Guest Lecture Taxation

1
Guest Lecture Taxation

• Dr. Maria Racionero
• School of Economics

2
Overview

• Tax design versus tax reform
• Recent reforms
• Fiscal federalism
• Commonwealth-State financial arrangements
• Globalisation and fiscal competition
• New international tax arrangements

3
Tax design versus tax reform

• Who bears the burden of a tax?
• What determines the welfare loss of taxation?
• What are the desirable properties of a tax
  system?
• Should production be taxed?
• What are the main tax options?
• What is the best overall system of taxes?
• How can an existing tax system be improved?

4
Who bears the burden of a tax?

• Tax incidence is the study of who bears the
  burden of a tax
• Tax burden is the true economic weight of the tax
• The burden of a tax falls more heavily on the
  side of the market that is less elastic

5
What determines the welfare loss of taxation?

• An increase in taxes makes individuals worse off
• But some taxes reduce individuals welfare less,
  for each dollar of revenue raised, than do others
  
• Tax policy is concerned with designing tax
  structures that minimize welfare loss for any
  given amount of revenue raised

6
What are other desirable properties of a tax
system?

• Administrative simplicity the tax system ought
  to be easy and relatively inexpensive to
  administer
• Flexibility the tax system ought to be able to
  respond easily to changed economic circumstances
• Political responsibility the tax system should
  be designed so that individuals can ascertain
  what they are paying, and evaluate how accurately
  the system reflects their preferences
• Fairness

7
What is a fair tax system?

• Horizontal equity Individuals who are identical
  (or in essentially similar economic
  circumstances) should be treated the same
• Vertical equity Individuals who have greater
  ability to pay should pay more taxes

8
What should be the basis of taxation?

• Income an indirect and imperfect measure of both
  ability to pay and economic well-being
• Consumption seems fairer than income (it
  measures what one takes out of society rather
  that what one contributes)
• Benefit individuals should contribute in the
  proportion of the benefits received

9
Should production be taxed?

• Economic welfare is maximised if the economy is
  maintained on the PPF
• Government should not alter the prices that
  producers face in trades between themselves
  (i.e., there should be no taxation on trade
  between firms)
• Taxes on income or consumption can achieve
  desired welfare outcomes more efficiently

10
What are the main tax options?

• Lump sum taxes No efficiency cost, but
  generally inequitable
• Income taxes
• General, linear or non-linear ? taxes savings
  twice!
• Non-linear differential
• Consumption taxes
• General expenditure tax, linear or non-linear
• Uniform value added tax
• Uniform retail tax
• Differential commodity taxes (by VAT or retail)

11
What is the best overall system of taxes?

• Both income and commodity taxes have
  disadvantages and combining them may be
  beneficial
• Optimal tax models that attempt to determine the
  optimal combination are complex. However, some
  general principles emerge

12
What are the main principles of taxation?

• Tax revenue is raised most efficiently by taxing
  factors or goods with inelastic supply or demand
• In the absence of lump sum taxes, tax creates
  excess burdens and a strict target-instrument
  approach may be inefficient. The optimal policy
  for any tax depends on the availability and
  levels of other taxes

13
What are the implications of these tax
principles?

• When sources of income and factors of production
  are highly substitutable, there are efficiency
  benefits in taxing all sources at the same rate
• An income tax penalises savings. However, an
  expenditure tax raises less revenue that an
  income tax with the same nominal rate and is
  generally more inequitable
• Whether an income tax or an expenditure tax is
  preferable depends very importantly on the size
  of the distortions, but it is generally accepted
  that income taxes are superior

14
Should commodity taxes be included?

• Commodity taxation captures income that may
  otherwise evade tax
• It may provide a more efficient relief for
  savings than a differential income tax system
  that taxes income from savings at a lower rate
• It may be considered fairer to tax what
  individuals take out of the economic system

15
If commodity taxes are included, what is the
optimal form?

• When demand elasticities are similar across
  commodities, for any revenue target, a broad set
  of low tax rates is preferable
• However, when demand elasticities vary
  significantly, differential tax rates, in inverse
  relation to the price elasticity of demand,
  reduce the excess burden

