Home > Economics - General > My latest piece on the Fin

My latest piece on the Fin

February 24th, 2005

is a response to the push to cut the top marginal tax rate. As well as criticising a variety of spurious arguments on the topic I make the point, in line with Reserve Bank Governor Ian Macfarlane (and even Peter Saunders of the CIS) that the real problems in our tax system are high effective marginal tax rates for low-income earners and the incentives to speculate in real estate rather than invest in the production of tradeables, incentives that contribute to our massive trade and current account deficits.

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  1. still working it out
    February 24th, 2005 at 11:23 | #1

    The tax incentives to speculate in real estate as opposed to tradables is such an obvious target for labour policy its a wonder that they have not taken it up. It might be a good time to adopt it as policy with the real estate boom coming to an end. With returns on houses and units going to zero or negative the more “aspirational” voter might be interested in hearing about tax breaks for investing in something else. Should be easy to sell if labour emphasises the jobs it will produce.

    However with the Windbag from the West back in charge I somehow don’t think this will be adopted by Labour.

  2. Homer Paxton
    February 24th, 2005 at 11:35 | #2

    If my memory serves me right the RBA in their submission to the Productivit commision said one should lat at the generous depreciation allowances rather than negative gearing.

    I have always wondered why anyone would invest in a venture that will mean your interest rate costs exceed your returns on your investment.
    This is a great selling point.
    Why????

  3. Fyodor
    February 24th, 2005 at 11:57 | #3

    Homer,

    The interest costs typically only exceed the rental income. Most residential property investors expect to make up for these losses in spades on the capital gains, which are only taxed on realisation, and now attract a lower rate than the rental income due to CGT relief on assets held for more than one year. These issues aren’t unique to property by the way, as you can negatively gear yourself into shares, etc.

  4. still working it out
    February 24th, 2005 at 13:40 | #4

    “Real Estate Riches” by Dolf de Roos explains it really well.

    Basically with the interest being tax deductible and depriciation being tax deductible and getting rental income you end up putting paying X dollars per year out of your pocket into the mortgage while the property goes up in value by 3 or more times X dollars. For every after tax dollar you put into the property the property goes up in value by 3 or more (depending on how good the market is).

    Its basically an investment with an annual return of 200% plus. Only works in a rising real estate market though.

  5. Homer Paxton
    February 24th, 2005 at 13:45 | #5

    Fyodor,
    The people who have bought apartments over the last couple of years ‘invested’ on that basis however they are sitting on capital losses now.

    If one invests then the surely a positive return is the only rational reason to go unless avoiding tax is the be all and end all of ‘investing’.

  6. observa
    February 24th, 2005 at 13:49 | #6

    There has always been and always will be an incentive to invest in real estate, irrespective of the vagaries of current capital gains tax. We need to be quite clear here that what we largely mean by real estate, is land covered by buildings concrete and bitumen. There has never remotely been the same incentive to invest in pristine wilderness and so it shrinks and disappears. IMO this is the number one defect of our economic/investment regime. Wilderness needs the economic incentive, nay imperative, to be its long term friend. The constitution of our free market system should ensure it has such a friend, or rather the friendship of the many.

  7. Fyodor
    February 24th, 2005 at 14:16 | #7

    Homer,

    If capital gains are actually negative, then, yeah, it’s a dumb move. However, as SWIO notes at #4, it does work in a market where capital gains are significant. There’s nothing inherently irrational about it – it depends on your investment expectations.

  8. Andrew Reynolds
    February 24th, 2005 at 14:17 | #8

    Interesting piece, John. My only comment at this stage is I believe there would be even greater gains from reducing the compliance costs while remaining revenue neutral. The army of tax accountants out there could then be put on to doing something useful with their lives. As it is without them we mere mortals have no hope of complying with a set of laws that we legally must understand in full.
    I would entirely agree on the tax-free threshold – a person earning $10,000 a year should not be both paying tax and receiving benefits – the situation is ludicrous.

