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Tuesday, July 19, 2011:

Opting out of income tax & GST

Property owners should be able to opt out of recurrent income tax and GST, says Gavin R. Putland.*

The proposal

If you're a property owner, you should be able to sign a contract with the Australian Tax Office (ATO) whereby:

You can stop paying recurrent income tax and GST if you pay a negotiated Tax-Exemption Rent (TER) on every property that you own.

As long as you own the property, you pay the Tax-Exemption Rent to the ATO in lieu of tax. You don't “rent” the property; you “rent” the tax exemption that goes with the property. If you stop being a property owner, you re-enter the old tax system.

What's the point?

Obviously the ATO will insist that you pay at least as much TER as you now pay in recurrent income tax and GST. So what's in it for you? Two things:

  • You escape the paperwork. If you're a business, you no longer collect GST or claim input credits (that is, you become “input-taxed” for GST purposes, except that your customers can still claim input credits if they remain under the old system), and you no longer self-assess your business income tax — and no longer risk prosecution for making a mistake with any of the above. If you're an employee, you no longer need to submit tax returns; and prospective employers no longer need to deduct PAYE tax on your behalf — so you become more employable.
  • You escape the deadweight. If you're a business, growth opportunities made unviable by income tax and GST become viable again (because more turnover, which meant more tax under the old system, doesn't mean more TER). If you're an employee, you can earn extra income without losing most or all of it to the combination of income tax and withdrawal of benefits.

(Will employers avoid PAYE paperwork by discriminating in favour of job applicants who have opted out of income tax? If they do, they'll need to pay their workers enough to service mortgages! That's not a problem for workers.)

And what's in it for the government? Four things:

  • The removal of deadweight means more business activity, more jobs, more prosperity, hence more votes!
  • Financial advisers will support the reform. In the short term, the need to negotiate TERs will create demand for advice. In the long term, increased business activity will maintain employment for the financial/accounting profession.
  • The TER plays the politics of choice. If you don't want to pay the TER, you can simply stay in the existing system. That's no reason to deprive other people of an alternative. Opponents of the TER are opponents of choice.
  • Remember the First Home Owners' Boost, which pushed home prices back up? When home prices in other countries collapsed, so that mortgaged buyers owed more than their homes were worth, governments responded by bailing out the banks. Australia was different because the government propped up the housing market before the problem reached the banks. But now prices are collapsing again. If owning property lets you escape the paperwork and deadweight of income tax and GST, that will encourage property ownership and support prices — at no cost to the taxpayers.

What if you don't own property? Is there anything in it for you? Yes:

  • Landlords who opt out of the existing system will need rental income to cover their TER bills. And they won't be taxed on that income. So they'll make more properties available for rent and try harder to attract tenants. That will enhance the bargaining power of tenants.
  • In an “investor” with a portfolio of empty properties, hence a low taxable income, wants to join the TER system on a correspondingly low negotiated TER, the ATO will obviously want that person to sell or let those properties first, as part of the price of escaping the income-tax/GST system. Such cases will make more properties available for sale (helping non-owners to become owners) or to let (making life easier for tenants).
  • If you're a business that doesn't own its premises, you'll probably receive an attractive merger/buy-out offer from one that does. Of course such offers are always possible. But the advantages of owning one's premises under the new system will make you more likely to receive such offers, and more inclined to accept them.
  • If you're an individual in a cohabiting relationship with another individual who owns property, the two of you can merge your affairs for tax/TER purposes (see below).
  • Accelerated economic growth due to the removal of distorting taxes on property owners will create opportunities for non-owners — especially employment opportunities. That will enhance the bargaining power of workers and jobseekers even if they don't own property.
  • The growth dividend — that is, the rise in TER receipts and the fall in welfare payments due to that accelerated economic growth — will make the government less and less dependent on the remaining income tax and GST paid by non-property-owners, so it will become easier and easier to devise methods of removing non-property-owners from the old system.