16
How can an existing tax system be improved?

• In practice, if the derived optimal tax rules
  were to be implemented it would be likely that a
  major change of the fiscal structure would be
  required
• Many countries, including Australia, have opted
  instead in favour of gradual policy reforms which
  involve slowly phasing in some taxes and removing
  others

17
Recent reforms in Australia

• Introduction of FBT Sept 1985
• Introduction of CGT Sept 1985
• Full imputation for company tax July 1987
• Introduction of CGT discount, abolition of
  indexation averaging Sept 1999
• Abolition of wholesales sales tax July 2000
• Introduction of GST July 2000
• Introduction of consolidation regime July 2002

18
GST

• Major tax reform that took place in July 2002
• Why?
• The Wholesale Sales Tax (WST) introduced in the
  1930s taxed a narrow range of goods, but did not
  directly tax services (over two thirds of
  Australias economic activity)
• Personal tax rates believed to be too high and
  complicated tax laws and loopholes allowed those
  who could afford financial advice to avoid paying
  their fair share

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Indeed, a bundle of reforms

• Reforms to the income tax and social security
• Reforms to the indirect tax and State finances
• Reform to business taxation
• Reform to tax administration

20
Reform to the income tax and social security

• Why?
• Disincentive effects of high income tax rates
• Unfairness through tax minimisation
• Complexity (in particular, lack of integration
  between the income tax and the social security
  system)
• How?
• Lower income tax rates
• Reform of family assistance
• Increase in social security payments

21
Reforms to indirect tax and State finances

• Why?
• WST outdated
• Inefficient State excise duties and fiscal
  imbalance
• How?
• Abolishing inefficient indirect taxes
• Introducing a GST
• Giving all GST revenue to the States
• Reforming excise duties

22
Reforms to business taxes

• Why?
• Business tax outdated
• Inconsistent entity treatment, inappropriate
  taxation of company groups and inconsistent
  treatment of distributions
• Incoherent framework
• How?
• Reforming taxation of business entities
• Reforming taxation of business investments
• Review of business taxation

23
Reforms to entities taxation

• Taxing trusts like companies
• Addressing tax minimisation
• Moving towards consolidation
• Achieving consistent treatment of company
  distributions

24
Reform to tax administration

• Why?
• High costs of dealing with many bodies of
  administration
• Inflexible and arbitrary business payment
• Inefficient and outdated withholding systems
• Complex tax laws
• Increasing size of underground economy
• How?
• Improving business registration system (through
  ABN)
• Introducing one tax instalment system for all tax
  payers
• Improving certainty and reliability of advice
• Simplifying tax returns and integrating the tax
  code
• Reducing tax avoidance

25
Fiscal federalism

• What economic functions and tax powers should be
  allocated to each level of government?
• Is there an optimal multilevel system of
  government?
• What principles should govern inter-government
  financial relations?

26
What economic functions should be allocated to
each level?

• Government has three main functions
  macroeconomic stabilisation, income distribution
  and resource allocation when markets fail
• Central government is best placed for
  macroeconomic stabilisation and
  redistribution/welfare policy
• The major function of local government is the
  provision of local public goods

27
How should taxes be allocated to different levels
of government?

• Distributional concerns
• Allocative efficiency the allocation should
  minimize DWL
• Fiscal adequacy the allocation should provide
  adequate funding for each level of government
• Accountability the allocation should take into
  account the preferences of citizens

28
Vertical fiscal imbalancefiscal adequacy and
accountability

• The central government is the most efficient
  taxer of the most important tax bases (income and
  consumption)
• This creates vertical fiscal imbalance (VFI) -
  one level of government raises more revenue that
  it requires for its own purposes and another
  level of government raises less than it needs
• Central government is likely to overspend or
  place conditions on grants that are inconsistent
  with local preferences

29
What are the equity issues in taxation with
multilevel government?

• Local taxes are often regressive - in order to
  retain their tax base, local government must
  attract and retain higher income households
• Local government have unequal capacity to provide
  public services. This is known as horizontal
  fiscal imbalance (HFI), which arises because of
• differences in the revenue raising capacity, and
  
