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Thursday, July 15, 2010:

Our reverse-protectionist tax system

Australia's tax system protects foreign producers against their Australian competitors, writes Gavin R. Putland. (P.S.: See also Maximalist ‘fiscal devaluations’ for Greece and Australia.)

The Resource Super Profits Tax (RSPT) was sunk by the advertising firepower of the big miners, ostensibly because it would make Australian mineral deposits less competitive with foreign alternatives. The complex, bureaucratic, maximally-interventionist Carbon Pollution Reduction Scheme, which was a pollution tax in so far as the permits were sold rather than given away, was opposed by big polluters, ostensibly because it threatened the international competitiveness of trade-exposed industries. The simple, small-government, minimally interventionist alternative, namely a carbon tax, is opposed by the same interests, ostensibly for the same reason.

The need to maintain international competitiveness is indeed a popular argument against any new tax. That the argument comes from those who stand to pay the tax is of course purely coincidental. Nevertheless, it might be instructive to work out how much the existing system cares about competitiveness, just in case the altruistic, patriotic indignation of the opponents of new taxes could perhaps be better directed elsewhere.

In seeking a benchmark of competitiveness against which various taxes can be measured, one must understand that “free trade” does not mean what it says; it is not a system in which trade is free of taxes and restrictions, but rather a system in which any such taxes and restrictions don't discriminate between domestic and foreign products. Thus the heroin trade is “free” because it is equally illegal regardless of which country the heroin comes from, while a “free trade agreement” obliges us to impose another country's restrictive trade laws on our domestic producers. What is called “free” trade would be more accurately called “impartial” trade. To avoid confusion, I shall use the latter terminology here.

My approach is to adopt a particular tax or combination of taxes as the benchmark of “impartiality”, with which the major existing taxes can be compared. If, compared with the benchmark, a tax is easier on domestic producers and harder on foreign producers, I shall classify it as protectionist. If it is easier on foreign producers and harder on domestic producers, I shall classify it as reverse-protectionist.

The benchmark can be somewhat arbitrary as long as it is consistent. But it might as well come from an authoritative source. The Australian Taxation Office, on a web page headed “Excise essentials”, defines an excise duty as a “tax on certain types of goods produced or manufactured in Australia”, and helpfully adds that a “customs duty” (commonly called a tariff) is imposed at an “equivalent rate” on corresponding imported goods “to ensure that imported goods are treated consistently with local goods.”

(The ATO's terminology is consistent with common usage. For constitutional purposes the majority of the High Court has settled on a wider definition of “excise”, including all inland taxes on goods. Here I use the ATO's terminology because it happens to aid brevity.)

According to the ATO, the combination of a tariff plus an excise (at equivalent rates) is impartial. That will do for our benchmark. As we compare other taxes with the benchmark, it must be understood that the taxes are imposed at “equivalent rates”.

Compared with a tariff plus an excise, a tariff by itself is protectionist because the burden on domestic producers is removed, so foreign producers are less able to compete with them, whereas an excise by itself is reverse-protectionist because the burden on foreign producers is removed, so domestic producers are less able to compete with them. If tariffs and excises applied to services as well as goods, this would not change their classification but would merely extend the scope of their protectionism and reverse-protectionism, respectively.

For a tariff or excise, the classification matches the obvious intent of the tax. For other taxes, as we shall see, the intent is less obvious and the classification more surprising.

A consumption tax, like a tariff, applies to imports. Like an excise, it applies to local products consumed locally. But unlike an excise, it does not apply to exports. So a consumption tax is equivalent to a tariff plus an excise plus an export rebate, and the last feature makes it protectionist.

I can suggest four reason why this form of protectionism is permitted by GATT/WTO rules. First, it does not involve any rigging beyond that which is inherent in the choice of consumption as a tax base. Second, the “export rebate” does not erect a barrier to imports or subsidize exports, but merely removes a barrier to exports. Third, the size of the “rebate” is limited by the size of the tax rebated, whereas a straightforward tariff or export subsidy has no such built-in limit. Fourth, and most importantly for the national interest, a consumption base does not discriminate between industries in the usual protectionist manner; it is defended not by the protectionist fallacy that a nation can grow richer by taxing its competitive industries to prop up its uncompetitive ones (thus diverting investment from the former to the latter), but by the simple truth that it can grow richer by consuming less than it produces.

