IS IT TIME TO BURY THE CONSUMPTION TAX? TAX MIX SWITCH POST-FIGHTBACK!

by RUSSELL SMYTH

1. Introduction Since the mid-1970s there has been growing taxpayer resistance to our

present hybrid income-tax base which, despite the Keating reforms of 1985, still treats some forms of income from capital concessionally while maintaining a top marginal tax rate for wage and salary earners which cuts in at 1.6 times average weekly earnings. This disenchantment has not been limited to taxpayers but also mirrored in the concerns of academics and policy makers. That same disenchantment rekindled the tax mix switch debate, which was put to one side in the fallout of the failure of the Draft White Paper’s (Australian Government, 1985; hereafter “DWP”) Option C at the l h x Summit, but which became the most explosive political issue in the lead-up to the last election. The electoral failure of the Hewson-led Coalition, however, has returned the tax mix debate to the political wilderness. This article examines whether there are any worthwhile economic reasons to resurrect the idea of a consumption tax or whether it is best left off the political agenda permanently.

A change in the tax mix involves a shift in emphasis away from income tax towards a new Goods and Services tax (GST). The GST could take the form of a Retail Sales l h x (RST) which was advocated in the DWP’s Options B and C, or a Value Added Tax (VAT) which was favoured in Fightback! (Hewson and Fischer 1991) at the last election. While the article will not discuss the relative merits of these two forms of tax or make any judgement about which should be preferred, we should note that today academic opinion seems to rest squarely in favour of a VAT (see Bascand, 1988 and Cnossen, 1989a, 1989b). With the exception of some mention in the conclusion, this paper also will abstract from mechanical issues surrounding reform of the indirect tax system. This is partly because it is possible to replace the Wholesale Sales ’Igx (WST) with a GST without a change in the tax mix (such as Chisholm, Freebairn and Porter’s 1990b first illustrative package) and partly because as such a proposal receives little (if any) criticism from anybody, there is really no room for debate. (The term GST is used throughout this paper to refer to a consumption tax in the generic sense.)

0 1994. Economic Society of Australia. ISSN 0812-0439. * Department of Economics, Monash University. The author wishes to acknowledge the

suggestions and comments of Professor John Head.

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2. Would a broad-based consumption tax reduce tax avoidance and tax evasion?

One of the primary factors motivating both the Fightback! and the DWP recomfnendations for changing the tax mix was the extent to which tax avoidancelevasion exists under the present system. The DWP offers two distinct reasons why a broad-based consumption tax would be more effective as a counter to tax avoidance and evasion. The first reason (at p. 116) is that a broad-based consumption tax “would ensure that income which currently avoids or evades income tax will bear some tax liability when it is spent”. The second reason is “it would enable significant reductions in marginal income tax rates across the board which would in turn reduce incentive for avoidance and evasion of tax”. These sort of arguments have had some support in academic circles from, for example, Mathews (1980, 1983, 1984) and Groenewegan (1984). Mathews (1984, p. 70) writes “incentives to avoidance and evasion will be greater under the income tax to the extent the rate structure is progressive. While evasion is likely to occur with both kinds of taxes, opportunities for avoidance will be significantly greater for the income tax than for the consumption tax”.

The first reason given by the DWP to support the view that a GST would reduce tax avoidance and evasion centres on the switch from an income to a consumption tax base. There is no doubt that the problems which tax avoidance present stem mainly from the fact that income is taxed on an incomplete base. This means that as some forms of income are not taxed at all and other forms of income are taxed concessionally, taxpayers are able to shift income across time and across other taxpayers to reduce the relative amount of income tax that they pay.

The implicit assumption which underlies the DWP’s recommendations seems to be that a GST would be relatively more successful in eliminating these forms of abuse. There are, however, some problems with this. As Head (1986a, p.34) notes, “base broadening through tax mix changes requires in general a significant inverse correlation between taxable components of the income and the sales tax base. It is, however, precisely those income components which have been most subject to avoidance, evasion or legislative concession under the income tax which are also most likely to escape the sales tax net”.

