Since its re-election last October for a historic fourth term, the Howard Coalition Government has a rare opportunity to fix Australia’s flawed tax system.
From July this year, the Coalition will have the numbers in both parliamentary chambers to pass almost any legislation it pleases, without hindrance or amendment.
Business leaders, pundits and restive Coalition backbenchers have called for cuts to the top marginal rates of income tax to improve work incentives.
But far more fundamental tax reform is needed if Australia is ever to combat its low levels of personal savings and high levels of household indebtedness.
A tax scheme that would address these problems is the savings-exempt income tax (SEI tax), an idea associated with British Nobel prize-winning economist, the late Professor James E. Meade.
A savings-exempt income tax, as the name suggests, is a form of income tax where the tax is levied only on that part of income that is spent, exempting the part that is saved. Instead of paying 20 or 40 per cent on whatever you earned, you would pay a progressive rate of tax on whatever you spent.
Taxing personal consumption expenditure in this way would not, as some fear, require hiring an army of taxmen to follow you into supermarkets to check how much you were spending. Instead, you would simply add up your incomes from all sources, take away whatever you had saved (the change in your savings account, shareholdings and so forth), and pay tax on the remainder.
SEI tax would effectively be a tax on personal consumption expenditure, but would have none of the drawbacks of the goods-and-services tax (GST). It would neither add to the cost of living nor hurt the poor.
Like the income tax it would replace, an SEI tax would have a tax-free threshold for low-income earners and special allowances for families with dependants. Above that threshold, people would pay a progressive rate of tax according to their level of consumption expenditure.
As all personal savings would be 100 per cent tax-deductible, SEI tax would do far more to encourage personal savings and investment than would any other tax reform currently being considered by the Howard Government.
Income tax, as it is currently constituted, is riddled with inconsistencies. The tax advantages given to some channels of savings, such as superannuation, are not available to all savings.
Anyone earning more than $58,000 a year is faced with a marginal rate of tax (including the Medicare levy) of 43.5 per cent or more on most savings outside the superannuation system. Worse still, such savings are slugged twice: first on any income one has earmarked for saving, and then again on any income this nest-egg generates.
This pernicious double taxation dramatically depresses after-tax yields, especially during a period of inflation. An SEI tax, by contrast, would sweep away these distortions and anomalies.
- Remove the wedge which income tax inserts between pre-tax and after-tax returns on savings, and would thus ensure that savings and investment decisions were no longer distorted by tax considerations.
- Abolish the need for capital gains tax — that is, the sale of capital assets would be taxed only to the extent that the proceeds were used to finance personal consumption, but not if they were re-invested.
- Remove income tax’s notorious bias — known as the “bunching” effect — against people on irregular or fluctuating incomes, such as writers, farmers, the self-employed or people working overtime. Instead of penalising them, as income tax does, SEI tax would — every time their earnings rose — exempt any portion of their earnings which they saved. The new tax would not penalise the receipt of a large lump sum by, say, a best-selling author or inventor, unless he spent his windfall all at once.
- Simplify the tax treatment of lump-sum retirement pay-outs and annuities. Any income saved — whether in superannuation or in a pension fund — would be tax free, as would all interest earned on these deposits. On one’s retirement, it would be the rate of one’s spending on personal consumption that would determine how much tax one paid.
Such a tax on “dis-saving” would strongly deter recipients of lump-sum super or redundancy pay-outs from “double-dipping” — e.g., a retiree spending his lump sum, then claiming a government pension.
If a person squandered, say, a $120,000 lump sum in a single financial year, he would immediately be hit with the highest marginal rate of tax; whereas, if he salted away this sum in financial assets and drew on it only gradually, spreading his expenditure over many years, he could be taxed at a far lower rate.
A tax which levied a charge on what people took out of the economic system in high levels of consumption, rather than on what they put into the system through their savings and enterprise, would unlock enormous opportunities for investment, modernisation and economic growth. It would be the entrepreneur’s charter.
