Australia's Future Tax System

Final Report: Detailed Analysis

Chapter D: Taxing consumption

D3. Payroll tax

D3–3 Broad-based taxes to capture the value-add of labour?

Recommendation 57:

State payroll taxes should eventually be replaced with revenue from more efficient broad-based taxes that capture the value-add of labour.

The Review has considered replacing the existing payroll taxes with a tax on employee remuneration administered through the pay as you go (PAYG) withholding system. However, a more efficient, equitable and sustainable means of taxing labour income would be a broad-based consumption tax.

Consumption is made up of labour income and any excess returns to other factors of production (such as capital). In particular, a broad-based consumption tax would be applied to all businesses selling goods and services, including the self-employed. As the base is broader than just labour income, the rate of tax would need to be lower for any given revenue target, making it more efficient and arguably more equitable than simply taxing the labour income component only. As the base includes labour income, there is little reason to have both a payroll tax and a broad-based consumption tax operating at the same time.

Administer payroll tax through the PAYG system?

One alternative option is to collect a single-rate tax on labour income through the PAYG withholding system. As it would utilise one existing system, this would be simpler than having many payroll taxes, and avoid many of the latter's inefficiencies. Because it would be on the personal income base, there would be limited opportunities for exemptions, improving the sustainability of the base. If the States prefer that the new arrangements reflect the revenue-raising autonomy currently provided by payroll tax, it would be possible for the States to vary (within limits) the rate applied to their residents, and to disclose the amount paid by each employee on their annual notice of assessment issued by the ATO.

However, without other reforms, this approach would create incentives for some employees to become independent contractors and for self-employed people to convert their labour income into capital income (by reinvesting it in the business instead of paying themselves a wage). There might be concerns about the impact on many small businesses who might find it more difficult to attract workers. Further, some people may be concerned about the equity of a single-rate labour income tax. Finally, a number of administrative issues would need to be considered, such as how to deal with employees whose wages are below the tax-free threshold and are not currently in the PAYG withholding system.