  9. Alex
    February 24th, 2005 at 17:08 | #9

    I suspect that the high effective marginal tax rates for low income earners will remain for some time yet, simply because the cost of removing them is prohibitive. This is on the assumption that the tax/social security systems are integrated in some way and the EMTRs lowered to reasonable levels (say 50%). The only non-expensive way to “avoid” the problem is to have “sudden death” cut-offs for social security payments. BTW, if you think EMTRs are a problem for the ordinary low income person, spare a thought for those paying child support as well.

  10. Razor
    February 24th, 2005 at 17:47 | #10

    The most interesting proposal I have seen is one that sets a minimum level of income, say $20,000. If you are below that, then you get topped up and above that a flat rate of tax applies.

    Nobody has yet come up with a better solution to the impact of coming off welfare.

  11. derrida derider
    February 24th, 2005 at 19:58 | #11

    Yep, Razor, its called a GMI (Guaranteed Minimum Income). Its a simple way of creating a 100% EMTR between $0 and $20k.

    The thing about lowering EMTRs is that there are no free lunches – if you want lower EMTRs on lower-income people you must either make the poor poorer or raise EMTRs on those further up the scale. And given the shape of the income distribution (roughly log-normal) you have to raise the EMTRs a lot on the top to lower them much on the lower-middle.

    From the revenue-raiser’s POV the beauty of taxing the poor is that there are so many of them.

  12. observa
    February 24th, 2005 at 21:13 | #12

    Big picture stuff for a moment. Does real capital gain really require for its growth, something akin to a pyramid scheme? ie an ever increasing number of players (national/world populations) to really work. Could real capital gain occur in a static demographic?

    I guess to theoretically analyse this we would have to play the economists ceteris paribus game as usual, since we don’t have any real world control group to study. So we might have to imagine say a fixed stock of rare pantings by dead artists(no possibility of increased supply)with no holding costs or risk of ownership(the govt national gallery stores, protects and insures them gratis for any owner so everybody can enjoy them). Population demographics remain stable over time and there are absolutely no tax incentives or disincentives to buy, sell or hold such investments. Under this scenario would there be any real capital gain for prospective owners?

    If the answer is no, then any real capital gain must come from tax and capital gain incentives, or alternatively fom a pyramid market in the real world. Hence some(most?) real capital gain for say Tokyo RE, might really come from the pockets of the odd successful entrepreneur in the Third World in a truly globalised investment environment. This might have some long term ramifications for RE values(real) in MDCs. They may track predominantly only one way, barring small hiccups, in an increasingly populous world. Any thoughts on this?

  13. Alex
    February 24th, 2005 at 21:37 | #13

    Let’s put tax cuts in terms everyone can understand – a modern parable.

    Suppose that every day, ten people go out for dinner. The bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this – The first four (the poorest) would pay nothing. The fifth
    would pay $1. The sixth would pay $3. The seventh $7. The eighth $12. The ninth $18. The tenth (the richest) would pay $59. So, that’s what they decided to do.

    They ate dinner in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a problem. “Since
    you are all such good customers,” the owner said, “I’m going to reduce the cost of your daily meal by $20.”

    So, now dinner for the ten only cost $80. The group still wanted to pay their bill the way we pay our taxes. So, the first four were unaffected,
    they would still eat for free.

    What about the other six, the paying customers? How could they divvy up the $20 windfall so that everyone would get their ‘fair share’?

    The six paying customers realised that $20 divided by six is $3.33. If they subtracted that from everybody’s share, then the fifth and the
    sixth would each end up being ‘PAID’ to eat their meal.

    So, the restaurant owner suggested that it would be fair to reduce each person’s bill by roughly the same amount, and proceeded to work out the amounts each should pay.

