Rethinking tax reform – it’s now or never
It is now 5 years since the Federal Government released it’s Re:think paper on tax reform, aimed at ‘beginning a dialogue on how [to] create a tax system that supports higher economic growth and living standards, improves international competitiveness and adjusts to a changing economy’. Although the release of the paper stated that the current tax system was ‘holding Australia back’, we have seen little traction in achieving true reform of the Australian tax landscape since its release.
In the era of globalisation we saw strong economic growth and a continued expansion of trade and commerce across the world. Whilst no-one could have predicted COVID-19 there is more than some suggestion that, at least in the short term, we can expect to see a contraction of globalisation measures and a move towards nationalism, with borders closed and trade stifled. Although ultimately substantial economic recovery will likely require global co-operation, there are questions as to how many months, or years, it will take to rebuild the global economy to pre-COVID-19 levels.
Australia is not immune to the COVID-19 driven economic decline. Coupled with the need to rebuild our own national economy and the unprecedented expenditure used to fund Government relief and stimulus packages (both that which has already been spent, and that which will be needed in the coming months) Australia’s fiscal management will need to be at its very best. This means that our tax and transfer systems need to be at world’s best standards. If they are not, the knee jerk reaction of simply tinkering at the edges to create ‘stop gap’ solutions like hikes on income tax rates is unlikely to be either sufficient or satisfactory.
The consequences of COVID-19 provide us with every reason to boldly and expeditiously push forward with the Re:think that was already considered necessary well before our economic wellbeing was faced with the COVID-19 crisis. Sensible, well considered, wholesale structural reform of Australia’s taxation system is likely to provide an efficient and contemporary way to manage Australia’s road to fiscal recovery.
For these reasons and for the further reasons set out below, it is now or never.
Issues with our current system
Even setting aside the issues of significant government debt, economic contraction and the current system’s failure to meet the changing nature of our economy, Australia’s tax and transfer system is arguably one of the world’s most complex – which is surely of very little benefit to anyone other than tax advisors!
Yet it has long been recognised (including by both the Asprey and Henry Reviews) that an effective taxation system should be based on the premise of achieving:
- fairness – or ‘equity’ as between taxpayers, with respect to ensuring that taxpayers in similar positions bear tax at the same level, but also that tax is borne at a level commensurate with the taxpayers’ ability to pay;
- efficiency – that is, the system should not encourage the distortion of economic decisions; and
- simplicity – the system should be relatively easy to understand and place a low administrative burden on taxpayers.
It is doubtful whether Australia’s current taxation regime achieves any of these criteria. In fact, our current system is arguably the exact opposite – inefficient, technically complex and often distortive.
For example, small and medium sized enterprises comprise a large proportion of Australian businesses and make a significant contribution to the Australian economy. Ordinarily it would be expected that businesses of this size and scale should not have to seek specialist tax advice in relation to their every day affairs, yet the complexity of the taxation regimes applicable to such businesses operating in Australia is astounding – in fact, Division 6 (in relation to the taxation of Trusts), Division 7A (relating to the extraction of profits from private companies), the small business CGT concessions and the minefield of legislation relevant to the recent changes in corporate tax rate and its impact on the imputation of dividends are some of the most complex divisions of our tax legislation.
The complexity in our system also stems from the differing tax treatment of legal entities (trusts, partnerships, companies) which might commonly be used in the operation of small and medium sized businesses, meaning that the ability of a business owner to navigate this complexity can have a significant effect on the tax liability of a business and can lead to different tax outcomes for businesses which are economically similar and/or operate in similar industries.
Therefore, taking just small to medium sized businesses as an example, it is clear that the system is incredibly complex, encourages distortion (for example, as between business structures) and does little to achieve equity as between taxpayers.
At the time the Re:Think paper was released, tax compliance costs in Australia were in the order of $40 billion per year. Anecdotally, there is very little evidence to suggest that this has changed dramatically in the 5 years since.
Even on an individual level, much can be done to simplify the tax and transfer system and neutralise its distortive impact. For low income earners, or a second income earner within a family unit, our current system will often act as a disincentive to re-engage within the work force. In the current economic climate rebuilding the Australian economy will surely require all Australians in a position to do so, actively engaged in the workforce. Coupled with the recent focus on the importance of gender equality, the necessity of redesigning the tax and transfer system to ensure alignment with the needs of modern society becomes clear.
Composition of taxation revenue
Broadly, as a proportion of Australia’s total taxation revenue, personal income taxes on income, profits and gains comprise approximately 40%, corporate tax 18% and the GST 12%.
