There's never ever any excuse for taxing labour
And if we agree on nothing else, we should agree on that much, says Gavin R. Putland.
Why is the workplace-relations issue so polarized? Workers think wages are too low because they receive so much less than their employers pay. Employers think wages are too high because they pay so much more than the workers receive. The difference is mostly tax. So workers and bosses fight each other while the taxman makes off with the money.
Why are Australian manufacturers so uncompetitive that two thirds of the voters are unapologetic protectionists? Because of taxes on inputs — especially labour. At the time of writing it is more fashionable to blame the currency, whose value is driven up by the success of less labour-intensive industries, especially mining. But, as mining booms come and go, and as currencies rise and fall, taxes on labour are ever present. And there's no need for them.
Taxes on the earnings of labour, in the forms of personal income tax and payroll tax, are rationalized on the ground that labour is less internationally mobile than capital, so that a tax on labour tends to be borne by the workers themselves and has little tendency to drive investment offshore. Apparently we're not supposed to ask for whose benefit we want the investment. We are even told that payroll tax, although payable by employers, is shifted onto workers in the form of lower wages. Apparently that counts as an advantage.
If we point out that land is even less mobile than labour, we are liable to be told that it's unsporting to tax things that can't run away. Apparently that objection doesn't apply when the sitting ducks are mere workers. And we are certainly told — repeatedly, ad nauseam — that while land can't flee from the taxing jurisdiction, investors can, wherefore land tax supposedly drives away investment. We are not meant to notice that land tax is a charge on owning the land and does not further penalize doing things with the land — as labour taxes do. Neither are we meant to notice that if the land-tax rates and thresholds remain constant, the tax is discounted in the purchase price of land and therefore does not affect the rate of return on investment. It reduces the rate of return only if the tax is introduced or increased after the land is acquired, and then only if the change is not compensated by cuts in other taxes.
Defenders of labour taxes further point out that under certain unrealistic conditions, a tax on labour-income is equivalent to a tax on consumption — as if that were some sort of benchmark. As you may infer from the preceding paragraph, I regard land tax, not consumption taxes, as best practice. Nevertheless, I can't help noticing that the most watertight argument against labour taxes comes from the conditional equivalence between labour taxes and consumption taxes — because when each of those “unrealistic conditions” is replaced by reality, consumption taxes gain an advantage.
Those “unrealistic conditions” are: (1) there are no pre-existing savings or capital; (2) the rate of return on investment in capital or land is the discounting rate; (3) the borders are closed; (4) if any labour-income is saved or invested, the proceeds together with the principal are consumed later. Under these conditions it can be shown algebraically that the consumption base and the labour-income base have the same discounted present value (PV).
But we can reach the same conclusion without any algebra if we re-examine the assumptions. Condition (2) means that investment in capital or land does not affect the PV of the consumption budget, which is therefore equal to the return on the other factor of production, namely labour. Condition (4) means that all proceeds of labour are eventually consumed. Condition (1) means that the consumption budget is not augmented by drawing down assets. Condition (3) means that the consumption budget is not altered by cross-border flows. So, what the algebra ingeniously proves is this: if we rig the assumptions so that consumption is funded by labour-income, the whole of labour-income, and nothing but labour-income, then a tax on labour-income becomes identical to a tax on consumption. Well, duh!
When assumptions (1) to (4) are replaced by reality, the advantages of taxing consumption instead of labour are, respectively, as follows:
(1) We broaden the base to include consumption financed by drawing down assets acquired through past decisions, which cannot be deterred by the tax. Hence, if we reduce the tax rate to compensate for the broader base, we get the same revenue with reduced disincentives. (This is an efficiency argument, not an equity argument. The implications for inter-generational equity depend on whether the introduction of a consumption tax causes a one-off jump in prices; see below.)
(2) We broaden the base to include consumption financed by returns on investment above the discounting rate. These additional returns include (a) insurance, which is the reward for bearing risk, (b) economic profit, which is the reward for bearing uncertainty (the difference being that “risk” is quantifiable while “uncertainty” is not), and (c) economic rent, which is the return to any sort of protection from competition (the archetypal example being the limited supply of land, especially well-located land). All of these tend to account for higher fractions of higher incomes, so their inclusion in the tax base makes the system less regressive. The last — economic rent — is not an incentive for productive activity. By adding it to the tax base, we can lower the rate and reduce disincentives while collecting the same revenue.
(3) In an open economy, a domestic tax on labour penalizes the labour content of exports while exempting the labour content of imports at the point of entry, whereas a consumption tax captures imports but exempts exports (which by definition are not “consumed” within the taxing jurisdiction). Thus a labour tax acts as a reverse tariff while a consumption tax does not.