Essential details

What exactly is this “recurrent income tax and GST” that you can stop paying? For present purposes you are said to “pay” a tax if you are responsible for finally settling the account with the ATO. Hence:

  • If you're an employee, your “income tax” includes PAYE tax on your wage or salary.
  • Therefore, if you're a business, your “income tax” doesn't include employees' PAYE tax remitted by you; but it does include company tax, Fringe Benefits Tax and superannuation taxes remitted by you.
  • Your “GST” means the GST actually remitted by you — not merely hidden in prices paid by you. But if you are under the TER, customers under the GST system can claim input credits on purchases from you, as if you were still registered for GST. (Under the present system, hundreds of thousands of businesses that are small enough to qualify for “input-taxed” status have been forced to register for GST because their customers want input credits. The TER would let them get off the GST-compliance treadmill.)

Capital Gains Tax (CGT) is not “recurrent” and is therefore not included in “recurrent income tax”. (Otherwise people could opt out of the tax system, realize their capital gains tax-free, then opt back in, leaving a “black hole” in revenue.)

How is your TER determined? In the short term, your negotiated TER will obviously be similar to your old tax bill, so that the ATO is happy (because it still gets its money) and you're happy (because you escape the paperwork and the deadweight). But when a property changes hands and the “old tax bill” loses its meaning, the TER must revert to some sort of “standard rate” which ensures that revenue remains adequate in the long term. So:

  • The TER on real estate has a standard rate of 6% of the site value per annum, except for homes owned and occupied by persons of pensionable age, for which the standard rate is 2% of the site value per annum. The “site value” is the value of the land and airspace, excluding buildings and other artificial structures; this base ensures that the TER, unlike income tax and GST, doesn't deter the construction, extension and renovation of buildings.
  • If the TER at the standard rate would fall short of your current tax bill, your negotiated TER on each property is specified as an initial annual amount with a CPI adjustment.
  • If the TER at the standard rate would exceed your current tax bill, your negotiated TER is specified as a lower rate on the site value.
  • Your negotiated TER on each property applies as long as you own that property, and the TER on any properties that you acquire in future will be at the standard rate.
  • The negotiated TER on your principal residence may include a downward adjustment when you reach an agreed retirement age.
  • If you're a business paying TER, your TER is renegotiated if you merge with or acquire a business that is under the old system (e.g. a business that doesn't own its premises). The negotiation could take place ahead of the merger/acquisition, or (more likely) the merger/acquisition could be subject to a satisfactory TER agreement.
  • A cohabiting couple can join the TER system as one unit if they own at least one property between them. If you're an individual paying TER, your TER is renegotiated if you form such a relationship with a person under the old system who wishes to join the TER system.
  • If the standard rate applies to an owner-occupied home, increases in the TER bill caused by increases in the site value may be deferred, in full or in part, until the home is next sold. (And if you don't think that's good enough, you can stay in the old system!)

The anti-avoidance provisions of the TER could be expressed in a single sentence: “The ATO shall not be obliged to make a contract with you.” It follows that the ATO can impose conditions on any such contract; e.g., you might need to bring related entities into the TER system with you, and you might need to sell, let, or fully utilize specified properties before you sign up, and thereafter to retain particular properties (on pain of re-entering the old system or renegotiating the TER). The conditions will be able to evolve quickly to ensure that any loopholes exposed by early contracts are not replicated in later ones.

The fine print

Most employees, small businesses and “mum-and-dad” property investors won't need to know more than has already been said. But if your affairs are more complicated, you might need to consider the following matters. Excuse the jargon.

For TER purposes, “property” includes not only real estate, but also:

(i) Secured debt (e.g. mortgage debt), with a standard rate of 2.5% of the principal per annum, payable by the creditor if the debt is to be enforceable;

(ii) Corporate shares, with a non-negotiable rate of 2.5% p.a. on the above-par component of the value, paid by the company, in which case shareholders don't pay tax on the dividends and the company is exempt from profit-based resource-rent taxes (which, however, are still needed for unlisted companies);

(iii) Perpetual licences and privileges that are readily valued (e.g. because they are tradeable — like taxi plates), with a standard rate of 6% p.a. on the value.

