Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E1. User charging

E1–4 Public goods should generally be financed from broad-based taxes

In general, tax revenue should be raised from one of the broad tax bases of income, consumption and land. The broader the base, the lower the rate needed to raise a given amount of revenue and the lower the efficiency costs of doing so.

Market failure can be addressed by taxation

There is a strong case for governments to use policy instruments, such as taxation and regulation, to address market failures. Where some activities result in unintended costs being imposed on others (spillover costs), there may be a role for a tax or regulatory fee. A 'public bad' is an extreme form of negative spillover where the same 'bad' imposes costs on everyone. The case for using taxation to target negative spillovers is discussed in Section E2 Taxes to improve the environment. Generally, taxation can be an appropriate tool for addressing negative spillovers where the social cost can be targeted and is highly correlated with a taxable activity.

Regulation can be used in a similar way to correct negative spillovers. For example, regulation of food preparation may mean an unhygienic restaurant faces sanction for causing harm to others, such as illness for its customers and loss of reputation for similar restaurants. Ideally, the unhygienic restaurant would face costs commensurate with the marginal social cost it imposes: the greater the risks it imposes, the more severe should be the costs.

Regulation can impose costs on people by enforcing a particular standard — for example, the unhygienic eatery needs to employ another cleaner — or by charging a fee or fine. To be efficient, the standards, fee or fine need to reflect the spillover cost. Ideally, restaurants that do not impose spillover costs should face little or no regulatory costs.

When regulatory costs are out of all proportion to actual social costs, they take on the attributes of a tax designed to raise revenue, rather than a regulatory cost correcting for a market failure. In some cases, charges that purport to recover the costs of regulation do so imperfectly and do less than they could to secure the efficient allocation of resources by the regulated industry (see Box E1–4).

Box E1–4: Passenger movement charge

The Passenger Movement Charge (PMC) is a fee of $47 imposed on passengers departing Australia. It raised $420 million in 2007–08.

The PMC was originally introduced to recover the costs of customs, immigration and quarantine processing of passengers entering and leaving Australia, as well as the cost of issuing short-term visitor visas (Senate Standing Committee on Legal and Constitutional Affairs 2008). However, the charge does not recover all the costs of border services, nor does it reflect specific costs. It falls primarily on international passengers and international airlines even though airports, cargo planes and domestic passengers — as well as the broader community — all contribute to the need for border services and benefit from them.

As the PMC does not provide meaningful price signals related to the costs or risks associated with border protection, and is on a relatively narrow base, other sources of tax revenue would be more efficient. Further, the funding provided by the charge may impede the adoption of more efficient cost recovery, such as charging airports directly for some of these services.

The regulatory cost acts like a tax even if the regulation is imposed by standards, rather than fees or fines. If a restaurant is forced to adopt costly procedures — such as new equipment or additional staff — that have no effect on hygiene, then this becomes income to those who provide such goods or services to the restaurant. Alternatively, the restaurant would have an incentive to invest in improving hygiene up to the point where the costs are around the same as any potential fine. In the absence of uncertainty, a fee and a standard would produce similar outcomes. However, where there is uncertainty about how much a business would need to spend to meet a standard, imposing a fee is likely to be more appropriate. Similarly, where there is uncertainty about the size of the costs imposed on others, setting a minimum standard is likely to be most efficient.

Recovering regulatory costs from those who cause the spillover effects has a number of advantages. First, so long as regulatory services are supplied efficiently, regulatory fees or fines should recover the marginal costs of the activity that can be attributed to particular producers (or consumers). These costs will then feed into the prices of the final goods and services (see Box E1–5). Otherwise, the goods or services would be too cheap and too much would be produced and consumed. For example, if the costs of quarantine were not recovered properly, then imported goods and services posing risks to the community would have a competitive advantage over other, less risky goods. Included in the attributable costs should be any administration costs from the regulation. Regulatory administration costs should be cost-recovered, since they are one part of the social costs that the community bears from quarantining goods. In the absence of the spillover, those administrative resources could be used elsewhere.

