In today’s Fin (subscription required), Sinclair Davidson tries to resuscitate the claim that Australian taxpayers are suffering from severe bracket creep, a claim I refuted in my piece last week (over the fold). The case is so thin that he spends half of his article restating a version of the claim I’d already refuted, before admitting that it is spurious (this is the claim that the abolition of the old 66 per cent rate, by making 47 per cent the new top rate, put more people into the top tax bracket. While this is trivially true, it’s also clear that this change was the opposite of bracket creep).
Davidson’s second argument, involves an interesting redefinition of the terms of debate. The standard approach has been to look at either the real income level or the proportion of average weekly earnings at which the top rate is payable. The real income level has risen over time and the proportion of average weekly earnings has been roughly stable. Davidson instead looks at the proportion of taxpayers paying the top rate. Obviously, if pretax incomes become more unequal, as they did over the 1990s, this proportion will rise, and this is what he finds.
The call for tax reform issued by Reserve Bank Governor Macfarlane in his recent appearance before a House of Representatives Committee is of interest as much for what he did not mention as for what he did. Macfarlane identified as major problems the distortions that promote speculative investment in housing and the high effective marginal tax rates faced by low income earners. He did not mention the top marginal rate of income tax, for the very good reason that reductions in the top rate are a low priority on any serious agenda for tax reform.
The absence of a substantive case for a reduction in the top marginal rate is reflected in the frequency with which spurious arguments are advanced. It has regularly been asserted, for example, that bracket creep over the last couple of decades has lowered the point at which the top marginal rate applies, so that middle-income earners now pay the top rate. This assertion is true only in the trivial sense that the abolition of the 66 per cent top bracket in the 1980s meant that 47 per cent become the top marginal rate. The point at which the 47 per cent rate cuts in has barely changed, relative to average earnings, in thirty years.
The income tax scale is less steeply progressive than it was in the past, not more. As observed by Peter Saunders (AFR 21/2/05), the big change that has taken place is the failure to adjust the minimum threshold in line with increases in prices and incomes.
An even more important negative change has been concessional treatment of capital gains, introduced at the height of dot-com mania in 1999. Far from encouraging productive investment, this measure has fuelled the growth in speculative housing investment deplored by Mr Macfarlane.
Then there are comparisons between the top marginal tax rate for individuals and the company income tax rate. Such comparisons are misconceived since, under dividend imputation, company tax payments are fully offset by imputation credits when income is distributed. The tax treatment of companies and trusts opens up all sorts of opportunities for tax avoidance and evasion, but most of these opportunities would exist even if company and personal tax rates are aligned.
Finally there is the claim that Australia has higher marginal tax rates, cutting in at lower multiples of average earnings, than other developed countries. This claim got a run in the latest OECD report on the Australian economy. However, a comparison of the summary of the report with the content of the main body suggests that the OECD position reflected pressure from the Australian Treasury, or perhaps the Treasurer’s office, as much as its own analysis.
The OECD’s own figures belie claims that Australia is an outlier. Of the 30 OECD countries listed in the report, 13 have top marginal tax rates (including social security taxes) in the range 45 to 50 per cent, 8 above this range and 9 below it. Similarly, in terms of purchasing power, the income level at which the top rate comes in is very close to the OECD median.
The real issue, though is not whether we are near the OECD average, but whether cuts in top marginal rates would boost growth. Econometric evidence on this point is inconclusive, but a look across the Tasman is instructive.
Readers may recall that New Zealand was hailed as pathbreaking miracle economy when Sir Roger Douglas cut the top marginal tax rate to 33 per cent in 1988. A rapid resurgence in economic growth was confidently predicted, even in the face of initially disappointing results. It was only after a decade of woeful economic performance that talk of the Kiwi miracle was finally abandoned. The Clark government elected in 1999 raised the top rate to 39 per cent. The economy promptly recovered and has grown strongly ever since.
It would be absurd to suggest that higher tax rates were responsible for the macroeconomic recovery in New Zealand after 1999. But, on the evidence, it is equally absurd to suggest that variations in top marginal tax rates have a significant effect on economic performance. Good macroeconomic management, rather than adjustments to tax rates, is the main prerequisite for sustained growth.
The main risks to our continued economic expansion come from weak labour force participation, excessive investment in the non-tradeable housing sector and a generalized focus on capital gains at the expense of production. These, and not the complaints of high income earners, should be the main targets of tax reform.
John Quiggin 
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Surely AUS pre-tax incomes became less equal over the nineties (ie larger functional gini coefficient) which is one reason why (the larger proportion of) high income earners are whingeing about being thrown into the higher income tax brackets.