For instance, there are some examples of tax avoidance such as imputed rent on owner-occupied dwellings and financial services which would present the same problems for a GST as they do for personal income tax, although it is certainly true that a GST would represent some improvement over the personal income tax in terms of income derived from say, barter, or even goods and services produced in the home. Moreover, suggestions that a switch to a GST would catch spending out of income which is lightly taxed or presently exempt from personal income tax (such as income from highly geared investment, from superannuation receipts, or from income splitting schemes) lacks substance. This is also the case with income which

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presently tends to be underestimated such as interest and dividends because the initial savings from which any investment is financed is exempt under a sales tax base.

The same problems exist with tax evasion. The supporters of a broad- based consumption tax argue that those in the “underground” economy who can evade personal income tax by selling their services directly to households for a cash payment will at least have to pay sales tax on their purchases of consumer goods. However, this ignores that it will be just as hard for the authorities to collect indirect taxes on the value of services offered directly for cash under a broad-based consumption tax as it is under the personal income tax. This is because the tradesperson will be in a uniquely favourable position to pass on hislher share of the sales tax burden by raising the price of hislher untaxed services. This problem is compounded once we recognise that tradespersons will be reluctant to pay even low rates of indirect tax on their services because to do so would effectively be to admit to the tax authorities the extent of their personal income tax evasion (see Kesselman 1986, p. 67-70, and Head 1986a, p. 33-35).

The other reason given by the DWP to support the view that a GST would reduce tax avoidance and evasion focuses on the incentive taxpayers who face high marginal tax rates have to avoid andlor evade tax. The purported advantages for a GST in this respect stems from a tax system which covers a number of broad bases in order to keep marginal tax rates on any one of them down. Hence, the DWP suggests that with much lower marginal tax rates the incentive to avoid andlor evade tax will be much less. There are also a number of problems with this view.

The first difficulty with this, which is fundamental, follows directly from the preceding discussion. As the whole purpose of a tax mix switch is to finance personal income tax cuts, if the broad-based sales tax cannot raise sufficient revenue by shutting down opportunities to avoid and evade tax, there will not be very much scope to reduce the top marginal tax rates which implies largely that the same incentive to avoid tax at high marginal tax rates would exist as they do now. While the DWP suggested in 1985 that a 12 ?h % RST would have been sufficient to not only compensate people outside the tax system but also finance income tax reductions, approximately equal to 30%, Fightback! proposed six years later a VAT of 15% in order to finance income tax cuts of approximately 10% depending upon the individual’s income tax bracket.

Moreover, both the DWP estimate of a fiscal dividend of $1.5-$2 billion and Fightback!’s estimate of a fiscal dividend of $4 billion from taxing consumption out of income that is avoided or evaded income tax are overstated. Bascand (1989, p. 316). for example, puts the fiscal dividend at most equal to $1.1 billion, suggesting $400-$500 million as more realistic. We need also to make some allowance for the fringe benefits tax and capital gains tax which must have reduced the scope for income tax avoidance. Further, even when we put the magnitude of the fiscal dividend to one side, increases in wholesale sales tax levels since 1985 mean that there is now

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much less scope for tax mix change than there was at the time of the 1985 Tax Summit.

The second difficulty is that even with an indirect consumption tax which is initially levied on a very broad base, the experience of the European countries who have a VAT suggest that special interest groups will invariably bring political pressure on the government to grant expectations and concessions which will steadily erode the base. This will provide an opening for tax avoidance. A s the consumption base erodes, the government will be forced to raise the rates of tax on remaining items, which will in turn provide taxpayers with the incentive to avoid the consumption tax. As Brennan (1989, p. 425) suggests, “replacing the income tax with say, a VAT, would generate essentially identical evasion and avoidance incentives in those same areas. It is the cost of monitoring and the potential for misreporting that drives the pattern of evasionlavoidance, and such things are a function of industry or business organisation . . . and are essentially independent of whether the tax levied is direct or indirect”.

The third difficulty is that to the extent which substitution of a broadly- based indirect tax for the personal income tax requires means-tested weltare payments for low income families, people in lower income deciles will face high effective marginal tax rates. This suggests that without effective base broadening, the incentive to avoid tax will shift from high to low income families. These problems all suggest that the only effective way to deal with tax avoidance is to combine tighter tax laws with a much broader income base. A partial shift toward indirect taxation will not do much to reduce personal income tax avoidance which can be directly attacked only by income tax reform measures. In fact, as Kesselman (1986 p. 113) notes, it is somewhat naive to expect that avoidance can be cured by adopting a GST if the political will is lacking to combat avoidance under the personal income tax.