No “rigging” is apparent when a consumption tax is implemented as a retail tax; export sales tend not to be retail sales and are therefore rightly exempt. If it is instead implemented as a value-added tax (VAT), like the Australian GST, a consumption base is obtained by border-adjustment — that is, by zero-rating exports and disallowing input credits on imports (on the assumption that other countries zero-rate their exports). Border-adjustment looks like rigging but is permitted because it places the tax on a consumption base, which is deemed not to be rigged.

If a VAT were not border-adjusted, it would have a production base: “value added” means production. So a non-border-adjusted VAT (NBAVAT) is a tax on domestic production; it's an excise, except that it extends to services as well as goods. Hence an NBAVAT is reverse-protectionist. And if you think we don't have an NBAVAT in Australia, you're in for a rude awakening.

Whether border-adjusted or not, a VAT is an indirect tax, being passed on in prices. Border-adjustment changes the base so as to include the value added to imports up to the point of importation, and exclude the value added to exports up to the point of exportation.

A profit tax — that is, an income tax as applied to a business — allows a deduction for wage/salary expenses. An NBAVAT does not. That is the essential difference between the two, other differences being jurisdictional peculiarities. But the reason for the “essential” difference is that wages/salaries in the hands of employees are subject to income tax but not VAT. Under an income tax, the taxable value added is split between employers and employees; under a VAT, it is all taxed in the hands of employers. Admittedly, under Australia's income tax, wages/salaries below a certain threshold are taxed at less than the company rate, and those above a certain threshold at more than the company rate; but that makes little difference on a national scale.

We must conclude that income tax in its entirety is not essentially different from a non-border-adjusted VAT — except that border-adjusting an income tax, although perfectly feasible, happens to be illegal. If income tax is calculated on a tax-inclusive base whereas VAT is calculated on a tax-exclusive base, then the nominal VAT rate must be higher to give the same revenue — in other words, the equivalent rates will not be equal rates. But that is one of those “jurisdictional peculiarities”, not an essential difference.

So income tax is reverse-protectionist. In so far as it applies to income earned in production of goods, income tax is an excise. Conversely, if an NBAVAT feeds into prices, so does income tax. Hence, because border-adjustment does not affect indirectness, we must conclude that if Australia's GST feeds into prices, so does Australia's income tax!

If the indirectness of income tax is surprising, it shouldn't be. If income earned in (say) production of food were exempt from income tax, then food prices would not need to be as high in order to give a competitive return to the labour and capital needed to keep production going.

But the nature of the tax is hidden by labeling value-added as income (as if it came from something other than prices), and splitting it into profits and wages before applying the tax rates. Hence, in Australia, where it is politically unacceptable to tax the value added in basic food production under the GST, successive governments do the same thing to a far greater degree under the guise of income tax, which raises about four times as much revenue as the GST. To maintain this hypocrisy, businesses incur the cost and inconvenience of distinguishing between GST-free items and taxable items for both sales and inputs, and pass on the cost in prices.

The conventional view that replacing income tax with a VAT would raise prices and regressively redistribute spending power assumes that gross wages would be preserved in the transition, so that what employers presently withhold as PAYE tax would be paid to employees, and the portion of VAT that replaces PAYE tax would have to come from extra income, through higher prices.

But that assumption is arbitrary and unnecessary. It is equally possible to preserve net wages in the transition, in which case “after-tax” wage relativities would also be preserved (that is, there would be no redistribution of spending power) and what employers presently withhold as PAYE tax would instead (in the aggregate, and hence on average) be paid as VAT, so no extra revenue needs to come from prices.

Preserving net wages for existing appointments has the interesting feature that two half-time workers would be paid more than the equivalent full-time worker. To achieve the same effect for new appointments, the new IR regime could provide a lump-sum per-shift bonus which would serve the same purpose as the controversial minimum-shift provisions of existing awards, but without the minimum shift.

Border-adjusting the VAT would bring imports into the tax base and take exports out of it. This by itself would tend to increase the cost of living, because import prices form part of the cost of living while export prices don't. But it would be offset by an appreciation of the currency (due to improved competitiveness) and by a huge reduction in compliance costs (due to the disappearance of PAYE accounting and the myriad deductions peculiar to income tax). Replacing the border-adjusted VAT with a retail tax would further reduce compliance costs, hence prices.