(4) Taxing working people's consumption only impedes their consumption. Taxing their income impedes everything they might do with that income, including not only consumption but also saving, investment, paying down debt, and leaving bequests. Thus a labour tax is a greater barrier to upward mobility than a consumption tax; it is not only less efficient than a consumption tax, but also less equitable.
Does reality no.(3) mean that a consumption tax is protectionist? No. Protectionism is the doctrine that we should tax our competitive industries in order to prop up our uncompetitive ones, causing a diversion of investment from industries in which we have an advantage to those in which we have a disadvantage, leading to lower national income, lower capacity to pay wages, and harder times for workers. A broad-based consumption tax is not open to that objection, because it does not discriminate between industries. It is, of course, open to the objection that higher export income is balanced by higher outflow of goods and services. But the latter objection is far less serious, because while the goods and services flow out of the country, the capacity to produce them — which is obviously more important — stays at home.
The last-ditch defence of taxes on labour is that if a labour tax takes the form of a personal income tax, it can be made progressive. But nowadays, “personal” tax on labour-income is almost invariably withheld and remitted by employers as “PAYG” income tax. That makes it arguably a business tax rather than a personal tax. It certainly looks like a business tax in employers' accounts. If we treat it as a business tax, we can replace it by a consumption tax without raising prices, and without widening after-tax wage relativities — that is, without losing its progressiveness. The trick is to let employers keep the withheld PAYG income tax but to give the workers credit for the withheld tax as if it had been paid on their grossed-up incomes. The withheld PAYG tax is thus made available to enterprises for the purpose of paying the alternative consumption tax, which can therefore be paid without having to raise prices in the aggregate. And if there is no price rise, there is no devaluation of past savings.
If the idea that we can introduce a consumption tax without raising prices is contrary to experience, that's because “experience” refers to a different transition mechanism. Suppose, for the sake of illustration, that the consumption tax is a border-adjusted VAT (that is, a VAT that targets consumption by zero-rating exports and disallowing input credits for imports). Whether prices rise when PAYG income tax is replaced by the VAT depends on what stays the same.
- If gross wages and salaries stay the same, then the PAYG income tax that employers previously withheld from employees is subsequently paid to them in gross wages and salaries, so that the income needed to pay the VAT must come from elsewhere, namely higher prices. That's our “experience".
- But if net wages and salaries stay the same, the PAYG income tax that employers previously withheld from employees is subsequently retained by employers and is therefore available to pay the VAT. In the aggregate, no additional income needs to be found to cover the VAT, so there is no overall rise in prices.
The “trick” of letting employers keep the withheld PAYG income tax is a quick-and-dirty method of making net wages and salaries stay the same. It does not abolish personal income tax altogether, but substitutes a consumption tax for personal income tax on wages and salaries only. In Australia, wages and salaries account for about 90% of personal income tax.
Of course, it would be possible to achieve the same result by abolishing personal income tax and using the workplace-relations power to maintain net, not gross, wages and salaries — except that the VAT base, if limited to employers, would not cover all of the former personal income-tax base. The shortfall could be remedied by registering, as VAT collection points, the various assets and entities through which individuals obtain income other than wages and salaries. For the affected individuals, the compliance costs of those VAT registrations would be incurred in lieu of the compliance costs of personal income tax. For the rest of us, the compliance costs of personal income tax would simply disappear.
It would also be possible to use the “quick-and-dirty” method for the sake of a rapid transition, while promising to abolish the rest of the personal income-tax system in a later Budget. That two-step process would be enough to neutralize a possible legal weakness in the “quick-and-dirty” method, namely that if personal income tax is not abolished outright, other countries might argue that the retention by employers of the PAYG component in order to pay a VAT is a back-door method of border-adjusting an income tax or part thereof, which is illegal under WTO rules. But that argument won't fly if personal income tax is abolished outright. So, if we first replace 90% of personal income tax by the “quick-and-dirty” method, the obvious feasibility of abolishing the other 10% will make it pointless to challenge the legality of the initial change.
Whatever the method, replacing a labour tax by a consumption tax while preserving net wages and salaries would reduce the cost of hiring a worker — and therefore create jobs — without reducing workers' take-home pay. Economic output would increase while workers' bargaining positions would improve. Thus efficiency and equity would both be enhanced.
In summary, the comparison between labour taxes and consumption taxes is 100% in favour of consumption taxes. There is nothing that can be done with a labour tax that can't be done better with a consumption tax. And if, as I claim, even a consumption tax is not the best method of raising revenue, then that is all the more reason to reject taxes on labour.