• differences in expenditure needs

30
Is there an optimal multilevel system of
government?

• Tiebout hypothesis a competitive system of local
  governments could provide an efficient outcome
  with no need for government intervention
• However, Tiebout conditions do not fully apply in
  Australia there are few states and household
  movement between them is expensive

31
Commonwealth-Staterelations

• Commonwealth provides national public goods and
  social security benefits, plus grant financial
  assistance to any State
• The States are the main public providers of
  services to the Community including law and
  order, primary and secondary education, most
  health services, and regional economic
  infrastructure services
• Local government provides several local services
  (local roads, parks, libraries )

32
Tax revenue by level of government 2001-02






State and local tax revenue 31.0















Commonwealth tax revenue 69.0
33
Commonwealth government tax revenue 2003-04
Fringe benefits tax 1.8
Indirect taxes 16.2
Agricultural Levies and Other taxes 0.9
Income tax Superannuation 3.3
Income tax Companies and PRRT 21.6
Income tax individuals and other withholding 56.
2

34
State and local government tax revenue 2001-02
Taxes on motor vehicles 6.4
Other 0.5
Insurance tax 4.2
Gambling tax 5.5
GST 40.6
Taxes on immovable property 14.1
Taxes on financial and capital transactions 14.4
Employers payroll tax 14..3

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What are the implications of this breakdown of
tax revenue?

• The Commonwealth raises much more revenue that it
  spends on its own programs whereas State
  governments raise less than they are required to
  spend
• The degree of VFI is large compared with other
  federations

36
How are the VFI and HFI tackled?

• In the 2002-03 budget, the Commonwealth
  government forecasted that it would provide 54
  billion to the states by way of
  inter-governmental grants. Of this about 60 was
  in untied grants and 40 in specific purpose
  grants. About two thirds of tied grants are
  directed to education and health
• Inter-governmental cross-subsidies are large NSW
  and Victoria are the main contributors to
  revenue South Australia, Tasmania and Northern
  Territory are the major beneficiaries

37
Recent changes in the federal tax-arrangements

• The tax changes introduced in July 2000 had a
  significant effect on federal-state tax
  arrangements
• Income from the GST replaced general purpose
  grants (financial assistance grants) and
  revenue from some taxes that the States gave up.
  Like the financial assistance grants, the GST is
  untied
• The Commonwealth distributes GST revenue to the
  states on the basis of horizontal fiscal
  equalisation principles

38
Other Commonwealth payments to state and local
governments

• The Commonwealth also provides general revenue
  assistance in three main categories
• Budget Balancing Assistance (BBA) grants
• National Competition Payments (NPCs)
• Special Revenue Assistance (SRA)
• Specific purpose payments are payments for policy
  purposes that relate to particular functional
  activities, such as health or education

39
GST revenue provision and total Commonwealth
payments to state/local sector 2003-04 estimates
40
Is the Australian federal system an efficient
multilevel system?

• The allocation of functions is broadly as would
  be expected. However, there is much overlap of
  responsibilities and duplication of services
  (National Commission of Audit, 1996),
  particularly in health and education
• The Commonwealth controls the major tax bases
  income and consumption. Note that although the
  Commonwealth describes the GST as a state tax,
  the Commonwealth decides how this revenue will be
  allocated between the states

41
What are the implications of this control of
major tax bases?

• A high degree of VFI which is not conducive to
  accountability and efficiency in government
• The states reliance on a mixed bag of taxes
  (payroll taxes on medium and large firms, stamp
  duties on the exchange of assets (mainly
  property), motor vehicle taxes, taxes on
  insurance and on gambling, taxes on the turnover
  of financial institutions and land taxes) which
  do not provide an efficient tax system

42
Globalisation and fiscal competition

• In what ways does globalisation affect government
  revenue and expenditure?
• Globalisation may reduce government expenditures
• Increases the mobility of factors of production
• Modern technology facilitates the worldwide
  movement of money and increases the possibility
  of tax evasion
• Tariff reductions reduce taxes on trade