    And so -
    The fifth, like the first four, now paid nothing (100% savings). The sixth now paid $2 instead of $3 (33% savings). The seventh now paid $5 instead of $7 (28% savings). The eighth now paid $9 instead of $12 (25% savings). The ninth now paid $14 instead of $18 (22% savings). The tenth
    now paid $49 instead of $59 (16% savings).

    Each of the six was better off than before. The first four continued to eat for free. Once outside the restaurant, they began to compare their savings.

    “I only got a dollar out of the $20,” declared the sixth, pointing to the tenth diner “but they got $10!”

    “Yeah, that’s right,” exclaimed the fifth. “I only saved a dollar, too. It’s unfair that they got ten times more than me!”

    “That’s true!!” shouted the seventh. “Why should they get $10 back when I got only $2? The wealthy get all the breaks!”

    “Wait a minute,” yelled the first four in unison. “We didn’t get anything at all. The system exploits the poor!”

    The nine surrounded and beat up the tenth diner.

    The next night the tenth diner didn’t show up for dinner, so the nine sat down and ate without number ten. When it came time to pay the bill,
    they discovered something important. They didn’t have enough money between all of them for even half of the bill!

    That, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up at the table any more. There are lots of good restaurants in Europe and the Caribbean.

  14. Mark Upcher
    February 24th, 2005 at 21:49 | #14

    Alex,

    Your example is nothing like our tax system.

  15. Ian Gould
    February 24th, 2005 at 23:06 | #15

    Alex,

    Have you ever heard of indirect taxes?

    One of the principal justifications for progressive incoem tax is that most indirect taxes are regressive i.e. the poor pay a higher percentage of their income in such taxes than do the rich.

    In some US states the poorest fifth of the population pay 8-10% of their income in indirect taxes while the richest pay only 1-2%.

    Given that average income tax rates are considerably lower than marginal rates, it is quite possible for a low income taxpayer to pay aa higher percentage of their income in tax than someone on a much higher income once indirect taxes and various tax breaks are taken into account.

  16. rdb
    February 24th, 2005 at 23:19 | #16

    I though that the government had eliminating high effective marginal tax rates on welfare recipients on their agenda. That they haven’t is a statement of the priority they give it. How long would they last if the top marginal tax rate was set at the maximum of the current rate and the highest such effective marginal rate cutting in say at junior ministers salary amounts?
    Perhaps a Labour government could be shamed into such an arrangement.

  17. Dave
    February 25th, 2005 at 03:49 | #17

    Yes, Alex – and how does it work when the restaurant owner ups the cost of the meal by $20?

    (I was also going to suggest you acknowledge a source as well, but it would appear to be uncertain: http://www.snopes.com/business/taxes/howtaxes.asp)

  18. still working it out
    February 25th, 2005 at 09:50 | #18

    Re: #12
    observa,

    You can still have capital gains in real estate or rare paintings without it being a pyramid scheme when there are no demographic changes. All you need is economic growth. All things being equal (ie, if there were no demographic changes) you can expect capital gains to be the same as increases in GDP.

  19. Alex
    February 25th, 2005 at 09:53 | #19

    I thought that might provoke a reaction. The point of the parable (which I do not know the original source of, BTW) is not to exactly mimic all the details of our tax system, including indirect taxes, but to illustrate some of the difficulties facing those wanting to reform the tax system. The bottom line is that, as far as income tax goes, the vast majority of it is paid by high income individuals, notwithstanding all their efforts to reduce their tax levels by negative gearing etc.

    As for indirect taxes, yes I have heard of them – rather silly to imply that I haven’t, IMHO – but if the discussion is about the interaction between the social security and income tax systems, and possible reform thereof, they are of little relevance. And yes, I was also aware that low income people pay a higher proportion of their income in indirect tax. However, a good deal of their “income” actually comes from the rest of us, via welfare payments.

    Nobody seems to have come to grips with my substantive point, which is that it is extremely difficult to reform the income tax/social security systems without substantial expense. Perhaps my critics would like to suggest possible sources of the necessary funds.

