax system.
It’s certainly true that a highly complex tax system that is difficult to navigate imposes a burden on everyone involved. Taxpayers trying to comply with the system are often forced to pay a tax agent to complete their tax return. Employers and other firms are forced to hire additional staff and develop systems in order to calculate, store and disseminate the information required by the ATO. And carrying out audits and other administrative tasks means that the ATO has a lot more staff than it otherwise would.
When you hear talk of a simpler tax system, this is why it matters. The only simplicity we should care about is one that makes the tax system easier to comply with and easier to administer. And with this in mind, any reform to simplify the tax system should be targeted squarely at that objective. And there are, of course, a range of things the Government could do to reduce the compliance and administrative cost burden imposed by the tax system.
Fewer brackets makes the tax system worse but no simpler
The problem with the Government’s proposal to remove a tax bracket is that it does nothing to achieve that objective. It is window-dressing. Eliminating tax brackets certainly appears to make the tax system simpler, and in a trivial sense it does. Things look tidier. The table setting out the tax schedule contains fewer lines. A graph of the tax schedule has fewer steps. But that’s it. In no way does it simplify the lives of those who have to interact with the tax system on a daily basis. Indeed, this kind of superficial simplification serves only those among whom tidiness sparks joy. The policy clean-freaks.
Fewer tax brackets might satisfy the inner Kondo in some, but this comes at a real cost. The thing to understand is that the tax system is sometimes complicated for good reasons. This might arise from a desire to tightly target a tax measure so that only those of a certain income or those with kids receive it, for example. Not targeting the tax measure would make for a simpler tax system, but it might make it less fair and more expensive. And if we are going to do that, then we’d better have a good reason.
If we accept that some income redistribution is desirable, then in an ideal world the tax schedule would feature a smoothly increasing marginal tax rate from middle up to high incomes. This in fact implies an infinite number of tax brackets. Such a system already exists in Germany, where income tax rates rise continuously with income, so it is certainly feasible to implement here. And it would be trivial to provide an online tool for taxpayers that displays their marginal tax rate and tax liability.
But if we must have discrete tax brackets, then the goal should be to approximate this ideal system as closely as possible. Reducing the number of tax brackets only makes this approximation worse—some people are paying a higher rate than they should and others a lower rate. The ideal tax system calls for more tax brackets, not fewer. And the cost to simplicity—real, substantive simplicity—is nil.
Some have suggested that eliminating tax brackets would reduce the opportunity for taxpayers to manipulate their income around tax thresholds (known as bunching), increasing economic efficiency. But this is unconvincing. It overlooks the fact that this bunching behaviour is confined to only a narrow sliver of the income distribution and thus very few taxpayers—so few that it’s just not worth worrying about.
A standard deduction would really simplify the tax system
It’s clear that eliminating tax brackets makes the tax system less effective for no substantive improvement in simplicity. So what could the Government have done instead?
One simple idea, recently endorsed by the Inspector-General of Taxation and originally proposed by the Henry review almost a decade ago, is to introduce a standard deduction. This would entitle every taxpayer to claim a prespecified amount of deductions without needing receipts. Those with deductions in excess of the standard deduction would still be free to claim those. This system already exists in the United States and other countries.
Deductions aren’t necessarily a bad thing. In fact, there are good reasons why some deductions should be allowed (for example, the interest incurred on debt used to fund investment). But in practice it can be difficult for the ATO to distinguish between legitimate expenses and personal consumption (is that car really for work purposes?), which should not be deductible, something the ATO Commissioner has complained about. Indeed, in my own research I have found that deductions are a substantial vehicle for tax avoidance, responsible for 12 times the tax avoidance response of gross income.
Critically, a standard deduction would enable most taxpayers to avoid submitting a tax return at all. The fewer the items other than a taxpayer’s salary on their tax return, the easier it is to predict the tax they owe through the year, so the less likely an adjustment will be necessary at the end of the year. Deductions are the primary reason for these kinds of adjustments. Not only would this save taxpayers time and money, but it would ease the burden on the ATO, freeing up resources that it could use, for example, to ensure multinational corporations comply with their tax obligations.
As it stands, this proposal would make some taxpayers a little worse off financially, but they could easily be compensated via offsetting adjustments to tax rates and thresholds. And it should not be forgotten that all of these taxpayers would finally be unshackled from the obligation of that dreaded annual tax return and the burden of hoarding and keeping track of all of those receipts throughout the year.
Now doesn’t that spark joy?
Other articles in the Budget Forum 2019
The Instant Asset Write-off Will Lift Investment—but Is That What We Want?, by Steven Hamilton
Refundable Franking Credits: Why Reform Is Needed (and Why It Should Be Targeted) – Part 1, by John Taylor and Ann Kayis-Kumar
Refundable Franking Credits: Why Reform Is Needed (and Why It Should Be Targeted) – Part 2, by John Taylor and Ann Kayis-Kumar
“All Without Increasing Taxes”? A Closer Look at Treasurer Frydenberg’s Refrain Repeated Eight Times in His Budget Speech, by John Taylor and Ann Kayis-Kumar
Tax Offsets and Equity in the Scheme for Taxing Resident Individuals, by Sonali Walpola and Yuan Ping
Forecasts and Deviations – the Challenge of Accountable Budget Forecasting, by Teck Chi Wong
Targeted Tax Relief Makes the Tax System Fairer but the Economy Poorer, by Steven Hamilton
A Budget That Supports Indigenous Australians?, by Nicholas Biddle
Women in Economics 2019 Federal Budget Reflections, by Danielle Wood
Tax Progressivity in Australia: Things Aren’t as Simple as They Seem, by Chung Tran and Nabeeh Zakariyya
Coalition and Labor Voters Share Policy Priorities When They Are Informed About Inequality, by Chris Hoy
Future Budgets Are Going to Have to Spend More on Welfare, Which Is Fine. It’s Spending on Us, by Peter Whiteford
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