Thanks, Jack, fixed now
I’m struggling to digest all this, though I don’t doubt your facts John.
Being in the top tax bracket obviously means that you are a high income earner, but it sure doesn’t feel like that sometimes. Hence you tend to grasp at straws like bracket creep.
I don’t think of myself as particularly rich, though I admittedly earn significantly more than the AWE. But, after paying expenses for ridiculous Sydney housing, and the seemingly unending miscellanea that two kids seem to bring, there’s not a lot of money in the bank to spend on Mercedes Benzes. Yes I’m whinging, yes I know a lot of people are far worse off, no I don’t know how they do it.
Thanks for the perspective anyway.
Um… Bearing in mind the creeping use of “refute” to mean “rebut” or “contradict”, I’d like to know more about JQ’s refutation.
PML the refutation is summarised in parentheses, and spelt out in more detail here
This seems to be a comprehensive refutation of Saunders’ argument. There is still the fact that the NE Asian (esp JAP) and N American (esp USA) economies are on much lower average and marginal tax rates than AUS. These states are few in number but dwarf in scale the various middle and small sized states of the USE. They also tend to have much better productivity perfomrance and earn higher per capita income. Peter Burns has a discussion of this here.
The group with the biggest beef about Australia’s relatively high personal income tax rates is the salariat, who discover that the Government has beaten them to their own pocket. I’m prepared to stand corrected, but I imagine that personal income tax remains the largest single component of federal revenue.
Self-employed persons, whether orthodontists or landscape gardeners, have ways of minimising declared personal income. The GST was designed to mine this source of previously untaxed income.
Now, it is the lot of the salariat that their work habits are relatively impervious to the influence of tax. They do their jobs with scant regard to the tax implications. Their satisfactions, such as they are, tend to the psychic end of the spectrum. Careers are pursued with little regard for tax implications. That being the case, it is difficult to develop the argument that, for this salariat, relatively high rates of personal income tax affect effort made at work.
I use the term “effort made at work” deliberately. I don’t mean “productivity” exactly. And in so doing, I’d like to propose a counter-intuitive point.
Indeed, high rates of personal income tax may improve productivity in a defined set of cases. Members of the salariat often think in this way: “I’d like to get a pay rise, but I recognise that tax takes close to 50% of what I’d get. So, it’s not really worth the bother. I’ll find some other way of making my work life rewarding.”
I realise that this thinking does not apply to the self-employed and it does not apply particularly strongly to blue and pink collar workers. But I guess that the bulk of income tax is paid by white collar employees, so this line of thinking must have some impact on the sustainablity of Australia’s relatively high rates of personal income tax.
Katz has a point for the salariat. In my experience they are the people who attend all the conferences and trade conventions that I and my fellow self employed get invited to regularly. You only have to note the venues to appreciate what’s really going on. Non taxable rewards. They also fill some of the most waffly and irrelevant training courses, which of course the self employed are very discriminate about attending.
Have a guess what is the only way for the high salariat to escape the high marginal tax rates? Negatively geared capital gains, to be enjoyed after you decide that with penal income tax rates it’s not worth it all and take an early retirement, when you can cash out your capital gains in a low income year. Have a guess what this salariat have been doing in droves these past few years and how that is affecting first home buyers? Now that so many have taken advantage of this distortion in the economy, no govt dares to change it. To do that politically you’d have to slash their marginal tax rates as the quid pro quo. Like squeezing balloons really.
Prior to the introduction of CGT in the mid 80s you could convert taxable income into a tax free capital gain. Using a negative gearing strategy the salariat had the option of paying no tax.
Back then I don’t remember a rush for the tax relief door utilising minimization strategies.
People started utilising tax minimization when the tax as a proportion of GDP started to rise.(it hit 26% of GDP in the mid 80s when they had to introduced CGT) Total Taxation revenue as a % GDP has gone from 22% in the early 70s to 33% now.
After the Ralph reforms we have a CGT that was made more onerous with the recent introduction of a tax on the inflationary component of the gain and the abolition of averaging- yet there is a rush for it.
Could any of you learned people out there tell us what is a reasonable proportion of the GDP to go to the Government? Obviously average people utilising tax minimization think they are paying to much tax.
If bracket creep isn’t a problem, then you should have no objection to indexing the brackets. Those who support indexation would be happy, and those who are opposed to it would also be happy because it wouldn’t acheive anything. Everyone’s a winner.
Econowit, do the words “Bottom of the Harbour” ring a bell?
Mike, I’ve got no problem with indexation. However, given the attractiveness of spurious tax cuts to politicians, I can’t see it coming any time soon.