43
What is the evidence?

• Globalisation appears to have had little impact
  in government revenue . However,
• Tax revenue is the product of tax base and tax
  rate(s)
• Globalisation may affect the structure of taxes,
  with low tax rates on mobile factors and high on
  immobile factors
• Tax revenues depend also on the demand for
  government services

44
How does globalisation affect taxes on production?

• The more mobile is the factor the more easily it
  can escape taxation
• The principal hypothesis of the tax competition
  literature is that tax rates on mobile factors of
  production (like capital) will fall and tax rates
  on more immobile factors (like labour and land)
  will rise

45
Capital

• Two types of capital financial (portfolio) and
  real or FDI, where portfolio capital is more
  mobile than FDI
• In theory, interest on portfolio capital is
  liable to personal income tax because governments
  can tax their own residents on their worldwide
  income. However, cross-border investments often
  evade tax
• Income generated by FDI is taxed through company
  income tax. Tax competition might be expected to
  reduce corporate rates and to create convergence
  of rates

46
What is the evidence?

• The average rate of corporate income tax in the
  25 OECD countries fell from 43.5 in 1986 to
  33.2 in 1998. In Australia, government reduced
  the corporate tax rate from 39 in 1988 to 30 in
  2001-02
• Tax rates converged range between the highest
  and the lowest tax rate from 28 to 20, and the
  standard deviation from 7 to 4.5

47
Labour

• Labour is less mobile
• However, skilled high-income workers are usually
  in international demand and can afford the
  transaction costs of relocation
• In the last 20 years, there has been a worldwide
  decline in the progressivity of income tax
  structures

48
How does globalisation affect taxes on
consumption?

• Consumption activities are generally less mobile
• Accordingly, we would expect globalisation to
  lead to an increase in consumption taxes and user
  charges
• OECD countries, including Australia, have
  significantly increased consumption taxes,
  notably by the use of VAT (or GST)
• Shifts in the tax structure away from taxation of
  capital and labour income to consumption affect
  the burden of taxation

49
How does tax competition affect economic
efficiency?

• When capital is immobile, there is no DWL due to
  loss of capital
• When capital is mobile across jurisdictions the
  marginal social cost of taxation includes the
  loss of output that arises when capital moves
  abroad to escape the tax burden
• However, this model assumes that income from
  capital is taxed at its source rather than at its
  destination

50
Source vs destination principle

• When tax rates at sources differ, taxation of
  income at source distorts the flow of capital and
  investment decisions
• If income is taxed according to the destination
  (or residence) principle, a residents worldwide
  capital income is taxed at the same rate,
  regardless of its source. The worldwide
  allocation of capital, and hence production
  efficiency, is then independent of local tax
  rates

51
Is the Australian system destination or source
based?

• Under Australian legislation most income is taxed
  under the destination (residence) principle ?
  Law-abiding owners of capital have no tax
  incentive to move capital overseas
• The Australian government also taxes income from
  Australian sources that accrues to foreigners ? A
  source based element that may discourage foreign
  capital and distort the worldwide allocation of
  capital and productive efficiency

52
New International Tax Arrangements Bill 2003

• Balancing residence and source taxation
  Bilateral tax treaties, controlled foreign
  company (CFC), foreign investment fund (FIF),
  transferor trust, transfer-pricing, thin
  capitalisation
• Taxing inbound investment source taxation of
  capital income
• Taxing outbound investment residence taxation of
  capital income
• Taxing conduit income

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References and further reading

• Stiglitz, J.E. (2000) Economics of the Public
  Sector, 3rd edition, W. W. Norton
• Abelson, P. (2003) Public Economics principles
  and practice, Applied Economics, Sydney

54
Tax policy papers

• Tax reform Not a new tax, a new tax system
• GST legislation
• Commonwealth-State funding
• Review of Business Taxation
• New Business Tax System
• Entity Taxation and Consolidation
• Review of International Tax Arrangements
• New International Tax Arrangements Bill 2003