Australia's Future Tax System

Architecture of Australia's tax and transfer system

4.1 Historical trends in tax

The Australian tax‑transfer system has changed significantly since the end of the 19th century. The six colonies raised the bulk of their tax revenue from selective customs and excise duties. The original design of the tax systems of the six colonies was driven largely by the feasibility of administration, rather than principles of equity or efficiency. Customs duties were easy to collect from the limited number of wharves where goods entered the colonies. Although highly regressive, customs and excise duties levied on necessities ensured a relatively secure source of revenue. They also acted as trade barriers between the colonies. One of the significant results of federation in 1901 was the removal of all duties on goods traded between Australian States.

Since federation, developments in tax policy can be broadly classified into two periods. Up until the mid‑1970s, the primary driver of significant changes to the tax system was expanding the revenue base to fund expenditure programs. Since then, the revenue requirement has been relatively stable. Increased attention has been paid to reforming the tax system to improve equity and efficiency and, more recently, attempting to reduce tax system complexity.

A revenue adequacy focus (1901 to mid‑1970s)

At the time of federation Australia's tax to GDP ratio was around 5 per cent. This ratio remained reasonably constant until the introduction of the Australian government income tax in 1915, which was used to fund Australia's war effort. Between the two World Wars, government expenditure and tax revenues grew significantly and by the beginning of the Second World War, Australia's tax to GDP ratio was over 11 per cent (Chart 4.1).

Chart 4.1: Australian government and state taxation
(1902‑03 to 2006‑07)

Chart 4.1: Australian government and state taxation(1902‑03 to 2006‑07)

Source: Budget Papers; ABS (2008a); ABS (2007a).

When income tax was first introduced in 1915, companies were taxed on their profits after deduction of dividends — that is, only on retained profits. Subsequently, this deduction was changed to a rebate for shareholders. In 1940, with additional revenue needed to fund Australia's involvement in the Second World War, the rebate of tax on dividends received by individual shareholders and non‑resident companies was removed. The company tax rate was increased and an undistributed profits tax was imposed on public companies.

By the end of the Second World War, tax revenue had grown to over 22 per cent of GDP. The further increase in tax largely reflected Australia's involvement in the war and the introduction of government support programs, such as the Widows' Pension in 1942 and Unemployment Benefit in 1945. This marked the beginning of the modern social security system which is discussed in more detail in Section 4.2.

Tax revenues declined during the 1950s and by 1963‑64 the tax to GDP ratio was around 18 per cent. In the early 1970s, tax revenue increased significantly, partly driven by funding requirements for social programs such as the introduction of free higher education.

Since the late 1980s Australia's overall tax to GDP ratio has been relatively stable and is currently around 30 per cent of GDP. The majority of tax revenue, equivalent to 25 per cent of GDP, is raised by the Australian government with around 5 per cent raised by the state governments.

Improving efficiency, equity and simplicity (mid‑1970s onwards)

From the early 1970s, a growing concern about the equity of the tax system led to the establishment of the Taxation Review Committee (Asprey et al 1975). A key theme of the Asprey Report was the need to broaden the tax base. In 1985, the Australian government released a draft White Paper which recommended a broadening of the tax base through the adoption of a broad‑based consumption tax, the introduction of a capital gains tax and comprehensive taxation of fringe benefits, and a broader foreign income tax base (Australian Government 1985). The capital gains tax and fringe benefits tax were introduced in the second half of the 1980s and the GST was introduced in 2000.

The broadening of the foreign income tax base, in part driven by the opening of the Australian economy, was achieved initially by making most foreign income taxable with a credit for foreign tax paid. However, to reduce compliance costs and reflecting competitiveness concerns, in 1990 dividends from non‑portfolio interests in foreign companies and active business profits of branches in comparable tax jurisdictions were made exempt from company tax. Further, to ensure residents could not defer tax by accumulating passive income offshore, attribution regimes (in particular, controlled foreign company and foreign investment fund regimes) were introduced in the early 1990s.

