Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E1. User charging

E1–1 User charging and taxation

Tax revenue is described by the Australian Bureau of Statistics as 'revenue arising from compulsory levies imposed by government. There is usually no clear and direct link between payment of taxes and the provision of goods and services …' (ABS 2005a). In contrast, user charges are voluntary and requited (that is, the person who pays the charges gets something specific in return). In many cases, the distinction is easy to see. Most people would see that there is no direct link between paying income tax and an entitlement to public health and education services. In other cases, the distinction is less clear. For example, while paying a congestion toll means that a driver can drive on a less congested road, many people would value the time they save less than the fee they have paid, even though society as a whole is better off. A congestion toll therefore combines elements of user charge (the benefit of the time saving to the payer) and tax (the benefit to others). See Section E3 (Road transport taxes) for more detail on congestion charging.

The distinction between user charges and taxation is important because user charges tend to provide positive work and saving incentives, while taxes do not. Further, user charges represent voluntary exchanges, while taxes rely on the coercive powers of the government. Making transparent the distinction between taxes and user charges is therefore important if citizens are to be able to hold their governments accountable.

What probably matters most, however, is whether the government is reflecting the social costs and benefits of the goods and services it is providing when it sets prices, regardless of whether the revenue raised through those prices is classified as tax revenue or user charges.

The Australian and State governments also levy a number of minor taxes. Many apply to narrow bases and are motivated by specific social or industry policy objectives. Many appear to have been introduced as 'user charges' for government-provided goods or services, although in some cases it is not at all clear that they do function as such. This section sets out a framework for assessing user charging arrangements and minor taxes that may appear to function like user charges. Section E8 (Rationalising other taxes) addresses insurance taxes, luxury car tax, tariffs and minor taxes specifically.

What is efficient pricing of government-supplied goods and services?

The key criteria for determining how to price government-supplied goods or services efficiently are:

  • rivalry — that is, the extent to which consumption by one person affects the consumption opportunities of others; and
  • excludability — that is, whether people can feasibly be prevented from enjoying the goods and services in question.

For example, it is currently not feasible to charge a car for driving on a remote country road (that is, it is not excludable), and such a trip would generally not affect anyone else's ability to use the road (that is, it is non-rivalrous). Many country roads therefore have the attributes of a 'public good'. However, cars compete for road space in the central business district of a large city during peak hours. The presence of congestion, as well as available tolling technologies, reduces the 'publicness' of some roads (see Section E3 Road transport taxes). Different goods (and services) can be categorised according to their degree of rivalry and excludability.

  • Public goods, such as national security, are both non-rivalrous — access by one person to the benefits of national security does not diminish the benefits to other people — and non-excludable — it is not possible to exclude anyone in the country from the benefits of national security. Thus, these cannot be charged for and should be funded out of taxes.
  • Club goods, such as a suburban swimming pool, are non-rivalrous — there is enough space for everyone to enjoy the pool (except on very hot days) — but excludable — you need a ticket to enter.
  • Common pool goods, such as fishing grounds, are rivalrous — past a certain point, an additional fisher reduces the fish available to others — but may be non-excludable for various reasons, for example, if it is unclear who owns the property rights.
  • Private goods, such as apples, are both rivalrous (only one person can eat a particular apple) and excludable (the owner of an apple can prevent others from eating it).

In general, markets will price private goods appropriately — sellers and buyers have incentives to reveal how much they value them. If they do not reveal their preferences, their competitors will get more business or other consumers will buy the goods and services instead.

Governments sometimes choose to finance the provision of private goods, such as electricity or postal services. (The term 'private' here does not refer to whether a company or government is the supplier, but the physical qualities of rivalry and excludability.) They may do so for many reasons, such as a community concern that people should consume more (or less) of a particular product than they would if left to the market, or that particular markets are unfair because their operation makes it impossible for people to develop the capabilities they need. Sometimes governments may be concerned about businesses making excess profits from undue market power. At others times, the provision of private goods may be a legacy of historical factors.

Providing public goods is a core function of government, mainly because markets tend to fail — sometimes dismally — to supply sufficient amounts of public goods. Markets undersupply public goods because people have an incentive to hide how much they value them in the hope others will pay for them — this is known as the 'free rider' problem. For example, if a single voter is asked to contribute to defence spending, they would have an incentive to under-report their own valuation of defence, knowing that if they pay for some defence the benefit would be shared with 22 million other Australians. Individual voters can free ride on payments for defence made by other people. In contrast, if the voter buys an apple they know that they will get all the benefit and will not be obliged to share it with others. People cannot free ride on the purchase of apples by others.

When a good or service is non-rivalrous there can be significant social benefits from some form of co-operative collective decision making about how much should be produced. This is because when a non-rivalrous good is produced, everyone can benefit from it at no cost. When a good or service is non-excludable, individuals have incentives to act individually and unco-operatively. Each person is tempted to exploit the commons for their own direct wants and needs.

