Australia's Future Tax System

Consultation Paper

Section 2: The structure of the tax-transfer system

Overview

Australia's tax-transfer system spans three levels of government. In legal form it is comprised of the many different taxes and transfers designed and administered by government. It can be considered a single economic system that, through complex interactions between elements, impacts on a broad range of choices made by individuals and business. While the various elements affect economic decisions in similar ways, key differences exist between, and within, taxes and transfers in terms of their underlying structural elements.

2.1 The legal structure of the tax-transfer system

The Architecture paper provides a detailed description of Australia's tax-transfer system. Chart 2.1 provides a schematic representation of its major elements and the key linkages between them.

In Australia's federal system of government, taxes and transfers are administered by three levels of government. The Australian government's role is considerably larger than that of state and local governments. The types of taxes and transfers administered by each level of government differ, though there is considerable overlap in their roles and impacts.

Individuals interact directly with five elements of the Australian government tax-transfer system: personal income tax; family assistance; superannuation; taxes on goods and services; and income support payments and supplementary transfers (including cash payments and concessions). Through the personal income tax system, via dividend imputation, individuals also interact with company tax.

On the state and local government side, individuals interact with a more restricted transfer system and a range of indirect taxes and property taxes. They may also be indirectly affected by payroll tax via their employer.

The tax-transfer system not only impacts on individuals but also on business. Business remits most personal income tax to the Australian Taxation Office (ATO) through pay as you go (PAYG) withholding. Businesses may be required to pay fringe benefits tax (FBT) and make superannuation guarantee payments on behalf of their employees. Businesses also interact with the tax-transfer system in their own right — for example, through the company income tax system, the payment of payroll tax, GST, excise, various taxes on land, and a range of other taxes levied on business inputs (Chart 2.1). Businesses operating in more than one state, or nationally, interact with multiple Australian, State and local government tax systems.

Chart 2.1: Schema of the tax-transfer system

Chart 2.1: Schema of the tax-transfer system

2.2 The economic structure of the tax-transfer system

The separate Australian, state and local government systems are interlinked and can be thought of as one tax-transfer system with multiple components. At the core of the system are Australians who make choices about: investing in education; engaging in paid or unpaid work (such as family care responsibilities and home services); how much to spend and on what goods and services; and how much to save and allocate to alternative investments. The different elements can have similar economic affects, which combine to influence individuals' incentives and behaviour.

All taxes affect choices by encouraging individuals to shift from higher to lower taxed goods and services or activities, and by lowering their available purchasing power. Similarly, transfers can influence people's choices by increasing their available purchasing power and altering the relative price of particular goods or services. The Architecture paper captures this similarity in its reference to 'transfers act[ing] like reverse taxes'. The Panel's approach is to consider how the many elements of the tax and transfer systems combine to affect individuals' decisions.

In some cases, the income and relative price effects described above work in opposite directions, making it difficult to identify the net effect. For example, a higher tax on labour income may reduce a person's willingness to work (as the after-tax return from work is reduced) but also have an opposite incentive effect through the person's desire to make up the reduction in after-tax income caused by the tax increase.

Given the strong parallels between the impacts that taxes and transfers have on individuals' behaviour, it is important to apply a whole of system perspective when considering its implications for equity, efficiency and overall social wellbeing.

To illustrate this point, it is useful to consider how the tax-transfer system impacts on individuals' decisions about how much to work. In the absence of taxes and transfers, individuals make decisions to work and consume based on their preferences for leisure, home production, (see Box 2.1), volunteer work and income with which to purchase goods and services. Taxes reduce the income an individual derives from working and therefore can influence how much they work and how much time they spend on leisure or other private activities such as house repairs, housework and child care. The availability of transfers for people with low workforce connection might also reduce the attractiveness of being employed, resulting in an even lower level of workforce engagement.

Additional income may also reduce entitlements to other payments such as Rent Assistance, public housing subsidies, Child Care Benefit, the Education Tax Rebate and eligibility for other concessions, such as concession cards and in-kind benefits.

Box 2.1: Home production

Home production is the private production of goods and services within the household. This includes activities such as home repairs, washing, cleaning, other housework, and child care. It represents a sizeable part of the economy, although it is not included in measured GDP. The Australian Bureau of Statistics estimates that it was worth 40 per cent of GDP in 1997 (ABS 2001). The 2006 census found that 39 per cent of women contribute more than 15 hours of domestic work per week, while for men the figure is 13 per cent (ABS 2007a).

Since home production is untaxed1, taxing paid employment can affect people's workforce participation choices. Within a household the tax-transfer system may influence the allocation of and specialisation in paid and unpaid work between members. Discussions about the equity of different taxation arrangements need to take into account the value of home production when considering household welfare.