Box E1–5: Recovering the costs of regulation

Where there is a market failure, due, for example, to information asymmetry about the standard of food preparation, regulation can play an important role in enhancing the wellbeing of society. Without such intervention a number of transactions which would improve each party's wellbeing would not occur as, due to the information asymmetry, one party would not be sure of the quality of the product they were purchasing (even though it actually meets their requirements).

Therefore, government regulation of the market reassures consumers that the product they are purchasing will be of an acceptable standard. Correcting this market failure provides benefits to both the producer (who will be able to sell more) and to those consumers who will either avoid purchasing poor products or now consume where before they would not.

However, regulations are not costless — resources to design, implement and enforce them need funding. Using general taxation to fund this cost is both inequitable and inefficient. It is inequitable, as it imposes a cost on people for regulating this market even though they do not benefit from the transactions occurring in it. It is inefficient, as those operating in the market would not face the true cost of their activities, and hence more than the socially optimal amount would be produced and consumed.

A better alternative is for the beneficiaries of the regulation (that is, the producers and consumers of the product) to bear the cost associated with it. It is generally most cost effective if the producer faces such charges, with the true economic cost of the regulation likely shared between the producers and consumers, depending on the elasticities of the product demand and supply (which determines the extent to which producers can pass on the cost of the regulation).

Importantly, these costs should not be over-recovered as this would constitute a tax on the particular product. This would reduce transactions that would otherwise generate value for each party, thereby reducing their wellbeing and that of society as a whole.

Second, recovering regulatory costs means that businesses can take steps to reduce the need for regulatory services (or other businesses can compete to provide the relevant goods or services in less risky ways). When regulatory services are funded from taxes, regulated industries do not face the full social costs of their actions. Businesses with riskier practices pay no more than businesses that are successful at managing risk. In the face of competition, businesses that spend money on effective risk management are worse off (see Box E1–6). This increases the burden on both the regulator and the taxpayer.

Finally, those who pay regulatory charges have an incentive to monitor the quality of the regulatory services and lobby government for better services or lower costs. This reduces the likelihood that regulatory services will be provided inefficiently.

Box E1–6: Recovering the costs of the Civil Aviation Safety Authority

The Australian government taxes gasoline and kerosene used in domestic aviation. In 2007–08, the aviation fuel excise rate was $0.02854 per litre and raised around $75 million in revenue. The revenue is allocated to the Civil Aviation Safety Authority (CASA), which sets and enforces safety standards for the civil aviation sector. It constitutes around one half of CASA's total net resourcing.

CASA ensures aviation safety through operational surveillance, spot checks and audits, based on the risk profile of the organisation. A large, complex charter operation is inspected more often than an aerial work operation with only an occasional charter. However, since half of CASA financing comes from taxing aviation fuel used in domestic flights, airlines pay for regulation according to how much fuel they use on domestic trips, no matter how risky their operations are. Reforming CASA fees to recover costs from those requiring tighter regulation (and therefore imposing the spillover costs) would improve the efficiency of the airline industry.

However, the introduction of taxes, fees or charges that better reflect risk may have unintended effects on existing players. For example, in the case of aviation it might reduce the costs of larger airlines (who currently bear a large part of the aviation fuel excise), but increase the costs of smaller charter operations that service regional and remote communities. To the extent that such services are considered socially important — for example, because they ensure access to medical services — they could be funded directly from the budget, rather than aviation excise.

At times, governments may not want to charge for regulatory services because that would conflict with other social goals, such as concerns for equity. In addition, some forms of regulation are not attributable to a specific negative spillover. In such cases, a regulatory fee acts like a relatively inefficient type of tax. For example, governments sometimes encourage pooling of losses in some markets subject to insurance market failures. Examples include some small State taxes on the sale of cattle, sheep and goats (or their carcasses) to compensate pastoralists in case they are obliged to destroy their stock because of an outbreak of disease. Most States charge compulsory third-party insurance at fixed fees, but because risks vary across drivers, this means that low-risk drivers are subsidising high-risk drivers. In contrast, New South Wales imposes compulsory third party insurance, but with actuarially based fees. These appear to be cost recovery regulatory charges.