  20. February 25th, 2005 at 11:54 | #20

    observa,

    Working couples probably contribute to the positive feedback in the RE prices over the last decade. Since a single income earner finds it hard or impossible to afford RE, the second partner goes off to work, and pricing the next single income earner out of the market.

    A lot of cities try very hard to retain the character of their old suburbs. This tightens the supply when some of these places could be better utilized by zoning them for high-rises.

    In Singapore, all most everyone gets public housing (you have to be married, though). Although RE speculation still goes on, it’s not partially funded by a large pool of housing. The Government also signals the market by making housing land available whenever there is demand, so there isn’t as much incentive to speculate.

  21. Alex
    February 25th, 2005 at 13:52 | #21

    There may not be much incentive for Singaporeans to speculate in Singapore real estate. However, I suspect quite a few are speculating in Aust real estate.

    On the question of capital gains, discussed at comments 12 and 18, the discussion so far has not canvassed one of the main reasons behind capital gains in real estate, that is falling interest rates. One of the limiting factors on real estate prices is the capacity of the buyer to finance the loan necessary to buy (or, if they are paying cash, theralternative income stream that could be generated elsewhere). If interest rates fall, the cash flow required to service a loan of a given size also falls. Thus a buyer with an unchanged cash flow ( eg from salary) can afford a bigger loan. This puts upward pressure on real estate prices, giving rise to capital gains. Of course, when interest rates rise, the pressures are reversed, frequently leading to capital losses. But significant capital gains can accrue to those who are fortunate or skilful enough to get the timing right.

  22. observa
    February 25th, 2005 at 14:23 | #22

    Comment by still working it out,
    Thanks, I had this sneaking suspicion I’d missed something obvious-income. Ditto others.

  23. Tony
    February 25th, 2005 at 15:03 | #23

    Dear Professor,

    Re Top Tax Rate, Low Priority Page 62 AFR 24/2/05I

    In the article you refer to “important negative change has been concessional treatment of capital gains, introduced at the height of the dot com mania in 1999″. Implying that there has been some cut in the capital gains tax. There has not been any cut in the capital gains tax.

    Capital gains tax was markedly increased in the Ralph business taxation reforms when they abolished averaging. At the same time they started to tax the inflationary component of the gain. These new reforms ensure that the revenue collected from capital gains tax as a percentage of GDP will increase over time. The net effect to the capital gain taxpayer under the new reforms is that he is worse off.

    I know this as I realised a capital gain just after they introduced the reforms. There was a transition period when they were phasing in the new CGT. During the transition period people had the option to go with the old way of calculating CGT or adopt the new method. We went with the old method as there was considerable tax savings using averaging and the CPI scales.

    I found this in one of your other articles. It must be The Productivity Commission who is the source of this misinformation/disinformation:
    “The Productivity Commission, scarcely a hotbed of left-wing activism, recently identified the concessional capital gains tax system introduced by the current government as one of the factors contributing to the unsustainable boom in housing prices, and the corresponding decline in home affordability. ”

    If there is an “unsustainable boom in housing prices, and the corresponding decline in home affordability” it is more likely caused by governments failure to adjust for bracket creep that has pushed average incomes into higher tax rates. The housing boom was just a by-product of people scrambling for the tax relief door -converting income into capital gain to take advantage of the lower rates. Both the average wage tax rate and the capital gain tax rates have risen. It would be safe to assume average workers have been pushed by over onerous taxation to seek negative gearing, CGT and other tax minimization strategies just to survive.

    ——————————————————————————–

    The debate about marginal tax rates should also visit the question of a single flat rate of tax. High incomes still pay more ie 33% of $100 = $33; 33% of $1000= $330

    The biggest smoke and mirrors stunt of all is tax scales. We are told that people who earn more are taxed more and that is why we have tax scales. The truth is tax scales are used to deceptively increase the rate of taxation. A tax scale used with inflation increases the rate of taxation. This is why we now have poor people in the highest tax bracket. We only have to look at growth in the rate of tax levied on the average wage or the average Sydney property price to illustrate this point.

