Australia's Future Tax System

Architecture of Australia's tax and transfer system

3.2 What does equitable distribution mean?

There is no commonly accepted benchmark for what constitutes an equitable distribution of opportunity in an economy. Whether elements of the current tax‑transfer system improve equity or not depends on a range of judgements. People put different degrees of emphasis on different priorities of a tax‑transfer system and these priorities can sometimes conflict. For example, some people believe that high marginal tax rates on capital improve equity since they may help to redistribute income from rich to poor. Others believe that high rates harm equity because they may reduce the level of investment and capital income formation, and through that channel result in lower growth in wages, as well as imposing a higher tax rate on Australians who decide to save rather than consume.

There are a number of perspectives on equity that people use to inform their assessments of the tax‑transfer system, including:

  • inter‑temporal equity, which looks at how the tax‑transfer system impacts on longer term decisions of individuals, such as work, saving, family structure and education. Equity therefore requires some consideration of dynamic or future lifetime resources;
  • intergenerational equity, which looks at how the decisions of today's individuals affect future generations. In general, this includes the objective of ensuring that the wellbeing of future generations is at least no lower than the current generation;
  • spatial equity, which focuses on the degree to which the tax‑transfer system should deliver individuals in different geographic areas similar consumption opportunities, at least for certain types of goods and services;
  • the opportunity and freedom of individuals to participate in society and to achieve the things they value. Considered here is the role of the tax‑transfer system in providing individuals with capabilities and opportunities rather than specific outcomes; and
  • 'rights based' frameworks, which emphasise that the tax‑transfer system should not violate fundamental rights and the procedural fairness necessary to sustain a liberal democracy. For example, the tax‑transfer system needs to treat issues of privacy carefully and certain forms of inequality — such as direct discrimination on the basis of race, gender or sexual preference — should be ruled out altogether.

While equity can mean different things to different people, there are some common concepts often used to discuss whether the tax‑transfer system contributes to equity, or not, according to different equity perspectives; in particular, the beneficiary principle and the ability to pay principle.

The beneficiary principle and ability to pay

The beneficiary principle states that people should pay tax according to the benefits they receive from spending funded by tax revenue, regardless of their income. The principle could be appropriate for funding the public provision of services where it is possible for a user charge to apply (such as public transport, electricity and water). There are, however, a range of government‑provided services where access to the service for one person has no impact on access for others: the services are 'non‑rival in consumption'. Examples include national defence, law and order, public health services and fire protection. The marginal cost of providing such services is usually close to zero, so excluding some people from consuming them can be inefficient. The beneficiary principle can, nevertheless, be used to justify higher tax burdens on groups that benefit disproportionately from public goods. For example, the principle may support progressive income taxation if higher income earners use relatively more public goods. It may also support taxing foreigners through company tax, as they benefit from government funded infrastructure, legal institutions, and a skilled workforce.

The ability to pay principle states that those who are more capable of bearing the burden of taxes should pay more taxes than those with less ability to pay. For transfers, this principle suggests assistance should increase with the level of disadvantage. This principle requires a measure of ability to pay, such as overall wealth, income, or consumption. Ability to pay may vary considerably depending on the measure chosen. For example, a taxpayer's ability to pay, measured by property and financial wealth, may differ significantly from his or her ability to pay measured by income. A taxpayer who works for many years and then retires may accumulate a significant amount of wealth relative to others, typically in the form of owner‑occupied housing, but have a relatively low income.

The period of measurement and the choice of tax‑transfer unit can also have a significant bearing on the redistributive implications of the tax‑transfer system. Annual income may not be representative of the past or future consumption opportunities of individuals. For example, some students may have the same current income as chronically unemployed job seekers but are likely to have significantly better prospects and significantly higher lifetime consumption opportunities. Lifetime consumption opportunities may provide a better reflection of society's view of equity but are more difficult to measure.

The choice of unit — individual, family or household — also has implications for distribution based on measures of ability to pay. While some are critical of the individual as the unit of taxation, it avoids specifying a family structure that is preferred for tax purposes, and minimises workforce disincentives for secondary earners, such as mothers in families. See Box 3.6 for further discussion about the choice of unit.

The choice of unit — individual, family or household — also has implications for distribution based on measures of ability to pay. While some are critical of the individual as the unit of taxation, it avoids specifying a family structure that is preferred for tax purposes, and minimises workforce disincentives for secondary earners, such as mothers in families. See Box 3.6 for further discussion about the choice of unit.