3. Efficiency and effects on the incentive to save and on the incentive to work The supporters of a GST argue it would generate significant efficiency

advantages. The current system combines a very narrow base with high variable effective tax rates, which distorts consumption and savings decisions. The personal income tax results in a double taxation of savings because income is taxed when earned, and then any income earned through saving is taxed again. This reduces the incentive to save, and so is biased toward current composition. This bias against saving is accentuated by inflation which exaggerates differences in after-tax returns on different saving options.

A broad-based indirect tax in contrast is neutral in relation to the choice between present and future consumption. Thus, the combination of a broad base (even if the base does not include leisure, housing or financial services) together with a low uniform tax rate creates a more level playing field by minimising intertemporal resource distortions. Compared with the personal income tax, an indirect consumption tax reduces the marginal rate of tax

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on savings, which promotes a substitution effect away from current and toward future consumption. With a revenue-neutral switch we can say that there will be no offsetting income effect (either full or partial) which suggests that a tax mix change will generate an unambiguous increase in domestic savings.

The present income tax system, with its array of exemptions and concessions, also distorts saving decisions toward less productive investment. However, supporters of a GST suggest that a tax mix change will create a more level playing field, not only in terms of the decision to consume or spend, but also in declining and investment options. This will increase both the effectiveness and productivity of investment and savings. While these have both been very important issues at a time when many believe that Australia must raise its private savings ratio, it is not entirely clear that a GST is the answer.

It seems highly questionable whether the magnitude of the savings response to a change in the net-of-tax return will be sufficient to raise savings levels to the extent which some economists have predicted. As Head (1991, p. 24-25) points out, the empirical evidence is very much divided about the impact on savings. Head also points out that long-term efficiency gains generally depend on the size of the intertemporal elasticity of substitution in consumption, rather than the interest elasticity of savings, and the available evidence strongly suggests a very low intertemporal elasticity.

As far as distortions between different types of savings and investment are concerned, there is no doubt that a tax mix change would reduce the extent of the distortions under the present income tax structure caused by differential tax treatment of the various ways households and enterprises can save and invest. However, it does not follow that the best way to eliminate these distortions is through a straight tax mix switch. While much would be gained by reforming the existing system of indirect taxes, in several respects the broad-base indirect consumption tax option is inferior to both the direct consumption tax and adjusted income tax options.

The introduction of the GST in New Zealand was accompanied by some significant effort to close income tax concessions and therefore broaden the income tax base to pay for marginal income tax cuts. Roger Douglas, for example, completely eliminated tax concessions for privately funded superannuation saving. In Australia, however, the Liberal Party moved in the opposite direction, proposing to water down Labor’s capital gains tax.

Without sealing off the loopholes in the income tax base, the best an indirect consumption tax can do is to reduce existing distortions. As there are significant areas of savings where a GST would not have any effect (such as saving via owner-occupied dwellings) or where a GST would actually deter savings (such as savings via employer-funded superannuation payments), a GST will never be completely successful in eliminating these distortions which only reform to the income tax base can achieve. It is true that estimates for the USA by Fullerton et a1 (1981). and for Australia by Piggot (1983) and Meagher and Parmenter (1993), suggest that potential gains to

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national welfare from fully eliminating distortions to investment and savings choices may be as high as 1% of GDP. However, in practice that gain would be much less than these studies suggest as any feasible tax mix change would only partially remove savings and investment distortions.

The supporters of a tax mix switch have also argued lower marginal tax rates will have a positive effect on worker incentives. Morgan (1991, p. 52) suggests the explanation is that “most employees view their marginal tax rates as that on income alone, and not that on income plus consumption”. The first problem with this view is that a lot depends ,on the shape of the labour supply curve and, of course, magnitude of labour supply elasticities are not at all clear. A second, perhaps more serious, problem is that it relies on the existence of repeated taxpayer illusion. As Morgan acknowledges (at p. 52) “while apparent (personal income tax) marginal tax rates will decline, actual total (income plus consumption) marginal tax rates would not”. This means that a worker faces the same terms for substitution between leisure and real consumption as before the change in tax mix and hislher real income is unchanged because of the offsetting change in the two taxes (Kesselman 1986, p. 65).