Hmmm, if tax rates fell, let me see….
Salaries would fall in absolute terms. Duh! Tax rates are not the issue, it’s after tax income, and that will stay the same (there are very stong market signals even the most imperfect market won’t ignore), so total salaries will erode, over time, with falling tax rates. There might be a one-off windfall in the time just after a tax decrease, but then, I’m afraid, it’s business as usual.
-pwe
econowit — 2/3/2005 @ 2:04 pm sheds crocodile tears for the legion of opressed high marginal tax ratees:
John,
“Bottom of the Harbourâ€? refers to a illegal tax scheme that was used by only a handful of people. The small amount of people that used “Bottom of the Harbour” or the legal minimization schemes of the 80s is totally dwarfed by the large percentage of taxpayers using the legal minimization schemes today.
Who cares if “The real income level has risen over time and the proportion of average weekly earnings has been roughly stable.” or what the top marginal rate was eons ago. What doe matter is are “Australian taxpayers are suffering from severe bracket creep”?-are they being taxed a higher proportion of their income.
The biggest smoke and mirrors stunt of all is having 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 real rate of taxation. A tax scale used with inflation increases the real rate of taxation. This is why we now have poor people being over taxed in high tax brackets. The average wage stays constant over time -buying you the average life style. 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 tell me:
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 of 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.
“Australian taxpayers are suffering from severe bracket creep” and total taxation creep!
The debate about marginal tax rates should also visit the question of a single flat rate of tax. High incomes still pay more i.e. 33% of $100 = $33; 33% of $1000= $330
The ratio of tax and public expenditure to GDP rose substantially from the 1960s to the 1980s, and some of this was facilitated by bracket creep. But over the last twenty years, there has been very little change. The ratio of tax to GDP hit 30 per cent in about 1985 and has fluctuated with the economic cycle since then. Expenditure has been, if anything, more stable
Econowit, the original case for progressive taxation was made by Adam Smith. It is quite simple – diminishing marginal utility means someone on the minimum wage suffers more from losing 20% of their income to the govt than Kerry Packer does.
If you believe what the ‘happiness’ literature tells us – that it’s your relative, not absolute, income that matters and that therefore this will determine your behaviour, the case for progressive taxation is strengthened further. If Kerry is happy so long as he’s better off than the 2nd richest man in Oz, then I can take a big slab of tax off both of them, and (critically) a bit more from Kerry than from his competitor and they’ll both still be just as happy. But JQ can talk about the implications of rank-dependent utility much better than I can – it’s what he originally made his academic name on.
I have to say your post put me in mind of John’s observation that “the absence of a substantive case for a reduction in the top marginal rate is reflected in the frequency with which spurious arguments are advanced” (we saw the same phenomenon in the buildup to the Iraq war).
PS John, to refute a proposition is to show a logical flaw in its derivation. It is not the same as to “rebut” it, which generally means showing the proposition to be empirically untrue. The distinction is important in this debate, because a lot of the low tax arguments cannot easily be refuted but can easily be rebutted.
Sorry for the pedantry, but if we use our verbal chisels as screwdrivers what will we use when a sharp chisel is needed?
Doc,
In relation to total taxation creep you are most likely right, but the long term trend is up, 1980s up 1990s- constant, this decade thus far it has kicked up to 31.5% .
see table of GDP taxation 27.19 on this web page:
http://www.abs.gov.au/ausstats/abs@.nsf/94713ad445ff1425ca25682000192af2/a6e24932616f91edca2569de00296982!OpenDocument
But on bracket creep you will have to convince me. I could be wrong but my preliminary investigations show that the effective tax rate of average incomes is rising.
Further evidence of this might be found table 27.20 on the above web page. It shows the COMPOSITION OF COMMONWEALTH TAXATION REVENUE. The % derived from income tax has gone from 70% in 89 to 74% in 99.
In 2002/3 it could be 80% if you take out the GST that was not there before. Com revenue $194b- GST $31b / total income taxes $131b.
see
http://www.abs.gov.au/Ausstats/abs@.nsf/0/F22E5832F4E4F280CA256F7200832FB8?Open
derrida derider
Thanks for the info, I am not an econowit so I am not up on all the economic theories and associated persons. We all have to live with policies based on these theories. The Adam Smith theory gives me something to ponder. Is the second poorest guy happier than the poorest? Would not having a single rate with a threshold and indexing them be a better compromise? I can see the econowits dilemma- these are not easy questions.
Adam Smith used marginal utility theory to justify progressive tax?? The Adam Smith of ‘Wealth of Nations’ fame, or the 1970s Adam Smith?