Yet despite heavy reliance on personal income taxes, our current system allows a large proportion of income to be retained within companies and subject to tax at no more than 30% (and reducing). For many wealthy taxpayers the corporate tax rate effectively operates as a cap on a vast amount of income derived in Australia (and certainly any income derived which exceeds personal spending).
Much has been made of the reduction in Australia’s corporate tax rate in recent years and the fact that this was needed in order to compete for international investment and stimulate economic growth. Whilst initially proposed as a broad-based initiative applicable to all companies, this was eventually watered down and now applies only to those entities deriving mostly ‘active’ income – from 30% to 25% by the 2022 financial year for those with turnover less than $50 million.
Again, the split rate does nothing to reduce the complexity of the Australian taxation regime (and as noted above substantially complicates our (anything but) ‘simplified’ Australian imputation regime).
In fact, the reduced corporate tax rate has the effect of ensuring that the rate of tax paid by foreign investors on a vast proportion of Australian sourced profits is reduced, rewards those taxpayers who are financially able to retain profits within companies indefinitely, but ultimately does very little to help Australian resident taxpayers more generally, who ultimately foot the bill on the profits distributed by way of ‘top up’ tax.
Different layers of Federal and State taxes also increase complexity – and we find ourselves with a vast range of inefficient taxes imposed by the State Governments (and each subject to its own legislative regime and rules). Taxes such as stamp duty and payroll tax are incredibly distortive and will often discourage business transactions and wage growth respectively.
In contrast, the Goods and Services Tax (GST) and its various permutations around the world is widely recognised as a relatively efficient tax to administer and collect and is ultimately borne only by the end consumer. However over time, the many exceptions which form part of the Australian GST legislation and the process required to implement reform have only served to hinder its efficiency. Australia’s GST rate is one of the lowest among developed countries and is roughly less than half the average rate amongst OECD countries. Further, due to the exemptions embedded in Australia’s GST system, a disproportionate level of goods and services consumed in Australia are simply not subject to GST.
In recent times we have also seen that the existing tax laws simply cannot ‘keep up’ with the fast-moving changes which come as a result of globalisation and the digital economy. As a result, we see a patchwork of amendments and administrators scrambling to ensure that the existing system operates as intended – in circumstances that were never intended!
All of these factors provide strong indication that our tax system in Australia is no longer fit for purpose – and is, as foreshadowed in 2015, holding us back.
Where to from here?
It is clear that if structural change is to be implemented this will require a fundamental change in the current modus operandi. A shift in focus to a longer term view of the Australian economic landscape and alignment of key decision makers in achieving both the redesign of tax policy and implementation of a new tax system will be key, as opposed to a ‘piecemeal’ approach to legislative change (or even worse, legislation by announcement) that we have seen in recent times.
It is time to take stock – and start from scratch where required.
At both a Federal and State level, Government should be looking to capitalise on the recent bi-partisan approach adopted amidst the COVID-19 pandemic and should be urged to implement ‘long-term’ structural change that will stand Australia in good stead – not just for the next 12 to 24 months, but for the next 50 years. Where bi-partisan discussions can continue with the aim of re-designing the taxation system in Australia, the result of the next election should not determine the outcome, whether at the Federal or State level.
Whilst I am not an economist and do not have the capacity to conclude the likely financial and revenue impact of each of the following proposals from a revenue perspective, nor do I advocate for or against any of the measures, if the aim of significant tax reform is to achieve simplicity, efficiency and equity, some or all should be considered as part of any re-design of the system.
- Expansion of the GST: Perhaps the simplest change, and that likely to have the greatest impact in the immediate term, would see Australia re-visiting its GST regime with a view to both increasing the rate, but also addressing the vast array of goods and services currently excluded from the regime. Coupling reform with reductions in tax payable elsewhere in the system (or assistance packages for those who need it in the short term) should make this more palatable for the Australian public – although of course the ‘elephant in the room’ is that this will require both the Federal and State Governments to agree on the reforms.
- Entity taxation: The principle of entity taxation adopted by the Australian taxation system, which sees the differential tax treatment of entities taxed based on their type arguably encourages distortion, as investors and business owners seek to structure their affairs in ways that will achieve the most tax-effective outcome.
Although corporate taxes comprise, on average, less than half of the revenue derived from personal income taxes, arguably the recoupment of such taxes could be substantially increased were private companies not used as vehicles to shelter income. Abandoning the principle of taxing based on entity type and taxing businesses similarly (regardless of entity type) might be considered.
