Tax Forum 2: Abolish personal income tax

There's a way to shift the tax burden from personal income to consumption without raising prices, says Gavin R. Putland.* (P.S.: See also Maximalist ‘fiscal devaluations’ for Greece and Australia.)

The trick

Conventional wisdom holds that if personal income tax is replaced by a consumption tax, prices rise, and high income earners are overcompensated for the price rise while low income earners are undercompensated, so that the overall effect is regressive.

That “wisdom” is true if gross wages/salaries (in nominal dollars) are held constant: the PAYE income tax that was withheld from wages/salaries is instead paid to employees, and the consumption tax must come from another source, namely higher prices. And because PAYE income tax is progressive, the benefits of its abolition are skewed towards high income earners.

But it isn't true if net wages/salaries are held constant: in the aggregate, the funds previously paid to the government as PAYE income tax are instead paid to the government as consumption tax. There is no need for enterprises to find extra revenue, hence no overall price rise.

Maintaining the same net wages for existing appointments is straightforward. New appointments can be subject to a new IR regime, preferably with a lump-sum per-shift bonus as an implicit loading for part-timers and casuals. The shift bonus would replicate the progressiveness of the existing system with respect to working hours, so that (e.g.) a worker on 18 hours/week would take home more than half the pay of a colleague on 36 hours/week. The shift bonus would also eliminate the need for minimum-shift rules.

VAT vs. retail tax

The existing GST is a value-added tax (VAT). It is usually argued that a VAT is harder to evade than a retail tax because, under a VAT, sellers who fail to declare sales may be exposed through their customers' input credits.

That argument conveniently ignores retailers, whose customers don't claim input credits under either system. In South Korea they plug the retail loophole by offering tax incentives to retail customers who use credit/debit cards, which create electronic records of purchases. Such incentives would work just as well for a retail tax as for a VAT.

It also ignores the problem of bogus input credits, which are possible only under a VAT, and which are particularly obnoxious in that the offenders accuse innocent parties of failing to declare sales.

VAT defenders further argue that a VAT encourages traders to declare sales so that they can claim input credits on the corresponding purchases — and never mind that it is more lucrative to hide both sales and purchases than to declare both! The only merit in this argument is that traders will pay VAT on any undeclared inputs — provided of course that they are not in cahoots with suppliers who are failing to declare the corresponding sales, and so on up the line! And isn't it funny that we never hear the same argument in defence of income tax, whose deductions cover a wider range of expenses than the VAT's input credits and should therefore, by the same logic, provide even more reasons to declare taxable income?

In truth, the only thing a VAT does better than a retail tax is to generate compliance costs, which make it harder for smaller businesses to compete with larger ones, and for new businesses to compete with established players.

At what rate?

The consumption tax should be imposed at whatever rate will make it price-neutral, because the same rate will make it revenue-neutral. That's the essential political answer. But we can easily estimate the fiscal answer.

In 2009-10, according to ABS 5506.0, personal income tax raised $124.8 billion. To ensure that the calculation is conservative, let us use that figure as the revenue to be replaced (although it presumably includes capital gains tax, which is to be retained).

To estimate the consumption base, let us first note that the GST raised $46.5 billion. The GST base, in terms of retail prices, was 11 times that, i.e. $512 billion. So if the new consumption tax were on the same base, it would require a rate of just under 25% of the tax-inclusive price. By comparison with income-tax rates, which are likewise expressed in terms of tax-inclusive income, that's not too scary.

But because the consumption tax is to replace personal income tax on a price-neutral basis, and because the personal income tax base is not subject to the same concessions as GST (e.g. while basic food is GST-free, the workers who produce it still pay income tax!), there is no need to complicate the new consumption tax with similar concessions, especially when the redistributive benefits of GST concessions have themselves been greatly exaggerated. As Peter Costello said at Thredbo while the GST was still a twinkle in his eye, “the broader the base, the lower the rate.”

According to Chart D2-1 in the Henry report, Australia's GST captures about 57.5% of its potential base. That puts the potential base at about $890 billion, which brings the rate down to 14% on the tax-inclusive price (or 16.3% on the tax-exclusive price).

The tax-inclusive base is more appropriate if marked and advertised prices are tax-inclusive — the more so if there is no longer any corporate income tax to be calculated on the consumption-tax-exclusive price.

Making Australia more competitive

Australia's personal income tax by its very nature operates as a reverse tariff: it applies to Australian personal income earned in producing products for export, but not to foreign personal income earned in producing imported products.

In contrast, a retail tax by its very nature would tax imports but not exports, helping Australian producers to raise their market share in both the domestic market and the global market. This will be especially necessary if foreign events — such as the sovereign debt defaults in Europe, overbuilding in China, or a double-dip recession in the USA — cause a fall in global demand.

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* This document is subject to revision.