DD, apart from housing tax, I cannot find any justification for progressive taxation in Adam Smith, perhaps you could provide some references.
derrida derider — 2/3/2005 @ 10:54 pm
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Marginal utility theory was “discovered” in the late nineteenth century, by English & Austrian political economists. The utilitarian foundations of progressive taxation were laid by Edgeworth, Marshall & Pigou – well after Smith had left the scene.
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Sinclair Davidson — 3/3/2005 @ 6:54 am
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Adam Smith was not a utilitarian theorist, but he did provide support for he progressive taxation, on grounds of ethical equity, rather than economic efficiency. ie the rich can afford to pay more from the state and benefit more from the state:
Nice try, Jack. Your quote is on page 368 of the 1976 Chicago reprint. Smith is talking about tax on house-rents. His first principle of tax is on page 350 of the same edition. There is says, ‘The subjects of every state ought to contribute … as nearly as possible, in proportion to their respective abilities’.
John, if you take into account the fraction who file tax returns, the progressivity of the Australian tax system didn’t change noticeably in the 1980s and 1990s. See http://econrsss.anu.edu.au/pdf/DP476.pdf (Fig 8).
That emoticon should be figure 8… did you turn on the ‘extra chic’ feature?
The real problem for the self-employed is not the 48.5% top marginal rate, its the yawning gulf between the corporate (and CGT) rate and the top personal rate. There is a huge incentive in the tax system for self-employed people to corporatise and capitalise income.
To quote Kohler from after the 2004 budget:
All high income earners understand that the gap between the top income tax rate (48.5 per cent) and the company tax rate (30 per cent) and the effective capital gains tax rate (24) is now such that they spend much of their lives trying to shift income into the lower brackets through contracting, leaving money in corporate structures and/or running fiddles to get it out as something other than income, and risky investment negative gearing, especially on property (a big part of the reason for the recent property boom).
Raise the corporate/CGT rates, or lower the personal rates (I don’t care) but they should be the same.
Razor’s Prescription:
Flat personal Tax of 20% (interesting proposal at the Australian Libertarian Website – saw it through the Yobbo before the last Federal Election). Same rate of corporate Tax. No CGT discount (except existing small business exemption). Capital Losses only applicable to same class of asset (eg. share losses can’t be offfset against real estate gains). And 10% GST on EVERYTHYING and then very limited specific classes of person/orgnisation able to claim back. And no tax on superannuation funds with any withdrawals then treated as normal taxable income.
Results: reduced non-compliance due to simplicity. Bracket creep removed. Reduced inequity of having to payout more and more as you improve yourself. Investment for retirement encouraged because of tax-free status. Increased international competitiveness.
Sinclair Davidson — 3/3/2005 @ 10:45 am throws Adam Smith to flat tax wolves:
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Smith is generally interested in taxing rents of all kind since rent on found objects, mineralty and realty, are rewards for unproductive economic function. Since they take up about > 20% of national income the fraction of resources that Smith believes is eligible for progressive levies is not a trivial quantum. As a Sydney rentier I speak with some feeling.
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The full quote from Smith is somewhat more sympathetic to the notion of social equity than Mr Davidson allows:
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If income is proportionate to “abilities” then Davidson is correct: Smith’s first principle implies a progressive tax. However Davidson, being an economist, would know that a persons income is usually not proportionate to abilities – still less effort – on account of Pareto’s-Winner-Take-80%-Law, market imperfections, political power, sociological and biological legacies etc. Thus a realistic interpretation of Smiths First Law of Taxation would justify some form of progressivity in income taxation, esp. when the full range of proportional and regressive taxes on expenditure are accounted for.
In general Smith took a fairly communitarian, rather than proprietarian or egalitarian, attitude towards social ethics eg the Theory of Moral Sentiments.
Give it away, Jack. we all have an equal interest in the state.
Sinclair, it’s good to see that at least in this context you support egalitarianism!
But Adam Smith is right here and you are wrong. Suppose police, fire services and so on were supplied by a private insurance company rather than by the state (as is the case in some places). It’s obvious that those with more property to protect would pay more.
As for public goods, on the standard assumption that they are normal or superior goods, standard economic theory tells us that willingness to pay increases with income.
I noticed that you got very huffy about this point in your CIS piece a while back, but you should take a careful look at the logic of your position.
Re: Andrew Leighs discussion paper.
It is a very impressive example of econospeak with all the bells and whistles. Unfortunately it went straight over my head with such speed and velocity, that I now have a receding hair line that was not previously apparent.
You make the comment that “the progressivity of the Australian tax system didn’t change noticeably in the 1980s and 1990s”.