1 Inputs to home production, such as electricity, are taxed through the GST, and homes cannot be depreciated for tax purposes, unlike work premises.

It is the interaction of these various elements of the tax-transfer system and people's awareness of them that influences behaviour. The complex interactions highlighted above are repeated throughout the tax-transfer system (Box 2.2 provides other examples). Understanding how they affect the economic decisions of individuals is challenging.

Box 2.2 Impacts of the tax-transfer system on decisions to save and consume

Several elements of the tax-transfer system interact simultaneously on decisions to save. In many cases, saving is likely to generate income that is taxed. Many forms of saving also affect transfer payments, through income and assets tests. Individuals are likely to consider the impact of savings, and the form of their savings, on tax liabilities and transfer entitlements as part of their savings decision.

Decisions about consumption choices are also affected by the tax-transfer system in a number of ways. Different taxes are levied on different goods and services — for example, GST-free fresh foods and additional taxes on some goods such as alcohol and tobacco. Governments also provide a range of rebates, payments and concessions linked to particular items of consumption (such as private health insurance, education expenses, child care assistance, and transport and utilities) and provide a range of goods and services directly to individuals (such as education and health services).

The concept of a total effective tax rate provides a way of assessing the net financial impact of the system on the economic decisions of individuals. For example, in the above scenario the effective tax rate would, in principle, take into account the effect of the system on the return to the individual from working by including all taxes and reductions in transfer payments. In practice, such measures are more limited. They do not usually include all factors. Eligibility for rebates, concessions and in-kind benefits can be closely linked to individual circumstances, making them difficult to represent in a generalised measure.

Effective tax rates are often analysed on the basis of taxes levied directly or very closely on the individual. However, a much broader range of taxes can ultimately influence the returns from working and other economic decisions of individuals. All Australian taxes are ultimately borne by individuals (resident or non-resident) on the earnings from the factors of production — labour, capital and land (including natural resources).1 Taxes are levied either on the income derived from these factors or on the use of that income to consume goods and services. Individuals pay these taxes in a range of ways, including as consumers through higher prices, as employees through lower wages, or as shareholders or investors through lower profits. Chart 2.2 provides an overview of how some of the main Australian taxes relate to income derived from these factors of production.

Chart 2.2: Relationship between economic bases and taxes

Chart 2.2: Relationship between economic bases and taxes

It does not matter whether the taxes are levied on activities, entities, goods or transactions, all taxes are ultimately paid out of the incomes of individuals. Taxes can be shifted from one person to another through changes in the prices of inputs to the production process, the price of goods produced, or in the distribution of the returns to economic activity. The true burden of a tax is not its 'legal incidence' (the person who is required to pay the tax to the administering authority) but its 'economic incidence' (the person who ultimately bears the cost burden of the tax). The economic incidence of a tax is much less obvious than its legal incidence, but it is the economic incidence that is important when considering the efficiency and equity implications of the tax-transfer system.

Similarly, it can be difficult to determine who ultimately benefits from some forms of transfer payment. This is particularly the case for transfers delivered through markets or tied to the purchase of particular goods or services, such as child care subsidies, the private health insurance rebate and subsidies for renters in private housing. In these cases it can be unclear to what extent it is the individual or the provider who gains the benefit of the transfer. The Age Pension may be another example. Increases in Age Pension payments reduce the need for individuals to draw on their own savings to finance their retirement, which can result in them making larger bequests. Thus, the ultimate beneficiary may be the pensioner's descendents.

A system of two parts — taxes and transfers

Notwithstanding the integrated nature of the tax-transfer system in terms of the way it affects the economic behaviour of individuals, key differences exist between, and within, taxes and transfers in terms of their underlying structural elements. There are different definitions of income, assessment periods and treatments of assets. There are also different approaches in categorising individuals and units of assessment. Section 4 discusses the implications of these structural differences.

The definition of income

A range of approaches to defining income are applied within the tax-transfer system. This means different forms of income have different impacts on tax liabilities and transfer entitlements.

The general principle guiding the existing income definition for taxation is that the costs of producing income should not be included in the tax base. For example, work-related expenses and the costs of investment are excluded. Certain other amounts (such as contributions to charities) are also excluded, as are fringe benefits (which are largely taxed in the hands of the employer). However, certain taxes and liabilities (such as the Medicare levy surcharge and the Higher Education Loan Program) are based on a broader definition of income, which includes some types of exempt income (such as foreign income) and fringe benefits.