If regulation is effective and delivered at least cost, all market participants can potentially be better off. But regulation often benefits certain market participants more than others, leading to some redistribution. The worst types of regulation may harm community welfare while benefiting sectional interest groups. In such cases, regulation is like a tax where all of the revenue flows to a particular group.

Principles

Public goods should generally not be charged for, but financed through general taxation.

Government costs associated with the administration and enforcement of regulation should be recovered by targeted charges or taxes, rather than being funded out of general tax revenue.

Cost recovery taxes should be levied on the parties who are best able to reduce the external costs of an activity. This is normally, but not necessarily, the parties whose activities impose costs on others.

Cost recovery taxes need to be subject to regular and systematic review to ensure that they reflect the cost of providing the regulatory service and that the service is provided in the least costly way.

Narrow-based taxes may be a high cost way to finance spending

Narrow-based taxes that do not target social cost or provide signals on the value of a public good are no more than a relatively high cost means of raising revenue. Two types of relatively narrow-based taxes that are sometimes used are universal service obligation (USO) levies and industry restructuring levies.

Universal service obligations

Governments can impose USOs on some service providers, such as phone, electricity and postal services. USOs can require the provider to provide a service to a particular standard or to certain groups. This requirement needs to be financed by higher charges imposed on customers. By requiring certain users of a good or service to cross-subsidise others, the USO taxes one group and transfers revenue to another.

Where they are used, such arrangements should be made transparent to the community; for example, in government financial statements (see Box E1–7). As the USO 'tax' is on a relatively narrow base, they are likely to be relatively inefficient. Other ways of funding the USO subsidy should therefore be considered.

Box E1–7: Telstra's universal service obligation

The Telstra universal service obligation (USO) aims to ensure that standard telephone services and related services are accessible to all people in Australia for the same price. Telstra provides these services at a standard price in areas where it is not commercially viable to do so. All carriers, including Telstra, are then levied to contribute to Telstra's costs, which are determined by the Minister on advice from the Australian Communications and Media Authority (totalling $145 million in 2007–08).

These arrangements mean that people in cities pay taxes on their telephone bills in order to subsidise regional phone calls. The Budget includes the USO as a tax (paid by all carriers, including Telstra) and a subsidy (paid to Telstra).

Levies to fund industry adjustment

Australian governments have sometimes hypothecated narrow-based taxes to particular industry adjustment programs. A recent example is the Australian government's Dairy Adjustment Levy, imposed on milk sales by processors to retailers on a cents per litre basis. The funds raised were used to fund structural adjustment in the dairy industry. The levy raised $228 million in 2007–08 and ceased to operate in February 2009 (Parliament of Australia 2008).

Taxes of this type have much in common with minor taxes used to fund access to essential services for particular groups, such as USOs. They tend to be narrow-based taxes with relatively high efficiency costs. The fact that consumers of milk will benefit from dairy industry restructuring does not justify imposing a levy on them. Raising the consumer price for milk does not send a price signal that reduces social costs. Rather, it imposes higher costs on society as a whole than would be imposed by raising the revenue needed to fund industry restructuring through broad-based revenue-raising taxes.

Industry-specific levies can be efficiency enhancing when they replace existing regulatory barriers that are more costly. This is one reason why the World Trade Organisation supports introducing tariffs to the extent they replace non-tariff barriers. Such regulatory barriers can be more costly as regulations may not allow lower-cost producers to enhance their output. Regulatory barriers can also deliver benefits to existing industry participants, rather than providing revenue to the government. For example, replacing the existing regulatory burden on taxis with an industry-specific tax hypothecated to licence holders would be a more transparent means of maintaining the existing system, while allowing some improvement in services (see Section E3 Road transport taxes).

Principles

Narrow-based taxes that do not target social costs are a relatively high-cost means of raising revenue.

The value of transfers provided through universal service obligations should be made transparent.