(Specifying the retail tax rate on a tax-inclusive base, as with the present income tax, would be conducive to fairness in comparing the rates.)

Thus, contrary to the received “wisdom”, it is possible to replace income tax with a retail tax without regressive redistributive effects.

Income tax is officially divided into company tax and personal tax. The latter is officially treated as an income tax on a gross (tax-inclusive) personal base, but could equally well be treated as a payroll tax on a net (tax-exclusive) personal base; indeed the latter treatment is more natural in the case of wage/salary income, because the tax thereon is remitted by the employer [1].

Thus income tax as applied to wage/salary income is not essentially different from payroll tax. Each tax is manifested as some combination of higher prices, fewer jobs, and lower pay; and at least the first two effects are regressive. Of course the initial impact of an increase in personal income tax is different from that of an increase in payroll tax; but after the market and the wage-fixing system have had time to respond to the increase, and to each other, the results are dismally similar.

A labour tax, whether it is called a payroll tax or a personal income tax, applies to labour embodied in domestic products, including exports, but not to labour embodied in imports at the point of importation. In so far as it applies to labour embodied in goods, it is an excise [2]. Thus a labour tax is reverse-protectionist. In Australia, personal income tax raises about seven times more revenue, and is therefore about seven times more reverse-protectionist, than payroll tax. Dollar for dollar, however, there is little difference except that payroll tax is more regressive.

As payroll tax is reverse-protectionist, the competitiveness of the tax system would be further improved if state payroll taxes were merged with the retail tax (proposed above as a replacement for income tax). The Commonwealth would then need to share the retail-tax base with the states, preferably by allowing each state to levy its own surcharge rate on top of the federal rate. To do this while complying with ss. 51(ii), 90 and 99 of the Constitution [3], the Commonwealth could legislate and collect the entire tax, setting the surcharge in each state at the request and consent of the state parliament, and the surcharge revenue collected in each state could be refunded to that state provided that it abolishes payroll tax.

Don't forget Canberra's great big payroll tax disguised as the Superannuation Guarantee. A federally mandated, employer-funded 9% superannuation contribution is equivalent to a federally funded 9% contribution paid for by a 9% federal payroll tax. Dollar for dollar, this is as regressive and as reverse-protectionist as any other payroll tax, and it has a higher rate and fewer exemptions than Australia's much-ridiculed state payroll taxes. And the Federal Government wants to ramp up the rate to 12%.

If we exclude the labour component of income tax, we are left with a profit tax, roughly corresponding to company tax. To understand its effects, we must distinguish between two viewpoints.

In microeconomics, which takes the viewpoint of the individual or firm (and therefore of the accounting profession), the “rent” paid for the business premises is a cost of production, and profit is the surplus left over after all costs, including rent, have been paid.

In macroeconomics, which takes the viewpoint of society (and therefore of public policy), it's the other way around. Normal profit (not to be confused with accounting profit) is the necessary return on capital. It comprises the risk-free interest rate, which is the price of time-preference, plus insurance, which is the price of risk, plus economic profit, which is the price of uncertainty (the difference being that “risk” is quantifiable and therefore insurable, while “uncertainty” is not). Normal profit is a cost of production because if the capital employed in an industry does not yield its normal profit, it will not be maintained or replaced, and new investment will go elsewhere. Competition reduces the return on capital to the normal level. Consequently, sustained super-normal returns (super-normal “profits” in accounting terms) indicate some sort of protection from competition. The return to that protection is called economic rent and is the surplus left over after all costs of production, including normal profit, have been paid.

Any tax on normal profit is therefore a tax on production. It applies to normal profit embodied in domestic products, including exports, but not to normal profit embodied in imports at the point of importation. Thus it behaves like an excise and is reverse-protectionist; it will either be recovered through prices of exports and import replacements, or shift production to some other jurisdiction in which costs of production are lower.

Thus Australia's company tax stands condemned.