The focus of reforms since the mid‑1970s has been to improve the efficiency, equity and simplicity of the tax system. As such, a key element of the reform agenda has been to broaden the personal and business tax base and lower the rate of tax (Chart 4.2).

Chart 4.2: Top personal income tax rate and company tax rate
(1965‑66 to 2007‑08)

Chart 4.2: Top personal income tax rate and company tax rate(1965‑66 to 2007‑08)

Source: Australian Treasury estimates.

Until 1987, Australia maintained a classical company taxation system, under which profits were taxed at the company rate and at personal rates when distributed. In 1987 an imputation system was introduced. Under this system, resident shareholders receive a credit for tax paid at the company level, thereby eliminating double taxation of dividends. Where the resident shareholder's marginal tax rate is below the company tax rate, the excess credit can be used to offset tax payable on other income (for example, wages and salary). Full refundability of excess tax credits for most resident shareholders was introduced to the Australian imputation system in 2000.

Under the imputation system, Australia's company income tax system operates as a withholding tax on the income that Australian residents earn through Australian resident companies, and as a final tax on (primarily Australian source) income earned by non‑residents through an Australian resident company or permanent establishment in Australia.

A review of business taxation was conducted in 1999. Key elements of the review included: lowering the company tax rate; more concessional capital gains tax arrangements; replacing accelerated depreciation with effective life depreciation arrangements; revised 'thin capitalisation' rules to prevent profits being shifted offshore; and simplifying the tax system for small business. The New Tax System package was introduced from 2000. The GST was introduced as a replacement for the multi‑rate wholesale sales tax and a range of inefficient state taxes. The GST revenue was provided to the States as a replacement for their state taxes and Australian government financial assistance grants. The package also included reductions in personal income and business taxes; reforms to the family payments system (outlined in more detail below); and reforms to the tax instalment arrangements for business income.

In response to the 2002‑03 Review of International Taxation Arrangements, a package of reforms was implemented to improve the competitiveness of Australian managed funds and companies with offshore operations, and reform other aspects of the international tax rules. The reforms included reducing the commercial constraints and compliance costs arising from the controlled foreign company and foreign investment fund rules, as well as extending the exemption for non‑portfolio dividends and branch profits to all foreign countries.

Retirement income taxation

Prior to the 1980s, no tax was paid on contributions to superannuation funds, earnings of superannuation funds were tax exempt and tax was only imposed on 5 per cent of lump sum benefits. In contrast, benefits paid as pensions or annuities were generally taxed at the recipient's marginal rates.

Changes made in 1983 reduced the scope for tax minimisation that resulted from the concessional treatment of lump sum superannuation and termination payments, by introducing a tax regime for eligible termination payments (ETPs). Under these arrangements, the full value of ETPs was included as income, with the post‑1983 component of the benefit taxed at a maximum rate of 30 per cent. For those aged 55 and over, this rate was reduced to 15 per cent on the amount up to a threshold.

The superannuation taxation arrangements were restructured in 1988 to bring forward the receipt of tax revenue. This involved reducing tax on the post‑1983 component of ETPs and imposing a 15 per cent tax on contributions and earnings of superannuation funds. A 15 per cent rebate was also introduced for the specified component of annuities and pensions paid to persons aged 55 and over.

In 1992, the superannuation guarantee was introduced which, enforceable through the Australian government's taxation powers, required employers to make minimum contributions to a superannuation fund on behalf of their employees. A superannuation contributions surcharge was introduced in 1996 to reduce the concessionality of superannuation contributions for higher income earners, but was subsequently reduced in a number of stages until its removal in 2005.

Reforms to superannuation in 2007 aimed to make superannuation easier to understand, and improve incentives to work and save. Under the reforms, superannuation benefits paid from a taxed fund to people aged 60 and over became tax free. The treatment of ETPs was also changed to differentiate between payments received from employers and those received from superannuation funds.