Talking Point: Budget lays bare urgent need to simplify tax system

Well-designed spending measures have a role to play and are an important part of the Budget. But simply cutting headline income tax rates is lazy policy, says Graeme Wells

The problem with Australia’s tax system is that high effective marginal tax rates crop up everywhere. They stifle incentives because of their impact on earnings from employment.

AS the famous physicist Niels Bohr was reported to have said, forecasting is hard, especially when it’s about the future. So you’ve got to have sympathy for the Treasury boffins as they have laboured to produce Treasurer Josh Frydenberg’s budget.

In recent times the imperative has been to produce plausible forecasts and projections leading inevitably to the promised land of a budget surplus. Debt and deficit disaster avoided. Happy times.

But even in relatively stable times before the pandemic, this single-number approach to economic management papered over underlying problems. Worthwhile economic reforms were sacrificed on the altar of the budget balance. Over time, this steady-as-she goes approach prove costly as lost opportunities accumulate.

Income tax cuts have been government policy for several years. Bringing them forward is not the reform required to stimulate a supply-side response from many people who make up Australia’s workforce. For them, it will provide a cash boost but won’t change incentives much, if at all.

Unlike the headline rate spruiked by Prime Minister Scott Morrison, it is more important to change the effective marginal tax rate. The effective rate measures how much of every dollar earned or saved you get to keep.

Take a couple of examples. For someone on the JobSeeker payment, earnings above $300 per week cut the dole payment by 60c per dollar. The effective marginal tax rate for someone in that position is 60 per cent.

Tax traps have accumulated.

For a second example, take a family with a single earner. Let’s call her Emily. She has income of $60,000. She has a HECS debt, and is eligible for Family Tax Benefit Part A.

Her headline marginal tax rate is presently 32.5c for every extra dollar earned.

Let’s call a spade a spade and add the other taxes misleadingly labelled levies and surcharges. Add 2 per cent for the Medicare levy. Add another 2 per cent for the HECS debt. That makes it 36.5 per cent, and that won’t change under Mr Morrison’s stage-two tax reductions.

Then there is the so-called taper rate for Family Tax Benefit Part A. That’s a cut of 20 cents for every extra dollar earned.

Emily’s tax affairs may involve even more wrinkles, but it is easy to see that her effective marginal tax rate could be as high as 56.5 per cent.

Tax cuts announced in the budget won’t change that.

The problem with Australia’s tax system is that these high effective marginal tax rates crop up everywhere. They stifle incentives because of their impact on earnings from employment.

Effects on saving can be equally dramatic. A few years ago, the Commonwealth Treasury constructed an example of the effect of the assets test on returns to pensioner’s savings. They used assumptions which were reasonable at the time, including that the pensioner faced a zero income tax rate. If she made a deposit in a savings bank account, she could face an effective marginal tax rate of 112 per cent.

Over time, these tax traps have accumulated for a number of reasons.

The first goes back to the preoccupation with budget balance as the over-used measure of good fiscal policy. Tax reform often involves, at least in the short run, a cut in revenue. But to use Tony Abbott’s nonsensical phrase, Australia supposedly faced a “debt and deficit disaster”. Any meaningful tax reform was taken off the table.

The second and related problem is that the tax system is prey to special interest groups. Granting concessions to one group, while keeping tax collections sufficient to keeping the budget on track, leads to piecemeal changes elsewhere. These often lead to tax traps.

The recent fall on global interest rates and the need for post-pandemic stimulus has changed the ground rules. With long-term bond rates well below 2 per cent, a short-term focus on budget balance is no longer such a constraint.

Well-designed policies to improve incentives to work and to save are likely to have a long term payoff greater than 2 per cent, even if the budget blows out in the short run. Mr Frydenberg should recognise this and use the opportunity provided by historically low interest rates to start simplifying the tax system.

Of course, well-designed spending measures also have a role to play, and are an extremely important part of this year’s budget. But simply cutting headline income tax rates is lazy policy. It may not achieve as much as expected by way of fiscal stimulus in the short run, or stimulate growth in the long run.

Dr Graeme Wells is former associate professor in economics at the University of Tasmania.