In contrast, a tax on economic rent is not a cost of production, but merely cuts into the surplus, i.e. the margin by which prices exceed necessary costs including normal profit. As long as the tax does not exceed the surplus, prices are set by demand combined with protection from competition and are independent of the tax, so that the tax neither needs to be nor can be recovered by raising prices — although those who pay the tax, having grown very fond of the surplus, can be relied upon to pretend otherwise.

Thus a tax on economic rent, unlike income tax, is a truly direct tax. It behaves neither as an excise nor as a tariff, but is compatible with free trade in the literal sense, and not merely in the sense of impartiality. It is obviously more competitive than taxes on production, including income tax and payroll tax. And it is more competitive than a tariff in the sense that it doesn't feed into the cost of living and therefore has no tendency to affect minimum-wage rulings.

As economic rent is the return to protection from competition, the assets that yield economic rent are those that cannot be replicated by competitive effort. These obviously include land and other natural resources.

The existing Petroleum Resource Rent Tax (PRRT) estimates the economic rent of an oil field as the margin by which accounting profit exceeds an allowance for normal profit. Credits for sub-normal profit can be offset against other super-normal profit but not refunded in cash.

The defunct Resource Super Profits Tax (RSPT) was an attempt to tax the economic rent of mineral resources. Credits for sub-normal profits were to be refundable, with interest at the federal bond rate, which was assumed to be the price of the risk that the Commonwealth would repeal legislation requiring it to refund unused credits. On that assumption, the same bond rate was to be the allowance for normal profit [3a].

The RSPT was widely condemned, ostensibly because the risk of losing the refunds was ridiculously underpriced (as indeed it was), so the allowance for normal profit was too low. But in both respects the RSPT was superior to the existing company tax, which offers no refunds and no allowance for normal profit. Hence the RSPT's critics, had they been genuine, should have welcomed any proposal to replace the entire company-tax system with a beefed-up RSPT. We must conclude that the RSPT was shouted down not because of its vices, but because of its virtues.

In principle, the economic rent of land can likewise be assessed by deducting an allowance for normal profit. In practice, however, as the value of land per unit area tends to be a smooth function of location, it is more convenient and more accurate to value land from real-estate transactions. Especially helpful to the valuer is the buyer who buys land with a building and promptly demolishes the building: the price paid for the bare land is the purchase price plus the demolition cost, and the purchase price is a lower bound thereon.

With a profit-based resource-rent tax, such as the PRRT, the assessed rent depends on the behaviour of the taxpayer, who must therefore be allowed to keep some of the assessed rent as an incentive to behave appropriately. So the tax rate must be less than 100%. A credit is given for sub-normal profit because without such a credit, the risk of failure combined with the tax on success could reduce the expected return below the normal profit and thereby deter investment.

Neither of these issues arises with a valuation-based resource-rent charge, such as land tax or site-value rating, because the assessed rent does not depend on the behaviour of the payer. In such cases, economic efficiency does not require the resource owner to keep any part of the rent, or to receive a credit for failing to realize normal profits from use of the resource.

What about other property taxes? Production cannot occur unless (a) employers can pay for business premises out of the proceeds of business, and (b) employees can pay for housing within commuting distance of business premises, out of wages that employers can pay out of the proceeds of business. Therefore any tax that inhibits the supply of accommodation is a tax on production. Municipal rates do this in so far as they are levied on values of buildings, or on services correlated with the quantity of accommodation. Conveyancing stamp duties do this because they include buildings in the tax base, and because they inhibit re-allocation of land for construction, and re-allocation of land and buildings for more productive uses. All these taxes are reverse-protectionist. But land tax and site-value rates are not, provided of course that more productive uses of sites don't attract higher tax rates.

So-called “profit”, which is divided (above) into normal profit and economic rent, can alternatively be resolved into current profit (income from assets) and capital gains. If the real value of an asset rises for any appreciable time, people will produce or import more such assets until competition re-establishes the usual pattern of depreciation — unless, of course, the asset owners are protected from competition because the assets in question cannot be produced or imported. So capital gains tax overwhelmingly captures economic rent rather than normal profit.

The argument that taxes on capital deter capital formation and repel internationally mobile capital is overwhelmingly not applicable to capital gains tax, because the assets that gain in value are overwhelmingly not the sort that require formation or are internationally mobile. The argument actually favours taxing income from capital at a lower rate than capital gains. That we do the opposite is simply a triumph of rent-seekers over the national interest.