Interestingly, the Re:Think paper proposed an alternative to the taxation of small business in Australia by introducing a flow through tax entity similar to the ‘‘S Corporation’’ currently used in the U.S.— essentially a ‘flow through’ entity which allows shareholders to be taxed on the company’s income and losses.
Ignoring the legal form of the business in this way certainly has some appeal in terms of simplifying the taxation of such businesses, and achieving neutrality across business structures, yet still retains the benefit of limited liability offered by companies. A further benefit of treating such companies as ‘flow through’ entities in Australia is that such entities will not retain profits, meaning that income is not sheltered and certain anti-avoidance provisions such as the deemed dividend rules will no longer be required.
Taking this concept one step further might see trusts (other than superannuation funds) taxed similarly to companies, a concept similar to that proposed recently by the Labor Government to introduce a minimum 30% tax on trust distributions.
- Differential tax rates: Whilst the individual progressive rates of taxation support fairness, the various exemptions or benefits available to different segments of the taxpaying community with respect to various categories of income have only served to increase complexity and promote opportunities to ‘exploit’ the system.
For example, whilst income is taxed heavily, proceeds on the sale of capital assets are generally subject to lower rates of tax by way of ‘capital gains tax’ concessions. In practice, this sees a ‘skewing’ of tax payable and greater reliance on personal income taxes – resulting in a broad sense in a reduction to the tax costs of more wealthy (or established) Australians with significant investments, to younger Australians who are instead deriving income predominantly taxed at progressive rates.
The various CGT concessions also serve to increase complexity – with the small business CGT concessions, varying levels of discount applicable depending on entity type and provisions regarding the streaming of capital gains via trusts glaring examples of this.
An exemption from certain capital gains (similar to the approach in New Zealand), or simply a zero rate of tax for capital gains made by small businesses might both operate as alternatives to the use of multiple concessions across the tax system and encourage taxpayers to spend their limited resources on expanding their business and contributing to economic growth, as opposed to managing increasingly complex taxation affairs.
We also see the impact of the differential taxation of income where negative gearing is in play – where taxpayers can reduce their effective rate of tax by offsetting deductions not just against income of the same type, but against all categories of taxable income. Proposals to simplify the complexity of the system and promote efficiency amongst taxpayers may see deductions for such expenses limited to offsetting income of the same source.
In a similar vein, whilst our current imputation system achieves the ‘correct’ result from a purely technical perspective (in terms of the level of taxation on company profits), the removal of refundable franking credits may promote both equity and efficiency, with credits in future simply offsetting any dividend income derived.
- Corporate tax rate: As noted above, the recent changes to the Australian corporate tax rate have only served to increase complexity and aid in the distortion of the rate of taxation of income. One queries also whether a reduction in the Australian corporate tax rate has had the impact on attracting foreign investment, expansion of the economy and creation of jobs as was heralded by its supporters – and now offsets the need to drive the revenue required to meet government debt.
- Superannuation: With an ageing population and a superannuation system which is both horrendously complex and subject to constant amendment, any true tax reform must see the Federal Government revisit and simplify the superannuation regime in Australia.
- State taxes: As was proposed initially with the introduction of the GST (and is hardly a new suggestion, being first proposed by the Henry tax review), tax reform should see the highly distortive stamp duty regimes in each State repealed, or at the very least limited to dealings in land or interests in land, as has been the move in some, but not all, States in recent years. In turn, the land tax regime, which sees tax levied on the value of land in each State and applied equally to all taxpayers could be modernised and expanded.
The removal of payroll tax which is arguably adds nothing other than an additional cost to business (and penalises those larger businesses who are assisting the economy by expanding the Australian workforce) should also be considered.
Australia is generally a stable economy and seen internationally as an attractive place to invest – simplifying and stabilising the tax system can surely only encourage and set the foundation for continued investment.
From the perspective of expanding the Australian economy coming out of COVID-19 and funding the stimulus required to keep the economy on life support, the fact that Australia places such a heavy reliance on taxes that can be easily manipulated, or are subject to significant shifts in a global economic crisis surely also means that Australia must re-visit the basis upon which our tax system is designed.
There are likely to be many barriers to achieving true reform – from the reliance on various levels of Government to work together (and for State Governments to yield some of their autonomy with respect to various taxes), to those vested interest groups likely to lobby against or seek carve outs from particular proposals. Although no system will ever be ‘perfect’, the potential risk of imperfections cannot be allowed to spoil the opportunity created by COVID-19 in light of our current position.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.