While it may be reasonable to expect taxpayers initially to miscalculate the total tax burden because the indirect tax is hidden in the price of consumer goods, it is not reasonable to assume that they will persistently under-estimate the amount of tax which they have to pay.

We should also recognise that the issue of excess burden under rising marginal tax rates compared with a proportional tax scale, which centres on the magnitude of the square of the marginal tax rate and the size of the labour supply elasticities of primary earners relative to secondary earners, is independent of the tax mix switch debate. Thus, if one believes there are efficiency gains or benefits in terms of greater worker incentive from flattening the tax scale, this could be achieved by broadening the income tax base without reducing the relative share of personal income tax in the total tax mix.

4. Equity Perhaps the main reason why the Fightback! proposal was rejected at

the last election was that many saw the GST as violating the vertical equity objective. Vertical equity requires people with a greater capacity to pay, in fact, more tax. The critics of Fightback! argued that if we increase our reliance on indirect taxation, it would result in a more regressive tax incidence. It would be vertically inequitable because as everybody would pay the standard 11% or 15% (depending on the specific proposal) across the board it necessarily follows that low income earners would pay a higher percentage of their income in tax than middle and high income earners. There is no doubt that there is an inverse relationship between income and average propensities to consume. However, to the extent these criticisms focus not on the overall package of compensation measures, but on the

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nominally regressive characteristics of the GST considered in isolation, they are not warranted.

There are two ways to reduce or even reverse the regressive incidence of a consumption tax. The first is to’htroduce exemptions for food and items used by the poor more heavily than items used by the rich. This was initially rejected in Fightback! because of its costs in terms of efficiency and complexity, although in Fightback! Mark II (Hewson and Fischer 1992) some basic foods were given a zero rating. Chisholm, Freebairn and Porter (199Ob, p. 151) show that as high income households spend absolutely more than low income households on food, exempting food from the GST provides a greater tax saving for middle and high income households than it does low income households. For these reasons, this approach has generally been shunned by tax economists (see, for example, Warren 1986, 1990). A GST with a broad base and a single rate also facilitates horizontal equity because it will not discriminate between households which have similar levels of aggregate consumption expenditure, but which choose to spend different amounts on different commodities according to taste. The second method, which is more appropriate to meet vertical equity considerations without impinging on horizontal equity, compensates low income groups either directly through the social welfare system or through the use of sales tax credits.

Those who argue that a GST cannot be vertically equitable have forgotten the 1985 Tax Summit and the explicit recognition in the DWP of the importance of maintaining the progressivity of the overall tax transfer system. In the DWF! as changes in the income tax threshold and marginal tax rates were designed to achieve revenue neutrality, they would have compensated most PAYE taxpayers for the extra 12?h YO they had to pay on consumer goods. There would also have been additional compensation paid through the income support system to people who do not pay income tax and supplementary measures paid to low income earners whose income was above the tax-free threshold, but below the income tax threshold for full compensation through income tax cuts alone.

There would, of course, still be some distributionally disadvantaged groups in the short run. These people (who include students, married couples without dependant children, women working part-time, and retired people with accumulated savings) account for 4% of the population (DWP, 1985 p. 146-147). The supporters of a tax mix change suggest, however, most of these people who appear as losers in the short run, will also benefit in the long run. A long-term perspective removes the constraint of a zero sum game, so the benefits to society as a whole will be enhanced to the extent one accepts a tax mix switch will enhance efficiency, boost productivity, and raise the level of government revenue.

As Chisholm, Freebairn and Porter (1990b, p. 150) put it, “at any one point in time, lower income households tend to have a higher ratio of consumption outlays to income than do high income households. However, over time, temporary good and bad years are averaged, and as households move

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through their career and family life cycles, there is far greater uniformity of average consumption propensities than is indicated by the snapshot statistical picture”. Certainly, as Head (1986a, p. 32) points out, the Household Expenditure Survey data which provide the foundation for statistical studies of sales tax regressivity are notoriously unreliable and therefore of dubious relevance to the question of sales tax incidence.

Kesselman (1986, p. 72) suggests that any popular appeal in changing the tax mix toward indirect taxation on horizontal equity grounds stems largely from myth and misperceptions. He points out that because the tax mix change will reduce the tax burden on the saving component of income, it will reduce horizontal equity between the high savers and low savers in any income class. As tax would affect consumption out of savings, accumulated prior to the tax mix change, the discrimination is most stark in its distinction between retired people who have accumulated savings, and people who have retired with little savings because they have had a higher average propensity to consume throughout their working lives.