The savings-exempt income tax has a distinguished intellectual pedigree. Its advocates have included Britain’s Lord Kaldor and James E. Meade, the late Nobel prize-winning economist; America’s Martin Feldstein, one-time chairman of President Reagan’s council of economic advisers; Australia’s Dr Vince FitzGerald, author of the 1993 report on national savings for the Keating Labor government; Access Economics, a major think-tank close to the Liberal Party; and former federal Labor leader Mark Latham in his 1998 book, Civilising Global Capital.
SEI tax is sometimes known as “expenditure tax” — a misnomer, as it inevitably gets confused with regressive consumption taxes, such as sales tax and GST. Professor Meade, chairman in the late 1970s of a high-powered committee of inquiry into the tax, later coined the more appealing name, savings-exempt income tax. American supporters call it the USA (unlimited savings allowance) tax.
Laurence Seidman’s 160-page book, The USA Tax: A Progressive Consumption Tax (1997), is probably the most lucid and succinct description of the SEI tax.
The transition from our present income tax to a savings-exempt income tax need not entail a great administrative upheaval. Our present system of personal taxation already grants tax advantages for at least some channels of savings.
To make our system of personal taxation more consistent, we really are left with only two options: either (a) move towards a pure income tax, by closing off all tax advantages for savings, or (b) move towards an SEI tax, by consistently exempting all savings from tax.
Under SEI tax, the existing tax system would be left just as it is, except that people would be given an income-tax deduction for any increase in their savings through designated savings vehicles.
The tax could be phased in over five years. Assuming that Australia’s economy grew even moderately during this period, there would be no need to raise pay-as-you-earn (PAYE) rates to offset the deduction of savings from the tax, since the expenditure-tax base five years from now could well be equal to, if not greater than, today’s income-tax base.
Even if the deduction cost the government revenue, the present Federal Government is well able to afford it. Its budget surpluses over the next four years are projected to amount to $24 billion.
To prevent the new tax from having a deflationary impact on consumer spending, the government would obviously take care to fine-tune the tax rates and the level of public spending to maintain the desired level of overall economic demand.
Various overseas studies have examined important administrative details associated with the tax reform, including the definition of occupational expenses for tax purposes, how to treat the acquisition of expensive durables such as the family home, as well as proposals to streamline company taxation. The Meade committee report looked into the options of introducing wealth and inheritance taxes in the event that it was felt desirable to disperse excessively large fortunes.
An SEI tax can be readily designed to maintain existing levels of tax revenue for the government. Moreover, the government can structure the tax brackets so that each income group will pay approximately the same amount of tax that it pays under our present income tax.
SEI tax would be especially good at bringing cross-national electronic commerce into the tax net. The celebrated GST — once touted as being the ultimate weapon against tax cheats and the black economy — is incapable of taxing items purchased on the Internet when the supplier is overseas. Federal Treasurer Peter Costello admitted in 1999 that e-commerce “is tax-free and you can avoid the taxation system because technology is defeating it”. (The Australian, June 22, 1999, pp. 1-2, and June 24, 1999, p. 27.)
SEI tax solves this dilemma because it shifts the point at which the government collects revenue from the seller to the buyer. Rather than attempting to keep track of billions of individual tiny transactions, it uses a far more effective measure of a person’s personal consumption expenditure: it simply measures the difference between his income and his net savings.
Each taxpayer would be required to provide a careful year-to-year record of (a) his income from all sources, (b) his purchases and sales of assets, and (c) his incurring and discharging of liabilities.
This would, incidentally, make it impossible for dishonest citizens to make a practice of saving one year, thus escaping taxation, and secretly selling out and spending their savings in the next year.
Spending on imports
By controlling the level of total spending more effectively than income tax (which taxes incomes saved as well as incomes spent), an SEI tax would enable steps to be taken to prevent spending during an economic upsurge from getting out of hand and spilling over into a consumer binge on imports.
