Increasing GST to cut income tax would be a zero sum game

The federal government’s agenda on tax reform still remains unclear and the discussion seems to alternate between the tax mix switch and the need to raise more taxes.

We seem to have gone from no discussion on changing the GST being allowed, to a situation where all we talk about is expanding or broadening it. As Prime Minister Malcolm Turnbull stressed yesterday, picking out one tax reform in isolation is misleading.

Treasurer Scott Morrison says to achieve a better a tax system, Australia needs to “carefully consider the impact of income tax, especially personal income tax, on economic growth and living standards”.

Increasing the GST (or broadening its base to include other services) may make sense as part of an effort to raise more taxes for health and education, or to support innovation. But the rationale for switching from income tax to GST on a revenue-neutral basis, which is known as the tax mix switch, is not as clear.

Why the switch?

The rationale for a tax mix switch relates to the notion that one can promote economic growth by switching from less efficient taxes to more efficient taxes while raising the same tax revenue. A tax is more efficient if it leads to less distortion of worthwhile economic activities.

This tax mix switch logic was likely influential in the Henry Review’s recommendation to introduce a tax on immobile mineral production (the mining tax) to fund a reduction in the corporate tax rate.

While improving the taxation arrangements for immobile resources such as land and minerals is clearly worthwhile, the relative inefficiency of corporate and income taxes vis-à-vis the GST has perhaps been overplayed. For example, there is well-documented evidence of a home bias in investment.

Estimates of the impact of corporate tax on wages also vary widely, with some suggesting the burden of corporate tax passed on to workers might be small. This implies that reducing the corporate tax rate may not be as important as many suggest.

Similarly, as I have previously explained, the GST can have a similar impact to an income tax depending on how the income tax is designed. Individuals care not about the dollar amount they receive as wages but rather about the goods and services they can purchase from their wages over their lifetimes (and beyond through bequests).

For example, consider a flat income tax of 10%, versus a broad-based GST of 11.11% for an individual on a $50,000 income. After paying income taxes, she has $45,000 left to spend on goods and services. Conversely, if she pays the GST instead, $50,000 of expenditure on goods and services would include GST of $5,000. That is, both taxes would allow the consumption of $45,000 of goods and services and, as a result, should lead to similar behavioural impact and distortions.

As the Australian income tax is progressive, you could argue the GST will be less distortionary as the response of labour supply to higher tax rates can be larger than the responses under a flat income tax. However, the existing empirical evidence suggests the response of labour supply to taxes is small although there may be some more significant impact on labour market participation. This seems plausible given many workers may have limited ability to adjust the number of hours they work as a result of changes in the income tax rate.

All this suggests a tax mix switch strategy may not have the desired effect. Increasing the GST or broadening its base in order to reduce income tax or the corporate tax rate is unlikely to increase productivity and create greater wealth for all Australians. It may also have a disproportional impact on low-income earners, reducing the overall progressivity of our tax system.

Look elsewhere for productivity

While increases in the GST (or a base broadening, or both) can play a meaningful part of an effort to raise more tax revenue, alongside compensation to low-income earners, the gains in productivity will be found elsewhere. For example, in the reform of the taxation of savings (e.g. introduction of a flat tax) to eliminate the tax arbitrage opportunities that currently exist given the various concessional arrangements such as capital gains tax exemptions and superannuation. By simplifying our tax system, taxpayers can concentrate on what they do best rather than spending time and effort attempting to legally minimise tax.

Business taxation is also up for an overhaul. Labor lost an opportunity for meaningful business tax reform so it is now up to the Turnbull government to revisit many of the issues discussed at the 2011 National Tax Forum. These include the elimination of various tax concession arrangements, the introduction of an allowance of corporate equity to eliminate the tax advantage that debt has over equity, and a change in the treatment of tax losses.

Tax reform will certainly be challenging but we should go beyond lazy reform –increasing the GST as part of a tax mix switch strategy that is likely to have limited impact on growth – and instead be innovative and bold.

The Turnbull government has already shown it is willing to take complex issues to the Australian people. Let’s hope it will continue to do so by clarifying the aim of tax reform. This should be to temporarily increase the tax burden, in an efficient and fair manner, so that we can return to a surplus and fund the education and health outcomes Australians aspire to.

It will require tackling the big ticket items such as taxation of savings and business taxation, and the interaction between the tax and transfer systems, and by pursuing a tax simplification agenda.

Flavio Menezes does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.