Kesselman (1986, p. 71) suggests that because all people have the same opportunity to engage in avoidance and evasion, it should not be considered as creating horizontal inequities. He further argues that the gains from avoidance and evasion are largely dissipated through either adjustments in the market or in legal costs to the taxpayer, and as such because “many of the individuals who utilise an offending provision in fact receive little or no benefit, moving to a neutral provision will inflict losses on them as the market readjusts”. This, however, is not an entirely convincing argument. While we would have to take care to minimise the transitional inequities caused to people who have in good faith invested in what they thought would be a tax free option, the problems this causes can be minimised with appropriately designed transitional devices such as “grandfather clauses”.

Kesselman also ignores what Brennan (1989, p. 425) terms “psychic costs in breaking the law”. In practice, people have different moral standards and different degrees of risk aversion and so while everybody may outwardly have the same opportunity to evade income tax, obviously some people will be more ready to act on that opportunity than others. Whether a shift toward indirect taxation would reduce tax avoidance (as discussed above), and hence improve horizontal equitable, is entirely another issue. However, Brennan (1989, p. 425) suggests “a shift to an indirect tax system in which firms act as collection agencies for the government, may reduce the level of self reporting and hence reduce the reliance on taxpayer morality in this way”.

5. Simplicity Compared with the narrow base, multiple base, multiple rates, and

complex array of exemptions, under the WST system, the combination of a broad base and a single tax rate provides administratively a relatively simple tax system. There would be a transition period where the cost of

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changing the tax mix and consequently educating taxpayers would be significant.

Businesses would also face additional compliance costs and the authorities would face additional administrative costs in collecting the tax. However, this cost has to be offset against the simplification of the indirect tax system. Firstly, businesses would be likely to benefit in terms of managerial efficiency from records used for V N compliance. Secondly, there are benefits in terms of lower administrative costs to enterprises who presently pay a number of arbitrarily defined varying rates on different products under the existing WST system.

6. Conclusion Many of the advantages which were claimed for a GST at the last federal

election seem to be politically motivated and, as such, are largely without basis in tax theory. A change in the tax mix is only a second best, and a highly ineffective way of reducing tax avoidance and tax evasion. The only effective way to reduce tax avoidance is to treat the source of the problem by broadening the income tax base. ’Igx evasion is a lot harder to overcome because it depends on subjective factors such as standards of mortality so that whatever the cost there will always be somebody who is willing to take the risk. Nevertheless, the best way we can treat tax evasion is by tightening the tax laws and increasing the penalty for tax evaders who are caught.

A change in the tax mix will have little (if any) effect on incentive to work. There may be some taxpayer illusion in the short run, although in the medium-to-long-term most people will realise their effective disposable income has not changed. As the personal income tax represents a double taxation on savings, a revenue neutral switch to a GST will unambiguously raise saving levels, but not to the extent which some supporters of a GST have postulated.

While the advantages claimed for a GST have been exaggerated, there is still a role for a GST in an efficient and equitable tax system. If the GST is levied on a very broad base with a single rate with compensation for low income earners through either the social welfare system or sales tax credits, it will meet the horizontal and vertical equity objectives quite well, and hence, provide a relatively simple method of raising large amounts of revenue and so help to relieve existing pressures on the personal income tax.

Warren (1990, p. 374) suggests “what is needed most in Australia is a rationalisation of what already exists rather than adding more cogs to an already complex model”. The straight switch in Canada of a WST for a 7% GST without the sweetner of income tax cuts, showed how politically hard it is to try to reform the tax system in parts. A change in the tax mix (such as Freebairn, Porter and Walshs 1987 Option V) which provided a sweetener in the form of income tax reductions might have, prior to the last election, been considered our best hope of achieving a “rationalisation of what already exists” by parcelling a politically acceptable package which

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included income base broadening measures and reforms to the WST. There is no doubt that, firstly, our existing WST has to be replaced by a broader, less distorting indirect tax, and secondly, that we need to reform our income tax base. It seems that, in spite of the political failure of Fightback! the best way to improve the reform prospects in both areas is still to reform the income tax and sales tax base simultaneously and trade- off across the mix.

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