Tax Reform

2016 ANU Working Paper:
Efficiency of the Tax System

Introduction

This working paper analyses the efficiency of the Australian tax system using CGETAX, a large-scale, long-run CGE model designed for tax policy analysis.

The total marginal burden on households from a government raising an additional dollar of revenue from a tax includes both the one dollar payment plus the marginal excess burden (MEB) from the inefficient activities undertaken in reaction to the tax increase. The MEB, which is borne by consumers, arises from the disincentive effects of taxes on labour supply, investment, saving and other economic decisions.

Consumers benefit when the tax system places less reliance on taxes with high MEBs and more reliance on taxes with low MEBs. For an optimally efficient tax system, the tax mix would be adjusted in this way until MEBs are equated across taxes to maximise consumer welfare. However, the equity of the tax system also needs to be taken into account, so a balanced approach involves considering both efficiency and equity.

Inefficiency Ratings (MEBs)

  • The MEB from changing tax on personal incomes depends on whether the change applies to labour income (e.g. compulsory superannuation contributions), asset income (e.g. superannuation earnings) or both.
  • A hypothetical labour income levy has an MEB of 33 cents per dollar of revenue, reflecting the labour supply disincentive effect.
  • A hypothetical asset income levy has an MEB of 18 cents per dollar of revenue, reflecting the saving disincentive effect. This lower MEB suggests that the existing tax concessions available for housing, superannuation and dividends are overly generous.
  • A levy on all personal income has an MEB of 31 cents, which effectively is a weighted average of the two separate MEBs for the labour and asset income levies.
  • The MEB from varying personal income tax also depends on the regressivity/progressivity of the change to the rate scale. By definition a more progressive change lifts marginal tax rates more than average tax rates. This results in a higher MEB because marginal tax rates drive disincentive effects while average tax rates drive the revenue yield. Thus, the MEB rises from 18 cents for bracket creep to 31 cents for the income levy to 41 cents for a tax surcharge.
  • Personal income tax is progressive by design, with the aim of improving equity. Ideally, the degree of progressivity in the personal income tax scale would be set by balancing the equity benefit from more progressivity against the efficiency cost.
  • Raising GST has a relatively low MEB of 18 cents per additional dollar of revenue, compared to 33 cents for the labour income levy, making it a more efficient option. This is mainly because only 71 per cent of the consumption expenditure tax base for GST is funded from after-tax labour incomes, limiting the labour supply disincentive effect. The remainder is funded from unsaved asset incomes and government transfer payments.
  • Broadening the GST to include fresh food has an even lower MEB of 10 cents per additional dollar of revenue. This base broadening makes GST more efficient by removing a disincentive to consume served and processed food rather than fresh food.
  • Raising the rate of payroll tax has an MEB of 37 cents per additional dollar of revenue, which is higher than the MEB for a labour income levy of 33 cents per additional dollar of revenue. This is because the small business exemption from payroll tax creates a disincentive for employment in large firms relative to small firms.
  • However, broadening the base of payroll tax by reducing the small business threshold reduces the associated inefficiency, leading to a lower MEB of 24 cents per additional dollar of revenue.
  • Company income tax has a very high MEB of 139 cents per additional dollar of revenue, when considering the difference between company tax rates of 25 and 30 per cent. This compares to the MEBs for the other major taxes – personal income tax and GST – of under 50 cents. This makes reducing the company tax rate to 25 per cent the top priority for tax reform in Australia.
  • This high MEB partly reflects the investment disincentive and labour supply effects from company tax. Adding to this inefficiency from company tax is profit shifting to lower tax jurisdictions, which wastes resources on tax avoidance and erodes the revenue base.
  • One reason that company tax has a particularly high MEB in Australia is the franking credits system. It raises the MEB from company tax from 85 to 139 cents per dollar of additional revenue by refunding around 30 per cent of company tax collections, eroding the government revenue yield.
  • Another reason that company tax has a particularly high MEB in Australia is our high rate of tax. Devereux et al. project that by 2020 Australia’s international competitiveness for company tax will place it only 15th out of the G20 countries, despite Australia’s relatively high reliance on foreign investment. Cutting the company tax rate from 30 to 25 cent would lower the MEB from 139 to 96 cents per dollar of revenue.
  • One factor mitigating the inefficiency from company tax is foreign tax credits for Australian company tax, although these tax credits only apply to around five per cent of Australian company tax collections and are fully taken into account in the modelling.
  • Another mitigating factor is when company tax applies to economic rents, including oligopoly rents. However, these rents can always be taxed more efficiently with rent taxes than with company tax. This is also fully taken into account in the modelling.
  • As a tax on ownership transfer costs, conveyancing duty has a narrow base and a high effective tax rate, which both make it a highly inefficient tax. The stocks of residential and commercial buildings are not used efficiently because of the tax disincentive against a change of ownership when circumstances change. The MEBs are 87 cents in the dollar of additional revenue for residential conveyances and 196 cents for commercial conveyances.
  • Shifting from land tax (MEB of 48 cents in the dollar) to the more broadly-based municipal rates (MEB of 23 cents in the dollar) would improve the efficiency of land taxation. A further efficiency gain would be available by removing discrimination in municipal rates between land uses.
  • Once it is taken into account that the true economic base for insurance taxes is the premium net of expected benefit, insurance taxes are seen to be levied at high effective rates on narrow bases, particularly in the cases of motor vehicle insurance and general insurance. This gives them a high MEB of 58 cents per additional dollar of tax revenue.

Download the Efficiency of the Tax System ANU working paper

"Efficiency of the tax system: a marginal excess burden analysis", ANU Tax and Transfer Institute Working Paper, 4/2016, June 2016.

Other Taxation Policy reports

  • "Fuel Taxation Inquiry Economic Modelling", Commonwealth Government Fuel Taxation Inquiry, 2002.
  • "Estimating the effects of the New Tax System on agency costs", all state and territory governments, 1999 - 2000.
  • Economic Modelling of the New Tax System, ACCC, 1999 - 2000.
  • "Industry Effects of Tax Reform", the Senate, 1999.
  • "General Effects of RBT", the Senate, 1999.
  • "Modelling Industry Effects", Section 25, The Review of Business Taxation (Ralph Report), 1999.

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