Australia's Future Tax System

Architecture of Australia's tax and transfer system

3.5 Measuring taxation of labour, savings and investment — analytical tools

To assess the impact of taxes on the production and distribution of resources in the Australian economy it is necessary to look beyond statutory tax rates. For example, companies do not pay the company tax rate each year on all of their profits, as corporate financing policies, generally available deductions, concessions for particular industries or activities, and tax planning opportunities may impact on the amount of tax payable.

To understand the impact of the tax‑transfer system on labour supply, it is also necessary to consider the effects of tax and transfers on disposable income. A number of measures are available that take into account the effect of tax offsets and transfers, and the withdrawal of these transfers (which has the effect of reducing the return from work and/or saving).

To describe accurately how much tax is actually paid, it is necessary to find alternative measures to the statutory tax rate. There are several other ways of measuring the tax rates on labour, savings and investment, each with its own advantages and disadvantages (see Table 3.2).

Tax to GDP

Tax to GDP ratios are commonly used for comparing the level of taxation across countries. These measures can be calculated for taxes paid by particular industries or under particular revenue heads and are calculated as the tax revenue expressed as a percentage of GDP. Tax to GDP ratios are a 'backward' looking measure of the tax burden, in that they are an estimate of taxes already paid.

Average tax rate

Average tax rates (ATRs) are commonly used to measure the tax burden on income. They are based on micro data and express tax paid as a percentage of an appropriate measure of income, such as profits from the annual accounts of a business or total income obtained from tax returns. ATRs incorporate most aspects of the tax system, such as variations in tax rates, deductions and offsets. ATRs also implicitly take into account impacts of tax planning, evasion and minimisation.

ATRs on labour can be structured in a number of different ways, for example, to measure tax as a proportion of total wage and salary income and transfers, or tax net of transfers as a proportion of earned income.

Effective tax rates on labour

Effective tax rates on labour take account of the complete wedge between gross income and disposable income, including any reductions in transfers, as well as income tax. The effective tax rate on an additional dollar of income is often referred to as an effective marginal tax rate (EMTR). Effective tax rates on larger increases in income (for example, an additional $100 per week) are often called effective average tax rates (EATRs), while the effective tax rate when moving into the workforce is referred to as the participation tax rate (PTR).

For labour, EMTRs, EATRs and PTRs are measured in the same way, but over different ranges of income. EATRs measure the effect of the tax‑transfer system over broader increments of income.

These measures do not directly measure the incentive to work, but rather the return from additional work (labour supply elasticities would need to be coupled with the effective tax rates to determine incentives). They do, however, provide an indication of the magnitude of potential incentive effects.

Effective tax rates on capital

EMTRs on savings and investment measure the effect of taxation on the return to an investment in a marginal project. A marginal investment is one where the investor is indifferent between undertaking the investment or investing elsewhere (that is, where the expected net present value of the investment is zero). The EMTR is defined as the difference between the pre‑tax and the post‑tax return on the project as a proportion of the pre‑tax return.

EMTRs measure the tax burden on an extra dollar of marginal investment, and are indicative of the extent to which saving or investment is discouraged and of tax driven distortions in investment choices. They do not, however, show all the potential impacts on investment choices. For example, stringent preservation requirements for superannuation and lock‑in effects in respect of assets with unrealised capital gains, are not captured in these measures.

The EMTR is a forward looking measure because it calculates the tax burden on a hypothetical investment under the current tax system. As such, the EMTR can be used to estimate incentive effects arising from the tax system.

In contrast to the EMTR, the EATR on savings and investment measures the effective tax burden on projects that earn more than the marginal rate of return (that is, projects generating so‑called supernormal returns or economic rents). The EATR for a future investment project is calculated as the ratio of the future tax liabilities to the pre‑tax financial profit (or some other parameter for the value of the firm over the estimated life of the project).

The primary use of EATRs in the empirical literature has been in examining the effect of the tax system on managerial decisions such as investment location.

Table 3.2: Comparing measures of tax

Method Advantages Disadvantages

Statutory tax rates

Simplest of all measures

Is a primary component of other measures such as EATRs but does not reflect all aspects of actual burden (does not include base adjustments and does not include withdrawal of transfers)

Tax to GDP

Relatively simple to calculate

Internationally recognised as a measure of comparing the level of taxation across countries

Backward looking (does not identify incentive effects)

Changes in the estimated rate may reflect variations in economic profit to GDP rather than tax changes

Tax paid and GDP may not relate to same income year

Problem with carried forward losses, tax expenditures

Excludes tax at shareholder level with respect to corporate income tax

Limited usefulness for analysing tax structures within a country

Average tax rate

Relatively simple to calculate

Calculates rates for particular taxpayers, groups or industries

Good estimate of the tax burden

Backward looking (does not identify incentive effects)

Issues with including loss making firms, upward bias

Problem with carried forward losses

Excludes tax at shareholder level with respect to corporate income tax

Provides no indication of incentives at the margin, particularly in relation to labour taxation

Effective tax rates (labour)

EMTRs and EATRs measure returns to additional labour supply

Calculates rates of tax and transfers for individuals and different family types

Provides an indication of returns to increased labour supply — particularly when examined over ranges of income

Focusing on EMTRs can lead to too great a focus on marginal return, when labour supply is 'lumpy' and effective rates over a broader range of income may illustrate returns more accurately.

May not take into account all costs (for example, childcare)

Provides only a static measure of the returns to labour (that is, excludes long‑term returns of increased labour supply)

Useful only for analysing substitution effect of taxes‑transfers on labour, not the income effect

Effective marginal tax rates (capital)

Forward looking measure. Can incorporate taxes at shareholder level

Calculates rates for particular taxpayers, groups or industries for various asset types and financing arrangements. Long‑standing, internationally recognised measure

Complex calculation

Not appropriate if project/asset earns inframarginal gains

Effective average tax rates (capital)

Forward looking measure. Measure for examining location decisions for investments

Measures the tax burden of an inframarginal investment

Can incorporate taxes at shareholder level

Complex calculation

Problems with determining inframarginal gains