Australia's Future Tax System

Final Report: Detailed Analysis

Chapter D: Taxing consumption

D3. Payroll tax

D3–1 Taxing labour income

Labour income (effectively the value-added from working) is the most important tax base for developed countries (see Section A1–2 Income from work and deductions). In Australia, employee compensation (which is the largest part of labour income) has accounted for around half of gross domestic product (GDP) for the past 50 years (see Chart D3–1).

Chart D3–1: Compensation of employees as a proportion of GDP over 50 years

Chart D3–1: Compensation of employees as a proportion of GDP over 50 years

Source: ABS (2009a).

Because payroll taxes are generally levied on all components of employee remuneration, they are designed to tax the value-added from labour. As such, payroll taxes are similar to the labour component of Australia's personal income tax as well as the goods and services tax — they all generate revenue by reducing the real return from working.

Labour is relatively immobile, but high tax rates can deter certain people from participating in the labour market. Therefore taxes on labour income can be relatively efficient. Australia's future tax system will need to raise significant revenues from the value-added by labour. However, as Section A1–2 Income from work and deductions and Section D Taxing consumption show, this value-added can be taxed in many ways.

Who bears the burden of payroll tax?

While businesses are legally responsible for remitting payroll tax, in the long run they are unlikely to bear the burden of the tax (in terms of returns to capital).

In the short run, the situation is not always as clear. Businesses demand labour so they can produce goods and services (to earn a return on capital), while workers supply labour in return for wage income. Who bears the burden of a rise in the payroll tax rate will depend on which factor (capital or labour) is relatively 'inelastic' — that is, which one has fewer options for avoiding the tax.

Different businesses will be in different situations. For example, an increase in payroll tax rates may not feed through to lower wages until wages can be renegotiated. In the short run, businesses can bear some of the burden (or receive some of the benefit) from changes to payroll tax, and many say they do (see Box D3–1).

Box D3–1: Why do businesses feel the burden of payroll tax?

Businesses often lobby governments to lower payroll tax rates or increase exemption thresholds. Why do they do this if payroll tax is actually paid by labour in the long run?

Some businesses may believe they bear the burden of payroll tax simply because they are the ones with the legal liability to remit the tax and are able to observe the compliance costs they incur. However, others may be seeking the short-term profits from payroll tax relief caused by markets taking time to adjust and shift the benefit to labour.

Exemptions have an unpredictable impact on the market. Due to the threshold exemption, for example, a taxpaying firm may be in competition with exempt firms. Each type of firm will have a different cost structure (for example, the taxpaying firms might employ more capital equipment relative to labour). When a growing business in that sector enters the payroll tax system for the first time, it may need time to adjust its cost structure and is likely to make lower profits in the short run.

The opposite may happen if the tax-free threshold rises, taking a small number of competitors out of the tax net, and giving them the chance to make additional profits in the short run. That is, if there is an unanticipated cut in the rate of payroll tax, businesses are likely to enjoy additional profits briefly until competition causes prices to fall or wages to rise.

These effects may lead businesses to conclude that they bear the burden of the tax. While not considering the timeframe issues, Carling (2008, p. 6) takes a similar view, stating that 'even though most of the economic incidence of payroll tax may not fall on employers, the illusion that it does may be so strong that it actually influences business behaviour'.

For example, a business might prefer to locate in a jurisdiction with lower payroll taxes believing this will increase the return to its capital, even if in the long run this actually results in paying employees higher wages.

The 'short run' is an imprecise concept; generally defined as the period during which capital is fixed in its current use. For example, if a business thinks that demand for its product has fallen, it may continue to produce in the short run because it is expensive to move or re-tool the existing machinery. For a capital-intensive manufacturer, then, the short run may be more than a year. For more labour-intensive industries such as house building most machinery is rented, rather than owned, and labour can be adjusted rapidly in response to demand. For these businesses, the short run may be only a few months.