Income support payments (pensions and allowances) use an even broader definition of income. This definition includes a range of income types on a gross receipts basis. Income defined in this way is not reducible by losses and is only reducible by deductions in limited circumstances. Eligibility for certain other transfer payments is based on taxable income with adjustments to make it more comprehensive. These transfers include Family Tax Benefit, Child Care Benefit, the Child Care Tax Rebate and the Commonwealth Seniors Health Card.

The income assessment period

Taxes are generally assessed on annual income, though regular tax payments may be made throughout the year. For example, for most personal income taxpayers, employers withhold amounts on a regular basis through the year as part of PAYG withholding, and the individual's final liability is assessed after the end of the year.

Transfer payments have various assessment periods. The assessment and payment period for allowances is generally a fortnight. This is intended to make both the entitlement and the rate of payment responsive to changes in the individual's circumstances. For pension payments, unearned income is assessed annually, even though pensions are paid fortnightly. While earned income is annualised for Age pensioners, it is assessed fortnightly for other pension payments.

Eligibility for family assistance is assessed against annual income, although it is generally paid on a fortnightly or quarterly basis. Family assistance is, in effect, pre-paid during the year, with amounts reconciled after the end of the income year.

The treatment of income from assets and asset holdings

The tax and transfer systems have very different treatments of the income earned from assets. The personal income tax system includes earnings from capital as part of an individual's assessable income, and taxes capital gains upon disposal at half the rate applied to other income.

The definition of adjusted taxable income used for family assistance (and certain taxes) follows this treatment. In contrast, the concept of income that underpins entitlement to pensions and allowances includes actual earnings on non-financial assets, such as real estate (excluding net losses) and a deemed rate of earnings on financial assets.

While the personal tax system generally does not tax asset holdings, certain transfer payments are affected by the value of an individual's assets, other than their home, and those of their spouse. Assets over a certain threshold value reduce entitlements to income support. Recurrent taxes based on asset values are similar in effect to an income test with a deemed rate of return. Neither the value of a person's own home nor the value of the rental services derived from their home are assessed when determining taxes or transfers.

Categorical structures

The tax and transfer systems adopt different approaches to the categorisation of individuals.

The transfer system provides different income support payments for retired people, unemployed people, those with dependent children, those with other caring responsibilities, students, and people with disability who have little or no capacity to work. People demonstrate their membership of these categories in various ways, such as by fulfilling an age requirement, having an eligible disability, or by meeting an activity test relating to work, study or training.

Some commentators note that such an approach offers a way for governments to separate the population into groups and offer them different outcomes according to notions of who is most deserving or needy and how different groups are likely to respond to different incentive structures. However, categorical approaches create an incentive for individuals to try to change their category (Akerlof 1978, Moffit 2008). Family assistance is mostly provided to eligible families without reference to the way parents approach their role.

The tax system is less categorical. In general, individuals face the same requirements regardless of their activities or status. There are two key departures from this approach. One is age-based taxation — the effective impact of the senior Australians tax offset is to provide a higher tax-free threshold for those of Age Pension age. The second is through occupation and sector-specific benefits, such as income exemptions for certain defence force and foreign income, and through special FBT provisions for not-for-profit sector employees (see Section 7).

The unit for taxation and transfers

All transfer payments are assessed and paid on a couple or family basis. Income support payments take into account the income of a spouse or partner, while for Youth Allowance, parental income is taken into account. Family assistance is also based on couple income, but the number and age of children determines the level of payment. There is also consideration of child income. However, the way in which the couple's income is assessed varies. For pensions and most family assistance payments, it is pooled for assessment purposes, while for allowances and Family Tax Benefit Part B, there is different treatment according to which partner receives the income.

The primary taxation unit is the individual, which is used for the assessment of personal tax. The individual's various sources of income are drawn together and taxed as one whole. Income from directly carrying on a business or through a partnership is included in the income of the individual.

Some minor elements of the tax system are based on couple or family units. In some cases, these entail pooling of income entitlements of a couple. This applies to the Medicare levy low income phase-in, the Medicare levy surcharge and the Education Tax Refund (through its link to Family Tax Benefit Part A). Other elements are calculated with separate reference to the incomes of both members of a couple (without pooling), as is the case with the dependent spouse rebate and the senior Australians tax offset.

Individuals may choose to conduct their affairs (business and investment) through trust arrangements. Trusts, especially discretionary trusts, provide opportunities to allocate income between different individuals. Many trusts are constructed around family relations, which can effectively give rise to a form of family-based taxation. A number of submissions express concern that people who can access this mechanism are able to minimise the tax payable on a given amount of income by allocating it to individuals with lower personal tax rates.