Box 3.6: Individual versus family unit

The tax and transfer systems differ in terms of the unit of assessment to which they are applied. The individual is generally the unit of assessment for the taxation system. However, there are exceptions, as the Medicare levy surcharge and the senior Australians tax offset take into account the incomes of partners.

The unit of assessment in the transfer system is the couple or family, based on the principle that providing targeted support should take into account other sources of financial support, including from close family members (spouse, parents of dependent children). The type of household also determines eligibility for assistance.

The possibility of using the family unit to determine tax liabilities has been debated regularly. Some people consider that using the family as the unit of taxation better reflects the ability to pay of individuals in a family. Others argue that the individual unit of taxation avoids specifying what is a suitable family structure for tax purposes and promotes the autonomy of individuals within a family, particularly secondary earners.

The family unit of taxation tends to reduce work incentives for secondary earners since the family's tax rate reflects the income of the primary earner. This also increases the incentive for home production inherent in the tax system due to the exclusion of home production from tax. The individual tax unit of taxation is generally thought to be less complex to administer and comply with, but it may provide some opportunity for informal income splitting of unearned income.

In Australia, the income needs of families are addressed through the transfer system as well as the tax system. Those with children in particular receive government support according to an assessment of the family's income and circumstances. More broadly, many OECD countries have moved away from family based tax in favour of individual based systems (although the Czech Republic is an exception, introducing joint tax in 2005). Consistent with this direction, reform in Australia over the past decade and a half has been focused on facilitating the employment of secondary earners, where this is compatible with their personal circumstances.

Horizontal and vertical equity

The concepts of horizontal and vertical equity are refinements of the ability to pay principle. Horizontal equity requires individuals in the same economic position to be treated the same by the tax‑transfer system. Vertical equity is generally considered to mean that individuals in different economic positions should be treated differently, usually with those having greater economic capacity paying more.

The 'same economic position' is often defined by reference to criteria such as individual income, family circumstances (such as the number of dependants) or geographic area. For example, Family Tax Benefit is sometimes justified on the basis of the demands on a given level of income for individuals who are raising children.

Different perspectives on the 'same economic position' can lead to different judgements about whether a policy is horizontally equitable. Consider two individuals who earn the same amount of income but do so from different sources, such as wages and dividends. Taxing these two individuals in an equivalent manner may be considered horizontally equitable by some but others may consider it appropriate to tax wages less as this income is derived from an individual's work effort while dividend income may be derived from inherited wealth. As noted in Section 7, the basis for determining 'capacity to pay' differs fundamentally between the tax system focus on the individual and the transfer system focus on the family.

Vertical equity deals with differences in ability to pay. Subjective judgments about vertical equity are reflected in debates about the overall fairness of the following three types of personal tax rate structure:

  • progressive tax rates — where the tax liability as a percentage of a taxpayer's income increases as their income increases;
  • proportional tax rates — where the tax liability as a percentage of income stays the same, regardless of the taxpayer's income; and
  • regressive tax rates — where the tax liability as a percentage of a taxpayer's income declines as their income increases.

A progressive statutory rate structure for the personal income tax does not ensure that the overall tax system is progressive. Progressive statutory tax rates could be offset by other features of the tax system that reduce the average rate of tax paid by individuals with higher incomes.

The transfer system provides a number of benefits, including pensions, allowances and income tested payments which affect the overall redistributive impact of the tax‑transfer system. Whether people think higher or lower taxes will improve the distribution of income or consumption, it is generally acknowledged that both income and consumption need to be measured broadly and consistently to determine whether a system is vertically or horizontally equitable.

Some further considerations regarding horizontal and vertical equity

Importantly, the horizontal and vertical equity of the tax‑transfer system depends on who actually bears a tax or benefits from a transfer. As noted above, the actual burden of a tax or benefit of a transfer does not always fall on the people or businesses that actually pay the tax to the government or receive the transfer payment. Horizontal and vertical equity outcomes will also be influenced by the level of compliance with tax and transfer obligations and the ability of taxpayers to avoid the payment of tax or receive increased transfers through income planning arrangements. Many of the tax reforms introduced in the latter part of the 1980s were intended to address a widespread perception that higher income individuals were able to reduce their tax liabilities through income structuring arrangements. The design of the tax‑transfer system and the level of compliance enforcement are important determinants of the extent to which intended and actual equity outcomes align.