In the long run, investment will flow elsewhere and any plant or equipment will be sold. Capital is very mobile across Australia and the world, whereas workers are less mobile. As a result, a payroll tax reduces the demand for labour, lowering wages to the point where the return on capital is again equal to the world level. Capital owners such as shareholders and lenders will seek higher returns by locating their investment elsewhere. So, while a business may relocate or shut down to avoid the tax, the underlying capital invested in that business will be applied elsewhere in order to earn the prevailing after-tax return. In the long run, the supply of capital is likely to be significantly more responsive (that is, 'elastic') to the effects of a payroll tax than labour. This means that labour tends to bear the burden of such taxes rather than capital owners (Freebairn 2009; IPART 2008; Carling 2008; Ryan 1995). In the long run, payroll tax therefore has a very similar effect to the labour component of personal income tax.

There is one more significant effect of payroll tax — it is likely that all workers, not just those in businesses remitting payroll tax, bear the tax burden through lower wages (Freebairn 2009). In the long run, businesses will pass the burden of payroll tax onto workers, so some workers are likely to leave businesses that remit payroll tax and seek higher wages in businesses that do not. The influx of workers trying to get jobs in the exempt sector means that such businesses will not have to pay as much to attract workers. This means that workers in untaxed businesses receive lower incomes than they would have otherwise, effectively sharing the payroll tax burden (see Box D3–2).

In effect, the narrow-based payroll tax is a tax on all workers, but one that is levied in a very inefficient way because it pushes into the untaxed sector some workers who would be more productive in the taxed sector. This implies a decline in average labour productivity, reducing national income.

Box D3–2: A payroll tax on some firms can affect workers in all firms

Even though a payroll tax may be levied only on businesses with payrolls above a certain threshold, the effect of the tax may be felt by those working in businesses with payrolls below the threshold.

Chart D3–2 illustrates a simple model which shows the impact of a narrow-based payroll tax. The model assumes that the total labour supply is fixed and that businesses are split into two categories: large and small. The tax is only imposed on payrolls of large businesses.

Chart D3–2: The effect on wages and employment of a narrow payroll tax

Chart D3–2: The effect on wages and employment of a narrow payroll tax

Source: Freebairn 2009.

The total labour supply is the distance between SB and LB on the chart. The demand for labour by small businesses slopes downward from the left hand side of the chart (Demand (SB)), while the demand for labour by large businesses slopes downward from right to left on the chart (Demand (LB)). Before a payroll tax is introduced, each worker gets paid the equilibrium wage W0. The distribution of workers in large and small business is indicated by E0; that is, the distance SB–E0 represents the number of workers in the small business sector, and LB–E0 represents the number of workers in the large business sector.

The introduction of a payroll tax on the wages received by employees of large businesses results in each employee now costing the firm more. Demand for labour in the taxed sector therefore contracts, reflecting the extra cost now payable to government, and the new demand curve is shown as Demand (LB tax).

In the short run, wages may be inflexible and large business may have sunk costs that make it costly to reduce wages or withdraw capital. But in the long run, as capital is mobile, large business fully shifts the burden of the tax to workers in the form of lower wages, and the existing LB–E0 workers in the large business sector will have their wages reduced from W0 to W (tax). As wages in the (untaxed) small business sector are still at W0, the prospect of higher wages will entice some large business workers to move to the small business sector. As this movement happens, wages in both sectors converge to W1 and employment in small businesses increases from SB–EO to SB–E1, while employment in large businesses falls from LB–E0 to LB–E1.

There are two main results from this analysis:

  • A narrow-based payroll tax (imposed only on certain employers) will reduce wages for all workers in the economy.
  • The imposition of a narrow-based payroll tax changes the composition of employment, moving some workers away from jobs where they would be more productive (in the absence of the tax).

Principles

In the long run, the burden of a stable labour income tax, such as payroll tax, is likely to fall on workers rather than on capital.

In the short run, however, an unexpected increase (decrease) in the payroll tax burden might be borne partly by the owners of capital through lower (higher) returns.

The burden of a relatively narrow-based labour income tax, such as the current State payroll taxes, is likely to be shared between workers in the taxed and non-taxed sectors. This also means that some workers are not working in their most productive jobs, with the result that overall labour force productivity is reduced.