Expanding the GST would hit the ‘middle’ and women the hardest

Shifting the tax burden to wage earners in the middle is a costly and outdated approach to tax reform. Dave Hunt/AAP

Many developed economies have experienced a significant increase in inequality in recent decades. Survey data for Australia show that the share of the top 10% of the income distribution, and more markedly that of the top 1%, has grown dramatically. At the same time, tax reforms over the period have reduced tax rates on top incomes.

Over the short period from 2004-05 to 2008-09 alone the top bracket limit rose from A$70,000 to A$180,000 and the top marginal rate fell another two percentage points, concentrating billions of dollars of tax cuts in the upper percentiles. Those in the middle of the distribution gained little to nothing, an outcome achieved by combining tax cuts at the top with the Low Income Tax Offset. The LITO raised the zero rated threshold for those on very low incomes while simultaneously denying gains for the middle through its withdrawal rate of 4 cents in the dollar.

Against this background an expansion of the GST, which is well recognised to be highly regressive, is a reform that will further undermine the “middle”. A weakened “middle” will have negative effects on aggregate demand, jobs growth and productivity.

Proponents of an expanded GST typically claim that a consumption tax is more efficient than an income tax. For example, Liberal MP Dan Tehan argues a shift from direct to indirect taxes like the GST will deliver higher standards of living. This view, which is supported in the Henry Review, reflects the belief that a tax on consumption is more efficient because it allows capital income to be tax exempt. The argument, however, contains a fundamental error in logic.

Modern public finance now recognises that the optimal tax rate on a given source of income, whether labour or capital, can only be determined on the basis of empirical evidence on distributional outcomes and behavioural effects. Even if capital were highly mobile, which is very much open to question in a number of important contexts, this does not imply an optimal rate of zero. This principle, derived from the theory of “second-best”, has been well established for over half a century.

Outdated thinking

The argument for a shift towards consumption taxation also reflects an outdated view of the household.

As explained in detail in the Henry Review, capital income is tax exempt under a cash flow expenditure tax (a consumption tax) and under a labour earnings tax (e.g. a payroll tax). The two are said to be equivalent. This is a fallacy that can be traced to the failure to observe that with the dramatic increase in female workforce participation over the last half century the majority of working-age adults live in couple households with two earners.

With information on earnings we can have an individual based tax that is not only progressive but applies a lower rate to the earnings of the partner with a lower income, typically the female on a lower wage. In contrast, we cannot observe individual consumptions (or saving) in two-person households. A consumption tax is inevitably limited to a flat rate tax on joint consumption and therefore cannot be superior to a well-designed labour income tax.

Compensation problems

The labour supply of partnered women as second earners is far more sensitive to taxes than male labour supply, as evidenced by the significantly higher estimates of their labour supply elasticities. The higher they are taxed the more likely they are to drop out of the workforce. Efficiency therefore requires they face lower marginal tax rates. Due to the Howard family tax reforms many face effective MTRs that are much higher than the top rate on personal income. Expanding the GST will not only add to these already excessively high rates, but the provision of compensation targeted towards low income earners, as suggested by Tehan, will exacerbate the problem. Higher effective rates can only be avoided by introducing a more progressive rate scale on personal income, and this is clearly not the intention.

These issues are missed by KPMG in its analysis of the costs of alternative taxes in terms of consumer welfare loss per dollar of additional revenue. Liberal MP Angus Taylor cites KPMG’s finding that taxes on labour cost 24 cents for every dollar levied, in contrast to less than 10 cents for the GST. The result is based on a single-earner household with a single labour supply elasticity set at 0.2. While findings from KPMG’s modelling approach might have been relevant in the 1950s when most households were single-earner, they are entirely fictional for a 21st century economy.

The evidence on wage elasticities suggests female labour is the most mobile factor of production. Yet under current policy settings partnered mothers not only face the highest tax rates on earnings, many also face excessively high child care costs due to the failure of successive governments to invest in a learning focused public sector child care system.

Not surprisingly, well over 50% of married mothers of prime working age remain out of the work force or work part time not only during the child rearing years but throughout the entire life cycle due to loss of human capital. A conservative estimate of the overall loss would be in the order of 20% of GDP, a loss we cannot afford with an ageing population.

To reduce this loss we need to reverse the direction of tax policy in recent decades – that of shifting the burden from top incomes to wage earners in the middle of the distribution, and particularly towards partnered mothers as second earners. We also need to cut massive tax expenditures that primarily benefit high income earners and invest the revenue in child care. Expanding the GST is no solution.