Forgive my naivete and correct me if I am wrong. Do you maintain that by the progressivety not changing we are maintaining a progressive taxation system?
A progressive tax, is a tax that is larger as a percentage of income for those with larger incomes. It is usually applied in reference to income taxes.
If this progressivety claim is correct why do I detect traits of the opposite- regressive taxation? :
+at the low income end more low income earners are being taxed who previously we not. This is due to the tax threshold not being adjusted. As inflation dilutes the value of currency, they need more dollars to buy the same good and services. They are no better of in real terms but they are being penalized by the tax system by being introduce to tax. AN INCREASE IN PERCENTAGE OF TAX ON FOR PEOPLE ON LOW INCOMES
+in the middle the effective tax rate of Average Weekly Earnings has increased. 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 2003-17% TO 23% ( Andrew might have access to better data on these figure) AN INCREASE IN PERCENTAGE OF TAX ON FOR PEOPLE ON MODERATE INCOMES
+at the top the abolition of the top marginal rate A DECREASE IN PERCENTAGE OF TAX ON FOR PEOPLE ON HIGH INCOMES
It appears to me on the face of it, that the movements of tax rates at the top and bottom end could better be decribed as regressive.
“But Adam Smith is right here and you are wrong. Suppose police, fire services and so on were supplied by a private insurance company rather than by the state (as is the case in some places). It’s obvious that those with more property to protect would pay more.
As for public goods, on the standard assumption that they are normal or superior goods, standard economic theory tells us that willingness to pay increases with income.”
How does this apply to income transfers, JQ? Should the rich be willing to transfer more of their wealth to the poor? Are these income transfer “public goods” a normal or superior good?
John, I always support egalitariamism – that’s why the flat tax is good:)
seriously though there are two issues here. (1) There may well be good arguments for a progressive tax system, but Smith is not one of them. (2) When the state treats people differently some end up as ‘slaves’.
John Quiggin — 4/3/2005 @ 9:58 am
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This is obviously true, although Davidson’s counterpoint would be that the economic theoretic superiority of community services/public goods does not imply that they should have a statist proprietorial status, or progressive equitability in financing. Such goods may be “public” (inclusive consumption) yet privately owned and/or financed by proportionate or regressive levies.
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Smith sits about halfway between Davidson’s free-market and Quiggin’s fair-market philosophy of government. Smith saw the open & competitive market as an institution that promoted both individual liberty and social equity in the utilitarian service of the (mutually sympathetic) community.
Smith thought that the competitive market would bring about an equalization of net advantages to all employees, with the nice jobs being low-paid and the nasty jobs being high paid. Since high status jobs seem to be both nicely conditioned and handsomely remunerated, it follows Smith would have favoured some form of progressive redistribution to redress the inequity.
He would have also raised an eyebrow at the accountability failures in some joint stock corporations and the massive opportunities that globalising financial markets give capitalists to minimise their tax liabilities.
If he was alive today he would probably be a conservative social democrat.
‘He would have also raised an eyebrow at the accountability failures in some joint stock corporations’
Indeed, Smith had rude words to say on joint stock companies – basically the agency problem loomed large for Smith.
Having read through this string I have come to the conclusion that an interest in economics must require the ability to recognise social consequences and responsibilities to be surgically removed at an early stage. Thank god(dess) for the few who escaped this mutilation
That’s a bit wet, even for the lake sheila.
I somehow had the idea that Nimue was the one who lured Merlin astray.
Nimue was the one who lured Kevin the bard, whose official title was The Merlin of Britain, to Avalon to be executed by Morgaine (Morgan Le Fay) for treason against the Druidic faith and assisting King Arthur’s program of Christianisation of Britain. The title of Merlin of Britain had previously been held by Taliesin. At the time Britain did not have a capitalist economy.
Paul,
WTF? Where did you get that malarkey from?
Econowit, thanks for your note. Like you, I originally approached this topic thinking that income taxes were becoming more progressive. It’s just that when I did the calculations, the facts didn’t support my prior. That said, I’ve only looked at personal income taxes, and it’s conceivable that the introduction of the GST changed the picture.
Andrew Leigh,
Inflation is a strange beast. I think there is a correlation between higher inflation and an increase in the effective rate becoming more apparent. (ie 70s&80s, 01/03-GST induced)
Do you know of a time series that tracks the effective tax rates for say first quartile, median and third quartile of incomes with average weekly earnings in as well- or something similar? In my view this simple way of looking at it might help clarify what is happening.
Yes I agree the GST has probably changed part of the picture (but we still have marginal tax rates). I also think that changing the governments accounting from cash to accrual might have distorted the data as well.