The reasons for the above inclusions are, respectively:

(i) The preferred security (or “collateral”, as the Americans call it) is real estate, of which the creditor is the effective part-owner to the value of the debt. But because the range of possible security is not restricted to sites, or even to real estate, the standard rate is lower than on site values. If credit is rationed by a central authority, the limited supply of credit is analogous to the limited supply of land; and if credit is not rationed, those who create credit still constitute a cartel and their interest margins are still, in part, economic rent — that is, a return to protection from competition. The rate per annum on the principal (in lieu of income tax on the interest) is a much-needed incentive to reduce the principal on non-performing debt rather than “extend and pretend”.

(ii) The “above-par” component of the share price is a crude proxy for super-normal profit, which in turn is a crude proxy for economic rent, including resource rents. The said crudeness is one reasons for the low rate. But any attempt to distinguish economic rent from the necessary return on investment, however crude, is better than the existing corporate income tax, which taxes all profits, including inadequate profits. A simple rate on the share value, unlike a “super-profits” tax, is not susceptible to transfer-pricing tricks. The rate is non-negotiable because the rapid turnover of shares would make a negotiated rate impractical and ineffectual. The rate is the same as the standard rate on secured debt, but applies to less than the full share value, so that equity-financing is made more attractive than debt-financing; this is appropriate because financial crises are caused by excessive debt, not excessive equity.

(iii) Government-created licences and privileges confer protection from competition and are therefore sources of economic rent. (Incorrigible economic-rent deniers are free to remain in the existing tax system!)

Sales of intellectual property (IP) and income from IP royalties are treated as capital gains.

TER is payable only on “properties” that are under Australia's jurisdiction. So if you're a multinational company wanting to “stop paying recurrent income tax and GST”, you'll need to separate your Australian operation for TER purposes. But this is not a new problem; e.g., income tax also raises jurisdictional issues.

Balancing the budget

Because the initial TERs will be negotiated, the movement of taxpayers from the old system to the new will be revenue-neutral for each taxpayer and therefore revenue-neutral overall. Only in the very long term does the adequacy of revenue depend on the adequacy of the standard rates. But, using recent revenue totals and asset values, we can check that the standard rates are in the right ballpark.

In 2009-10, according to ABS 5506.0, income tax and GST raised a total of $234 billion (apparently including the CGT component, which does not need to be replaced by TER).

In June 2009, according to ABS 5204.0 (Table 61), the total value of residential, commercial and rural land was $2821 billion, which at a rate of 6% would have yielded about $170 billion in revenue. This is a slight overestimate because the sites of homes owned and occupied by persons of pensionable age would have been rated at 2%.

Mortgage debt was at least $1 trillion, which at a rate of 2.5% would have yielded at least $25 billion. This is an underestimate because mortgage debt does not include all “secured debt”.

Equities listed on the ASX were worth about $1.4 trillion. If $1 trillion of that was above par, the revenue yield would have been another $25 billion. This does not allow for the movement of capital to Australia in response to the simpler tax environment.

The subtotal from these three sources is $220 billion. Even if that is optimistic in itself, it does not include the revenue from perpetual licences and privileges, or the effect of economic growth on revenue. Neither have we allowed for the associated reduction in welfare expenditure — or for the “carbon tax” package, which would reduce the amount of income tax that needs to be replaced by the TER.

So the figures are rough. Even if they were exact for 2009-10, they would be only roughly applicable to that future time when the standard TER rates become critical. But they show that the proposed standard rates are not unreasonable.

Preventing future bubbles, bursts and recessions

In the long term, the TER at the standard rate would function as an auto-stabilizer on the property market: if land prices rise, the TER bills rise, encouraging selling and therefore tending to moderate prices; and if land prices fall, the TER bills fall, encouraging buying and therefore tending to support prices. Thus the growth of prices is stabilized around the long-term trend, avoiding speculative bubbles and the ensuing bursts and recessions.


* Revision history

July 19: First publication.

July 20: Minor edits.

July 26: Reduction of proposed rate on above-par value of shares; reasons for “fine print”; new section on “Balancing the budget”.

July 27: Clarification of anti-avoidance provision and its benefit for non-property-owners.

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