Individuals may also conduct their affairs through companies. Companies are taxed as a distinct entity. They file their own tax returns without reference to the financial position of their shareholders. Imputation, whereby individual shareholders receive credits for underlying Australian company tax paid on distributed dividends, creates a degree of integration with the individual unit for tax purposes. However, this integration is incomplete. For example, when companies retain rather than distribute earnings, those earnings are taxed at the company rate, rather than at the shareholder's tax rate. There are also differences in the treatment of some types of income or expense, such as capital gains and losses.

'Closely held' private companies can offer similar opportunities to trusts in achieving family-based taxation. This can arise where companies are owned by family members, pay wages to family members or allow family members to use company assets for private purposes.

Most individuals hold savings in superannuation funds. While these holdings are based on individual accounts, the taxation of these accounts is independent on the individual's circumstances. Earnings within an individual's superannuation account in a taxed fund are taxed at a flat rate of 15 per cent regardless of the income level of the individual. Some degree of integration occurs when funds are drawn before the age of 60 years or from untaxed funds after the age of 60 years.

Indexation

The tax and transfer systems use a range of different approaches to maintaining the value of rates and thresholds over time.

Personal income tax thresholds are not indexed. Instead, governments may counter the effects of inflation by taking specific decisions to provide tax cuts through a combination of changes to rates, changes to thresholds or adjustments to the low income tax offset. While the general rates and thresholds are not indexed, some components of the personal income tax system are indexed, either by wages or prices. For example, the dependency tax offset amounts are indexed by consumer price index (CPI) (provided this entails an increase); the superannuation co-contribution and spouse superannuation contributions offset are indexed by average weekly ordinary time earnings; while the senior Australians tax offset, the mature age worker tax offset (MAWTO) and the Medicare levy low income phase-in are not automatically indexed.

Most payment rates and thresholds within the transfer system are indexed, given its goal of responding to income needs. Pensions are indexed to a male total average weekly earnings (MTAWE) benchmark, ensuring they maintain their value relative to MTAWE over time. By contrast, allowances are indexed by CPI, ensuring they grow at the same rate as general prices. This distinction is resulting in an ever-widening gap between pension and allowance rates. Family assistance is indexed by CPI, with additional provision for increases in accordance with a MTAWE benchmark for the standard rates of Family Tax Benefit Part A. Supplementary payments are indexed by CPI.

In addition to influencing the value of rates and thresholds over time, inflation influences the value of income generated by assets. Parts of the income generated by assets reflect compensation for inflation that occurs during the period the asset is held. No indexation is applied in calculating the measured income from assets in the tax-transfer system.

2.3 The administrative structure of the tax-transfer system

Chart 2.3 outlines the administrative framework of the tax-transfer system from a broad perspective that includes policy formation, implementation and the resolution of disputes between administering authorities and taxpayers/transfer recipients. Section 2.10 of the Architecture paper contains a detailed description of the administrative arrangements governing Australia's tax-transfer system.

The transfer system is reflected in the upper half of Chart 2.3, the tax system in the lower half. While represented as spatially separate, there are strong links between the tax and transfer components at the Australian government level. These links exist through the income tests that apply to transfers and because some transfers are delivered through the tax system. At the state level, there are also interdependencies between the tax and transfer systems, with both mechanisms being used to deliver assistance to target groups.

Chart 2.3: Administrative and governance framework of the tax-transfer system

Chart 2.3: Administrative and governance framework of the tax-transfer system

The state tax and transfer systems operate parallel to the Australian government systems, again with links between them. For example, some state transfers such as subsidies and concessions are linked to Australian government transfer policy through concession card arrangements. GST policy is coordinated through the GST Administration Sub-committee (GSTAS). The states also interact more broadly with the Australian Taxation Office (ATO) under information sharing agreements to ensure that consistent information is used across the Australian government and State tax systems.

Another important aspect of the administrative system, broadly defined, is the private sector industry devoted to compliance with tax and transfer law. A higher proportion of Australians use tax agents than in most other OECD countries. Two major studies of the cost of complying with the main Australian Government taxes, both conducted before the significant reforms contained in The New Tax System and the Review of Business Taxation, estimated total taxpayer compliance costs between 1.4 and 2.1 per cent of GDP (Evans et al 1997, Pope 1994).


1 The division of the factors of production into these three categories reflects both a traditional and very simplified approach. More complex divisions may be possible. For example, the returns to entrepreneurship and to education may embody elements of both capital and labour, as well as components that give rise to multifactor productivity. However, these more complex divisions are not necessary for the purposes of this section.