In his 2012 State of the Union address US President Barack Obama lamented the fact that billionaire Warren Buffett faces a lower tax rate on his income than his secretary.
The situation arises because the secretary’s salary income will be taxed at the normal US tax scales. On an income above US$34,500 but below US$83,600, Buffett’s secretary would face a 25% tax rate. But the dividends and capital gains the billionaire investor makes on his directly held investments are likely to be taxed at a maximum rate of 15%.
Political deliberations to tackle the fiscal cliff in the US are focusing heavily on the tax system that gives rise to these types of anomalies.
But Australia’s income tax system has its own Warren Buffett-type anomalies. Indeed, there is considerable momentum to add more of them, albeit that it is presently halted in light of the fiscal position. For example, consider the government’s announced policy of giving a 50% discount (tax break) on interest income up to a certain level, and the subsequent withdrawal of this proposal.
One of the most contentious anomalies was introduced in 1999 by the Howard government; discount capital gains for individuals. This essentially means a person only gets taxed on half of the capital gain they make (e.g. only $5,000 of a $10,000 gain would be taxed).
The effect is that a person on the top marginal rate of tax over $180,000 of income) would only pay a rate of 23.25% on a capital gain (50% of the top marginal rate of tax of 46.5%). A person on the tax rate one down from the top marginal rate (income above $80,000 but below $180,000) would only pay a rate of 19.25% on a capital gain (50% of the 38.5% marginal rate band).
Where is the anomaly caused by discount capital gains? A wage earner on income above $37,000 will face a tax rate of 34% on income above that amount. When the income reaches $80,000, every extra dollar is taxed at 38.5%. Yet, the most that is payable on a discount capital gain is 23.25%.
Why do we have such anomalies or differential treatment in the tax law? After all, isn’t a buck a buck, and therefore they should all be taxed in a similar way? Yes, a buck is a buck in terms of economic well being, and for accounting purposes, but for tax purposes, not every buck is quite the same.
Why? In short, governments seem to believe - with considerable help from official enquiries, the latest being the Henry Tax Review - that different taxes have different behaviour effects on taxpayers, and tax measures that have a damaging effect on investment and economic growth should be avoided.
Because of this, the general suggestion from the Henry Review is that higher taxes should be imposed on factors of production or activities that are not movable, or activities that are not susceptible to change or relocation.
Higher taxes on these factors or activities are regarded as efficient taxes as their imposition does not change taxpayer behaviour.
On the other hand, lower taxes should be imposed on those factors of production or activities that are mobile or for which there are substitutes. High taxation here is regarded as inefficient as it is likely to change the behaviour of the taxpayer to the overall economic detriment.
Applying these guiding principles, the state and territory land taxes should be increased and they should be extended to the main residence and land used for primary production. (Note, there are local government rates on the family home and primary production land already).
A well-designed death duty regime ought to be introduced because such a tax should not result in significant changes to taxpayer behaviour. There is little need to lower taxes on income from salary and wages as workers have no real alternative but to work.
There is some discussion though about lowering the tax rate faced by some workers to increase workforce participation (e.g. older Australians, second earners in a household) as these workers may have a viable alternative to working.
Money capital (and assets readily converted into money) is perceived to be the most mobile of all resources. The thinking is, if Australia overtaxes the return on money capital, the capital will simply move somewhere else where the tax rate is lower. This is the reasoning behind the push to lower taxes on money capital. Further, state and territory stamp duties ought to be abolished, or at least substantially reduced because they have large distortionary effects on behaviour.
It is inevitable the tax rate anomalies and differential treatment will arise in the income tax system. There are many present already (e.g. generous capital gains tax concessions for gains made by small business taxpayers, near zero tax on long-term savings through superannuation, zero tax on savings held through the family home).
And fiscal difficulties aside, we can expect more and more tailoring of tax rules, and finessing of the tax system, to cater for the efficiency of an impost.
Of course, it is hard to predict or measure the behavioural effect of certain taxes or tax rates with a high degree of certainty. There are so many factors at play around investment choices, work choices, and spending choices that to isolate the tax rules, and claim a certain response from those rules is not plausible.
Those pushing their self-interest (usually packaged as the public interest) know this, and their solution is to fill the information gap with logic. For example, we have all heard the claim that if we lower the tax rate on salary income, people will respond by working harder or more hours or they will pursue education to get the higher paying job.
Governments and politicians cannot fully implement the efficiency principle. For example, levying very high taxes on the “necessities” of life would not mean a significant reduction in consumption of necessities and therefore this would be an efficient tax measure.
But such a tax measure would rank very low in terms of fairness, and central to the notion of fairness is the idea that a buck is a buck. And fairness is at the top of many peoples’ list when it comes to the design of a tax.