Lower tax rates for a truly beautiful set of numbers

The changes announced by Treasurer Peter Costello to the personal income tax system last week are a small first step towards unravelling the disincentive effects that our tax system creates.

These changes mean workers will keep $21.7 billion of their hard-earned wages during the next four years. But this number significantly underestimates the true economic benefits that income tax cuts will provide. All workers who pay tax will be better off, but there are additional supply-side effects that will benefit the entire economy.

High personal tax rates reduce the incentive to earn taxable income. High tax rates encourage workers to lower their work intensity, pursue do-it-yourself employment, engage in home production for barter and to devote more time to on-the-job leisure.

Because highly skilled workers tend to earn higher taxable incomes, high tax rates also reduce the incentive for individuals and employers to invest in education, training and skills formation in the long run. Labor’s policy of simultaneously opposing tax cuts and claiming to support investment in skills formation by individual companies and workers therefore makes very little economic sense. High tax rates also discourage overtime work and encourage workers to substitute activities or occupations with significant non-wage benefits.

The most recent economic evidence from the US suggests higher income earners tend to be the most responsive to changes in their taxable income. Each extra dollar of revenue raised by increasing taxes on the most productive individuals is therefore likely to carry particularly heavy economic costs.

The notion that there are little or no economic costs associated with higher taxes on high-income earners may be popular, but it is wrong.

All these negative effects of higher taxes add up and are dispersed throughout the economy.

The combined result is that each dollar raised by taxes costs the entire economy much more than $1. Equally, a tax cut that reduces government revenue by $1 benefits the entire economy by much more than just $1.

US economists estimate that every dollar raised in tax revenue costs the economy at least $1.20. This means that before government spending can generate any net benefit, the average dollar spent must yield a net return of 20 per cent. To create a positive overall net benefit, government spending must be much more productive.

Tax revenue for all levels of government in Australia in the past financial year was $257 billion. How much of that $257 billion generated a net return of 20per cent?

Nobody knows for sure because governments do not publish this kind of information. They should begin doing so. Governments should also publish estimates of the costs of taxation in the budget papers.

The terms of the public debate have become so skewed against taxpayers that Australian politicians rarely (if ever) consider whether the costs of raising an additional dollar of revenue are too high, relative to the alleged benefits an additional dollar of public spending might bring.

Applying the US estimates to Australia suggests that the total disincentive costs of taxation amounted to at least $50 billion in the past financial year. The true cost is most likely higher than this because Australia has the GST and much higher marginal tax rates than the US.

To put these numbers in perspective, governments at all levels in 2003-04 spent $51.5 billion on health. In other words, the total disincentive costs of taxation in Australia probably exceed total public spending on health.

In the long run, high taxes reduce gross domestic product levels and economic growth rates. In the US, low-tax states tend to grow faster than high-tax states. These same disincentive effects also tend to show up in international comparisons.

Countries that significantly cut their top marginal tax rates (or increased the top marginal rate threshold in real terms) between 1980 and 2000 enjoyed average per capita economic growth rates nearly three times higher than those that did not.

This evidence suggests that Australia’s two top marginal tax rates should be eliminated as a matter of urgency. There is no justification for anyone having to pay more than 30 per cent tax on their last dollar earned.

Taxes not only reduce output and growth rate; they also impose other costs including those associated with administration and enforcement of our complex tax system. More attention needs to be paid to the sheer density of our tax rules, their degree of technicality and the uncertainty that they create.

The tax rules are so complex that Australia’s tax army (the lawyers, accountants and public servants employed to process the tax system) is more than three times the size of our military army.

The budget did something to reduce the size of the tax burden and this will help sustain economic growth. But genuine tax reform will require the top marginal rates to be eliminated and the extraordinary complexity of the tax system to be radically simplified.

Alex Robson is the author of The Costs of Taxation, the latest in the Centre for Independent Studies’ series Perspectives on Tax Reform, published today.