    My back of the envelope calculations show:

    Taxation of the average wage has increased from approximately $17 tax per $100 of wage in the early 1980s, to $23 tax per $100 in 2003. The rate of tax payable on the average wage has increased nearly 40% in 20 years.

    In the last 10 years stamp duty on the averaged priced Sydney property has gone from about $2.67 tax per $100 of the purchase price to nearly $3.53 tax per $100 of purchase price. The rate of stamp duty payable on the average Sydney property has increased a whopping 32% in just 10 years. (first home buyers now excluded)

    A lot of government fees and charges are structured so that inflation increases the real rate of taxation by stealth over time. This is reflected in the growth total taxation revenue per head as a percentage of GDP per head. Going from 22% of GDP in the early 1970s to 32% now a 45% increase in the rate.

    Taxation will soon get to 33% of GDP and if the annual compounded growth rate of taxation of last century (1.62%)is repeated, in about 70 years taxation will be 100% of GDP. I think the Soviets found that system didn’t work.

    Governments are self regulating monopolies (like an unregulated toll bridge that everybody has to cross) and as such they do not have any competition to keep them efficient. Well run normal businesses subject to competition, achieve greater economies of scale and become more efficient as they grow with the economy. Generally they employ less capital to provide more goods or services as they get bigger and achieve productivity gains. Looking at the governments report card above the opposite appears to be happening. They spend more capital to provide less goods or services as the economy grows, becoming less efficient over time.

    The government is getting 10% more of the GDP than they were at the beginning of the 1970s. Approximately $75 billion per year extra revenue in todays dollars.The proportion of GDP spent on healthcare, roads, defence and education has changed little over the same period. The amount for welfare has increased significantly but the bulk of the $ 75 billion is wasted- the ineffecient government collects $3 to give back $1 in middle class welfare.

    The continual growth in taxation is a big issue because the huge taxation grab is severely impacting on average Australians and the young. It primarily hurts younger people- anyone generation X or younger is now 45% worse off tax wise than their baby boomer parents were in the 1970s. It is harder for them to save because more of their income is taken away from them in tax. It is harder for them to buy their home because stamp duties are higher. Generation taXed are 50% worse off.

    Good macro-economic management should answer the question- “for an effectively functioning society, what size public sector do we needed”?

    I was around in the seventies and life seemed reasonable with a smaller government- free health care, free universities, there wasn’t a toll road every 2nd kilometer and families could survive on one income.

    Getting taxation back to 25% of GDP should allow the young working poor to get back on their feet by allowing real tax cuts.

    Some radical macro-economic reforms would be needed to acheive this:

    Stop the practice of middle class welfare.

    Abolish one level of government to alleviate duplicated services. (maybe combine local and state and have regional governments)

    Mandate fiscal responsibility on government by pegging the % of GDP going to government.

    The excesses of government has reigned unchecked for the last century.The time for reducing the size of government has come. I have small children who hopefully will be around in 70 years time, for their sake and for young people today who are stuggling and can not afford excessive government- We have to do something about it.

    Sorry to put such a long winded weblog out there.

    Tony

  24. February 25th, 2005 at 16:03 | #24

    I wish I could get people to look at the Kim Swales approach, that sorts out the regressivity/minimum income problems with offsets on broad based indirect taxes with their point of impact on employers – like GST.

    These don’t help the poor by making it easier to be poor but by making it easier to stop being poor, getting rid of those harmful social security interactions in a Pigovian way. They don’t use income tax, since that confuses the point of impact.

    It’s about promoting people out of poverty. I have loads of stuff on it here, but for some reason whenever I raise the subject people don’t rise to it.

    Maybe it just isn’t sexy enough. But Katz – this is what I meant about everybody talking and nobody listening on the internet.

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