Taxation is the Australian Government’s main source of revenue as well as a method to intervene in the economy. The Government uses taxation for social, political and economical reasons; in the reallocation of resources, redistribution of income and stabilisation of economic activity. However, to maximise revenue, taxes must maintain equity, simplicity, and promote economic efficiency. Although achieving all of the above criteria would be ideal, in the words of Graham Hill, “these criteria are often, and probably almost always, incompatible with each other.” As result taxation reforms occur to maintain a balance between the three criteria.
Taxation reforms may aim to attain equity in the economy, which refers to the distribution of the tax burden on taxpayers and their economic circumstances. Vertical equity refers to the idea that the higher income earners should suffer a higher tax burden than the lower income earners.
From the tables above, a progressive tax system is evident, whereby the higher income earners pay a higher proportionate tax than lower income earners thus achieving vertical equity. An advantage of this is the achievement of a fair system with progressive taxes. This is to allow lower income earners with enough income to purchase necessities such as food and clothing. However, a disadvantage is the incentives higher income earners, especially those in the top marginal tax rate, may have for tax avoidance and possibly even tax evasion.
As they may be earning millions of Australian dollars and their marginal tax rate is 45%, it would be appealing for them to hire lawyers who will find loopholes to reduce their tax liability. Although tax evasion is illegal, tax avoidance is not and prior to the 1985 tax reform, taxpayers were able to convert their taxable income into non-taxable fringe benefits or capital gains. This reform reduced tax avoidance and acquired a more equitable distribution of income. In addition, the reform was advantageous to the government as it provided more revenue.
Nevertheless, another disadvantage is the complexity of the taxation system in Australia. Although the reform discouraged tax avoidance, it generated more legislation thus complicating the tax system. The reform was only successful to an extent as taxpayers were able to go overseas to earn their money, for example to Singapore where their tax liability is much smaller. Tax reforms reducing the marginal tax rates such as Kevin Rudd’s recent tax-cuts, can be advantageous to the economy as it promotes skilled migration as well as retaining Australia’s skilled employees.
The disadvantage was that it provided consumers with more disposal income which increased their spending and thus increased the already high inflation of 4. 5%. Apart from vertical equity, tax reforms may also achieve horizontal equity. Horizontal equity is refers to the belief that all taxpayers of the same marginal rate should suffer an equal tax burden. In Australia, income is accepted as the measure of tax liability however income is not the only factor which determines wealth. Wealth includes income as well as all liquid assets.
For example, although two taxpayers earn the same income, one might be struggling to pay off his rent while the other may have inherited three or four properties. In this example the one with several properties is wealthier, but is in the same tax bracket as the other taxpayer. As a result horizontal equity is not achieved. But it can be achieved through other taxes or fees, such as capital gains and stamp duty, where if the properties are sold or leased out, tax must be paid on the profit. Although this would attain horizontal equity, it would complicate the taxation system as well as reduce its efficiency.
Economic efficiency involves the efficient allocation of resources, where the tax system encourages resources to move from fields where individuals have a low tax burden to those fields which help the economy the most. The production possibility frontier above provides an example of possible allocation of resources. Assuming the Australian economy was producing at point A, it would be producing 50 units of both weapons and food. However, if 60 units of food were required, it would be the Government’s role to move production to point B, a position which is more beneficial to the economy.
It would do this by placing taxes such as excise duty on weapons so that it would become more expensive to produce weapons. After this, it is most likely that firms will switch production to food as it is much cheaper to produce. Reforms of the tax system will allow for the government to do this. The advantage is the gained 10 units of food whereas the disadvantage of this is the opportunity cost equating to 10 units of weapons. John Howards reform which took effect on 1 July 2000, introduced a regressive tax known as the Goods and Services Tax (GST) which is a constant 10%.
It is a regressive tax as the tax is placed on a particular good for example a game which costs $100. After GST, the game will cost $10 extra. This $10 represents a lower proportion of income of a higher income earner than the income of a lower income earner. This reform was effective in resource allocation as it caused firms to either pass on this tax to consumers, thus reduce demand or to reduce their costs through efficient resource allocation and maintain demand. Although it is advantageous for efficiency, it is disadvantageous as it is not equitable or simple.
Company tax, although a direct tax, is a proportional tax levied at 30%. This is an extra cost to firms which also causes them to be more efficient to remain competitive. Again, although it will be effective at allocating resources, it would require much legislation to be passed to cover loopholes thus complicating it. Another example where the government used reforms to allocate reforms is in excise duties on alcohol and cigarettes. The Government placed tax on these individual wants as they are harmful to the health and possibly to the environment.
However, in order to do this, it had to give up simplicity. The simplicity of the taxation system refers to not only to its comprehensibility but also the ease of paying taxes. The simplest tax would be a flat rate tax on total income generated from wages, shares, investment properties, etc. However, despite its simplicity, equity would be completely ignored as well as economic efficiency. In Australia’s taxation system, a lot of time is consumed by individuals in filing their tax returns. The diagram above depicts how many Australians are required to file a tax return.
This time is uses resources as individuals could provide their labour instead of filing tax returns. An advantage of having to file tax returns is the increased jobs for accountants however it is balanced out with the disadvantage inefficient resource allocation. When compared to New Zealand’s tax system, it is clear that Australia’s system is more complex. This is mainly due to the absence of the many tax deductions available to Australians. Now the advantage of Australia’s tax system is the many deductions and tax benefits available but at the cost of complexity.
In conclusion, there are three criteria to a ‘good’ tax system; equity, simplicity and economic efficiency. Although an ideal tax system would incorporate all three criteria, unfortunately these criteria are often incompatible with each other. This can be seen through income tax, where in achieving economic efficiency, equity and simplicity are forgone or to achieve simplicity, equity and economic efficiency are forgone. Whilst tax systems aim to achieve a balance between the three criteria, economic circumstances call for reforms to update the tax system to fulfil its purpose.