Finally, where does this leave a carbon tax? A tax on the carbon content of domestic coal, crude oil and natural gas would obviously be an excise and therefore would be reverse-protectionist — but no more so, dollar for dollar, than income tax. And at the rates being talked about, it would collect only a fraction of the revenue that income tax collects. Moreover, any carbon excise on domestic fossil fuels would inevitably be accompanied by a tariff at the same rate on equivalent imports, making the whole package impartial. There are even proposals for border-adjusting a carbon tax or otherwise placing it on a consumption base, making it protectionist like the GST. To those who accept income tax as part of the furniture but complain that a carbon tax would damage competitiveness, one can only say: “Ye blind guides, which strain at a gnat, and swallow a camel.”

In summary, if the vested interests who keep lecturing us about the competitiveness of the tax system were genuine, they would agree that:

  • Our present tax system appears to have been designed to protect foreign producers against their Australian competitors.
  • The only parts of the income-tax system that might be worth keeping are capital gains tax and profit-based resource-rent taxes. The rest of it, together with payroll tax, would be better replaced by a retail tax. This would not cause regressive redistributive effects if net wages and salaries were preserved in the transition.
  • The only existing property taxes worth keeping are land tax and site-value rates, although one must be careful to avoid distortions due to differential tax rates. Municipal rates on buildings or services should be shifted onto a land-value base. Stamp duties would be better placed on a capital-gains base or replaced by land tax [4].
  • Dollar for dollar, any realistic carbon tax is more competitive than income tax.

To compensate the states for the loss of payroll tax, the Commonwealth could impose the retail tax at a federal rate plus a state surcharge rate, setting the latter rate in each state at the request and consent of the state parliament, and the surcharge revenue collected in each state could be refunded to that state.

Having replaced income tax and payroll tax with the retail tax and allowed the states to levy their own rates on the common retail-tax base, we would have no need for the GST either as a token consumption tax or as a means of funding the states. We could then afford the luxury of replacing the GST with some other tax in pursuit of some other goal, such as mitigating greenhouse emissions or saving the financial system from the housing bubble.


[1] But because employers are nominally collectors of tax owed by employees, and because employers are not paid for this service or even reimbursed for expenses, the constitutionality of the arrangement is highly dubious; see my earlier submission “Making the tax system comply with s.82 of the Constitution” (although the remedy offered in that submission is inferior to the above).

[2] Thus the constitutionality of payroll tax is also highly dubious; see my earlier article “What if GST and payroll tax are unconstitutional?” (although the remedy offered in that article is again inferior to the above).

[3] The cited sections are:

51. The Parliament shall, subject to this Constitution, have power to make laws for the peace, order, and good government of the Commonwealth with respect to:—

. . .

(ii.) Taxation; but so as not to discriminate between States or parts of States:

. . .

90. On the imposition of uniform duties of customs the power of the Parliament to impose duties of customs and of excise, and to grant bounties on the production or export of goods, shall become exclusive. ...

. . .

99. The Commonwealth shall not, by any law or regulation of trade, commerce, or revenue, give preference to one State or any part thereof over another State or any part thereof.

[3a] Not for the business model by itself, but for the business model as modified by the RSPT and its refundable credits. It was never pretended that the federal bond rate was an adequate return on a mining venture per se. But, as the “assumption” is false, the conclusion is moot. (Note added Dec.14, 2011.)

[4] To ensure that the retail tax as applied to property behaves like a land tax, and not like an income tax or stamp duty, the retail tax should apply only to the imputed rental values of sites — exempting actual rental income, sale prices, and values of buildings. All residential and commercial landlords should be treated as retailers in respect of their sites regardless of whether the sites are developed or tenanted. Owner-occupants of commercial sites could be treated the same way; this would be in their interest, because (a) a broader base means a lower rate, and (b) greater reliance on land values gives governments a greater incentive to invest in infrastructure which enhances land values for the benefit of the owners. For the same reasons, extending the same treatment to owner-occupied residential sites would be in the interest of home owners, although owners who are asset-rich but income-poor would appreciate deferral of the tax until their homes are next sold. But even without these refinements, a retail tax would be more competitive than an income tax.

[Text last modified July 20, 2010.]

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