To date, the Government has relied too much on a single policy instrument — interest rates — with which to steer the economy.
High interest rates give us the worst of both worlds. They cripple our export capacity, by making new investment and modernisation more expensive, and attract speculative money from overseas, causing the Australian dollar to soar in value. This makes exports dearer and imports cheaper, thereby exacerbating our chronic current account deficit.
In good times, when interest rates are low, all too many Australian households borrow heavily to finance increased consumption.
An SEI tax by contrast would go a long way towards discouraging household indebtedness and excessive consumption of imports, and would give taxpayers maximum incentive — a zero marginal rate of tax, in fact — for every dollar saved or invested.
- John Ballantyne is editor of News Weekly. This article is an extract from a longer paper on tax reform.
Savings-exempt income tax (SEI tax)
- Access Economics. Unscrambling Saving Signals: How Income Taxes Deter Private Saving while Budgets Overstate Public Saving: Proposals for Reform. A Report prepared by Access Economics (December 1996) for the Life, Investment & Superannuation Association of Australia Inc. (LISA) and the Investment Funds Association of Australia Ltd (IFAA).
- American Business Conference. Growth and Fairness: An Overview of the Unlimited Savings Allowance Tax with Distribution Tables. (Washington, DC: The American Business Conference, 1997).
- Feldstein, Martin S. “Taxing Consumption”, The New Republic (Washington, D.C.). Vol.174, No.9, February 28, 1976, pp.14-17.
- Feldstein, Martin S. “Fiscal Policy for the 1980s”, in: Walker, Charls E., and Bloomfield, Mark A., eds. New Directions in Federal Tax Policy for the 1980s. (Expanded edition, Cambridge, Massachusetts: Harper & Row, 1984), pp.23-34.
- FitzGerald, Vince W. Reform of Australia’s Taxation System. (Melbourne: Committee for Economic Development of Australia): CEDA Information Paper No. 46, October 1996.
- Freebairn, John, and Valenzuela, Rebecca. A Progressive Direct Expenditure Tax. (University of Melbourne, 1998): Melbourne Institute Working Paper No. 13/98. Web site: http://melbourneinstitute.com/wp/wp98n13.pdf
- Hinckfuss, Ian. Progressive Taxation on Personal Expenditure. Paper published by University of Queensland, 1996. Web site: www.uq.edu.au/~pdwgrey/web/morsoc/kaldortax.html
- Kaldor, Nicholas. An Expenditure Tax. (London: Allen & Unwin, 1955).
- Kaldor, Nicholas. Collected Economic Essays, 8 vols. (London: Duckworth, 1960-80): Vol. 7, Ch. 7: “A New Look at the Expenditure Tax”; and Vol. 8, Intro. and Ch. 2: “Indian Tax Reform”.
- Latham, Mark. Civilising Global Capital: New thinking for Australian Labor. (Sydney: Allen & Unwin, 1998): Ch. 14: “Financing Government”, and Appendix III: “The Kaldor Tax — Issues and Solutions”.
- Lodin, Sven-Olof. Progressive Expenditure Tax — an Alternative? (English edition, Stockholm: Swedish Government Commission on Taxation, 1978).
- Meade, James E., et al. [Meade Committee]. The Structure and Reform of Direct Taxation: Report of a Committee chaired by Professor J.E. Meade. (London: Institute for Fiscal Studies, Allen & Unwin, 1978).
- Saunders, Peter. “Twenty Million Future Funds”, Issue Analysis (Centre for Independent Studies, Sydney), No. 66, December 21, 2005. Web site: www.cis.org.au/IssueAnalysis/ia66/IA66.pdf
- Seidman, Laurence S. The USA Tax: A Progressive Consumption Tax. (Cambridge, Massachusetts: MIT Press, 1997). 160 pages.