Should we tax the capital income people receive from their investments or property? This may seem a strange question - don’t we already?
But the answer is that due to exemptions, we collect virtually nothing when people make a gain on investment or owner-occupied property. Of total net household assets of A$8 trillion, almost 45% is tied up in owner-occupied dwellings attracting no tax, despite the benefit of imputed rent and capital gains.
In theory, we could collect around A$180 billion a year by taxing all capital income, but we only collect around A$60 billion, mainly through company tax. Large exemptions make the economic costs of raising necessary revenues far higher than they ought to be and make the tax system less fair.
Where the income is
Of the A$8 trillion asset total, 15% is invested in real property which, after deductions for expenses such as interest costs, pays negative net tax. Owner and investment property in Australia yields an estimated total annual income of A$300 billion, which is pretty much untaxed except for rates and property tax. These fit uneasily in the list of capital taxes since they have a one-off impact by reducing the value of the land.
Some A$2 trillion or 25% of household wealth is in superannuation, which also pays virtually no – or negative - tax. About 10% is in personal use assets such as cars and boats. The great bulk of household capital assets – over 80% – yield virtually no tax.
In general, large business pays tax on a reasonable approximation of a comprehensive income tax basis, once corporate income tax is imputed at the personal level. Small business is a different story, with notable concessions in the area of capital gains and depreciation allowances.
An income tax in theory taxes yields from capital. But the yields are exempted by what’s known as an expenditure tax. This includes deductions or exclusions that reduce the amount of tax owed. Our hybrid system of capital income taxation, which comprehensively taxes a sub-set of assets but offers exemptions for the bulk of assets, is known to add to inequity and resource misallocation.
Investments are pushed into tax-favoured forms, despite the economic benefits being higher in taxed forms. In particular our system favours excessive spending on homes and inadequate spending on business investment.
How to fix it
There are generally thought to be two possible directions for reform: either move to a more consistent income tax treatment, or give up the goal of taxing annual income comprehensively and move to a full-fledged expenditure tax or its pre-paid equivalent, a wages tax. The defining feature of an expenditure tax is that there is no effective tax on savings yield.
Economists have increasingly favoured expenditure tax options, based at least in part on the practical and political difficulties in administering a fully comprehensive income tax.
There is also an increasing view that annual income is not theoretically appropriate as a tax base, partly reflecting “optimal tax” methodologies developed over the past 40 years. On this view the expenditure tax is favoured as it does not double tax savings and drive a wedge between the economic returns to investments and the yield to investors.
The problem with the “optimal tax” view is that its practical effect, if implemented, would be to worsen the dispersal of incomes and to increase disparities in wealth and living standards.
Removing taxes on capital incomes is likely to foster a widening gap between rich and poor, despite the economist’s prediction that it would foster capital accumulation, and this would enhance wages. However reducing some capital taxes while increasing others can provide options to “level the playing field” which make sense irrespective of decisions about what the aggregate weight of capital income taxation should be.
As French economist Thomas Piketty has argued, there needs to be some check on the tendency for wealth concentrations to grow dynastically. Some taxation of capital income or its equivalent, annual wealth taxation, can provide such a check. Ultimately some taxation of capital incomes is necessary and appropriate for achievement of a “just” society.
It may be that the degree of taxation of such income should not be dictated by the norms of the comprehensive income tax. But it is clear that we should not allow the personal tax system to move gradually into a simple wage tax. Nor is a cash-flow expenditure tax ideal, as it also exempts most capital income.
A cousin of the expenditure tax is the rate of return allowance (RRA) favoured by the UK’s Mirrlees tax review committee. This approach exempts the risk-free part of capital return (approximated by the bond rate) from tax. The tax base is then economic “rent”, being the return to capital in excess of the risk-free rate. I estimate that this might tax around 2/3 of the total return to capital.
A strong case can be made for at least taxing economic rent. While the RRA does this, it is administratively cumbersome. A similar approach (which I call the Z-tax) could be applied to all assets including housing and superannuation accumulations.
Though politically difficult, it would dramatically enhance the economic efficiency of the tax system and make measures such as GST increases less compelling from an economic perspective. Like the RRA it could – if comprehensive - raise an additional A$60 billion per annum, making it an important option for tax reform.
Reducing the tax burden on capital income might seem a great idea in theory but its practical consequence is to make for a more unequal society. Moreover, this inequality can persist across generations. Capital taxes should be made more even, however. If the political difficulties can be overcome, there is significant revenue potential.
The full paper is available on the website of the Tax and Transfer Policy Institute, ANU.