Australia: The Tax White Paper wish-list

Clayton Utz Insights
Last Updated: 25 February 2015
Article by Mark Friezer

Key Points:

It is time for some hard decisions to deliver long-term prosperity for the benefit of all.

Australia is not a high-taxing country. We are around the bottom of the pack in terms of tax as a percentage of GDP.

However the global position masks a capricious system riddled with incongruity, complexity, distortion and inequity. Some aspects of the tax system provide a welfare state for the middle class and the wealthy. At the same time we have a highly progressive personal tax rate structure constructed with very complex rules – particularly in the small business area – which hinders entrepreneurship.

There are some key problem areas which should be addressed as part of any root and branch review of the tax system.

The tax mix is too heavily weighted to income tax

Tax collections have nosedived following the GFC due to reduced company tax collections and, in particular, reduced capital gains taxes. These sources of taxation are volatile and mean that the budgeting process for a tax system that relies on these sources of revenue is highly speculative.

The prevalent view is that the problem is solved by reweighting the tax mix to the GST. But GST itself has a structural problem - collections have been steadily falling as consumption has trended towards untaxed education, health and rent. So it's not simply a question of bumping up the GST rate to 15% and our problems are solved. GST needs reform – elimination of exception items such as input tax financial supplies and exempt items including food, medical supplies and education should be reconsidered. If certain sectors will be disadvantaged then they can be compensated through the income tax or tax transfer systems. As it is, the GST system is riddled with inconsistencies and complex exclusions.

The added benefit from reducing the emphasis on income taxes in particular through a lower corporate rate will increase our comparative attractiveness to global business investment.

The income tax system is way too complicated

The heavy reliance on income taxes has caused a great deal of complexity in the system. Global business models and the variety of legal forms which can be used for transactions mean that very complex rules are needed to make the income tax system equitable (ie. treat substantively similar transactions in a consistent manner across taxpayers) there needs to be. But rules designed to ensure the income tax system is equitable are myriad - the debt equity rules, CFC rules, various integrity and anti-avoidance rules.

A good example is in the private company area Division 7A which looks to ensure that the owners of closely held businesses don't extract value from their companies in preferential ways. Each of these imposes a significant compliance cost on companies and individuals. Reweighting the tax mix away from income tax won't mean these complexities will disappear. It will require hard ongoing work from Government and business to reform the system so it is more user-friendly while remaining efficient and equitable.

Get to know the terms "Vertical Fiscal Imbalance" and "Horizontal Fiscal Equalisation"

There is a push for giving the States greater taxing power. It's argued that rejigging the Federal-State relations so that the States levy higher taxes will make the States more accountable and efficient as they will be responsible for balancing their budgets.

The current imbalance – that States spend far more than they raise through taxes – is known as Vertical Fiscal Imbalance. This is sought to be rectified by allowing States to tax further which is known as Horizontal Fiscal Equalisation.

It seems to me that creating a more powerful State taxation system doesn't sound like a good idea. I am not sure that the arguments against VFI sufficiently support giving increased taxing powers to each of the State bureaucracies in addition to the Federal Government. This seems to me to be going in entirely the wrong direction. The number of bureaucracies that taxpayers and businesses need to deal with should be reduced.

Adjusting the tax mix so that a redesigned GST regime bears more of the taxing burden – then distributing to the States through a grant system – seems to me a more sensible way to go than empowering six different State jurisdictions with additional taxing powers.

Reduce unnecessary State taxes

Many think that the introduction of the GST eliminated state taxes – and they'd be wrong. There's still a vast array of State taxes which form a compliance burden on business and individual taxpayers. Moreover, some taxes are a drag on economic activity (for example, stamp duty). Others, such as land tax, are considered efficient taxes – although extending tax to the family home is I think problematic since there is no liquidity and asset values don't necessarily align with the ability to pay (eg. retirees who find themselves living in valuable real estate).

There is probably a better argument for removing the CGT exemption on the family home – but good luck with that from a political point of view. State-based payroll taxes are complex and a further cost of employment, making life more difficult for small business.

Fix structural sacred cows

The Australian marginal tax rate structure is highly progressive. This perhaps explains the continued acceptance of various tax-effective investment strategies that taxpayers use to iron out the imbalance. But perhaps it is time to neutralise distortions to the system by removing the "sacred cow" tax preferences and ironing out the marginal tax structure.

I think it's time to take a hard look at negative gearing. Full interest deductibility for gearing into CGT discounted real estate or shares with imputation benefits is another example of the tax system extending welfare to the wealthy through overly generous tax subsidies. It would be a relatively straightforward solution to quarantine the deductibility of interest and other costs which have been incurred in order to earn passive income so that such amounts are only deductible against passive income and excess deductions may be carried forward – potentially to offset any gain on ultimate disposal of a taxpayer's passive investments.

I suspect super has somehow got out of alignment over the years. Relatively low deductible contribution caps mean that during a taxpayers early years it is difficult to put significant amounts into super in order to ensure a self-funded retirement. However, equally, it seems that providing uncapped concessional income tax treatment for funds is difficult to justify. After all, why should the income tax system provide subsidies where self-managed funds with multi-million dollar balances clearly provide for retirement incomes well in excess of that which should be supported by the State through tax concessions? It's not as if beneficiaries of such funds are going to rely on the Government Pension should concessions at the top end be reduced.

I am not sure of the policy support for a concessional capital gains tax rate for individuals on long-term capital gains. It began as a quid pro quo for the removal of indexation. I'm not convinced there is a sound policy reason for retaining the discount.

Where should we stand on dividend imputation? It's almost a weapon of mass destruction for super funds – not only wiping out liabilities but generating cash refunds. Franking of dividends means that ultimately it is the individual shareholders marginal rate which determines the tax on distributed profits. Reversion to a classical company tax system should mean that the company tax rate becomes a more relevant fiscal tool. The current system also creates distortions in that it gives benefit to Australian shareholders – but is less valuable to non-residents.

In closing...

So there it is. Some of these suggested changes would undoubtedly have a negative short-term effect on the income tax returns of many (including me). However, I think it is time for some hard decisions to deliver long-term prosperity for the benefit of all.

Since Asprey in 1975 there have been several major efforts at tax overhaul – most recently of the Henry Review and the efforts of the Business Tax Working Group, neither of course ultimately resulting in fundamental structural reform. Each commenced with enthusiasm but ultimately floundered, becoming entangled with special interests and producing flawed and compromised outcomes. We can only wonder whether it will be different this time.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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