Governments therefore have a clear role in financing the provision of public goods. They should generally not charge for public goods because, as they are non-rivalrous, it would be wasteful to discourage someone who wants a public good from accessing it.

In some cases, the appropriate pricing regime is not easy to determine because very similar goods and services may call for significantly different prices. For example, the Australian Bureau of Statistics (ABS) provides statistical releases on the internet at no charge. This information has some of the characteristics of a public good. Charging for access to the data would mean some people who value it would not use it, even though there is no material cost to the ABS (and the taxpayer) once the data is compiled.

In contrast, users who want the same information in book form do need to pay a user charge. Only a limited number of people can read a book at one time, making it rivalrous in consumption. Charging for the (marginal) cost of providing the book encourages people to reveal how much they value it, as well as providing the ABS with information on how many to print. This means the book goes to those who value it most and the right amount of resources is more likely to be devoted to supplying it. Importantly, as well as sending signals about value to producers and consumers, user charging relieves the need for the book to be financed from revenue collected through other economically inefficient taxes.

A simple categorisation is illustrated in Chart E1–1, with a suggested funding mechanism for each type of good or service.

Chart E1–1: Funding public goods

  Rival in consumption Non-rival in consumption
Excludable Private good
e.g. apples
[user charge]
Club good
e.g. agricultural levies
[beneficiary taxation]
Non-excludable Common pool resource
e.g. fisheries, forests
[user charge]
Public good
e.g. national defence
[general tax or corrective tax/regulation]

Of course, this is only a starting point for setting prices for government goods and services. Many goods have 'mixed' attributes that make efficient pricing difficult. A country road is close to a public good, whereas when it branches off to a specific farmhouse it becomes more like a private good. A local road system has the attributes of a club good, whereas when it becomes congested it is more like a common pool resource. This means that the ability to appropriately price goods is often limited by transaction costs, such as the costs of pricing technology or other administrative costs. Policy makers need to consider the costs of collecting and enforcing user charges or narrowly based taxes. It is unlikely to be worth the trouble or cost to set up congestion pricing system on a country road. This means charges may not fully reflect their marginal (social) cost — all drivers are charged the same price. Businesses make such decisions all the time. For example, some insurers have only recently moved to charging drivers premiums based on their actual mileage even though this is a relevant indicator of the chance of a claim. Those insurers that are not offering such a policy have effectively made the decision that it is too costly to remove existing cross-subsidises from short to long distance customers.

When such decisions reflect commercial choices, resources are likely to be allocated efficiently. However, governments sometimes make these decisions for equity or other reasons. For example, some States charge compulsory third party motor vehicle insurance without reference to actuarial risks, implying significant transfers between drivers unrelated to reducing transaction costs. There may also be 'second-best' reasons why full optimal pricing may not be appropriate. Sometimes problems in other markets influence the ability to set prices for some goods and services. For example, public transport may need to be subsidised so long as roads continue to be provided 'free' to users. Another example is a waste disposal fee that needs to be set with reference to the risk of illegal dumping.

Governments may also have other social objectives (apart from efficiency) for setting prices, such as a desire to provide merit goods or achieve equity objectives by helping people to develop the capabilities they need (see Box E1–1). Whenever prices are set for any but commercial reasons, the purpose and value of implied transfers should be transparent to the community.

Box E1–1: User charging in Australia's health care system

While most government-provided health care is free to users, some parts of the system do have some form of user charging. For example, the Australian government requires people to make a co-payment for pharmaceuticals under the Pharmaceutical Benefits Scheme, and the States charge for some services, such as ambulance transport. Individuals and families may also pay user charges to non-government health care providers; for example, by paying for a private hospital visit or for private health insurance, although these premiums may be subsidised.

A mixture of charging arrangements is appropriate as health care can be considered to be a public, private or merit good. Charging for a public good, such as medical research, is often not efficient as it is not possible to exclude people from benefiting and the benefits provided are generally not constrained by the number of people receiving them. Charging for private goods — such as a private room in hospital — can support the efficient supply of health care by ensuring that the services provided respond to the price people are prepared to pay. However, even though some goods may appear to have private benefits, certain types of health care, such as child health, can also be considered a merit good that people should be able to obtain regardless of their personal preference or ability to pay. For example, full user charging may not be appropriate where health care generates spillover benefits, or where user charges may restrict access to goods and services deemed important for public policy reasons, or where they would impose high costs on those with high needs.

Where full user charging is not appropriate, partial charging (such as co-payments), safety nets and direct government transfers can also play a role in supporting access to health care services. While these mechanisms deliver a weaker price signal than full user charging, the value of these arrangements is that they still provide a price signal to users but are less of a barrier to access and also protect people from high health care costs.