Australia's Future Tax System

Architecture of Australia's tax and transfer system

Section 6: The mix of taxes on work, investment and consumption

Outline

This section examines the mix of taxes in Australia on labour income, capital income and consumption and compares this with outcomes in other OECD countries.

Key points

  • Most countries have a tax system based on a mix of taxes on labour income, capital income and consumption.
  • Australia's tax mix is slightly skewed toward direct taxes on labour income. This accounts for around 40 per cent of tax revenue. Taxes on capital income account for about 33 per cent, while taxes on consumption account for 27 per cent.
  • Compared with other OECD countries, Australia has a low share of tax revenue from labour income and the highest share from capital income. In part, this reflects the relatively greater contribution of corporate income taxes to total tax revenue.
  • As a share of GDP, the total tax burden in Australia on capital is around 11 per cent (the fourth highest in the OECD). The total burden on labour is 12 per cent (the fourth lowest in the OECD), and the total burden on consumption is 9 per cent (also the fourth lowest in the OECD).

Most countries have a tax system comprising a mix of taxes on labour income, capital income and consumption. A key issue when considering the mix of taxes is whether some forms of tax impose larger efficiency costs than others. A key theme in tax literature over the past 30 years has been whether tax systems should be based on the concept of comprehensive income or the taxation of expenditure (see Box 6.1).

The OECD (Johansson et al 2008) has recently undertaken a cross‑country study of the effects of different taxes on economic growth. The indications from this analysis are that property taxes have the least detrimental impact on growth, followed in order by taxes on consumption, taxes on labour income and taxes on capital income. The OECD analysis only looks at the issue of the tax mix from the perspective of economic efficiency. Considerations about the distributional impacts of the tax structure also need to be taken into account when considering the findings of that study. Further, as the authors note, the general findings of the study need to be considered carefully within the context of each country's tax system and broader economic structure.

Box 6.1: The income tax versus expenditure tax debate

A key debate is whether tax systems should be based on the concept of comprehensive income ('Haig-Simons' income, defined as consumption plus the change in the real value of net assets) or the taxation of expenditure (which excludes saving from the tax base).

  • The comprehensive income base referred to by economists is based on real income — that is, the inflationary elements should be excluded from taxation.
  • Two types of expenditure tax have been identified in the literature — the so‑called pre‑paid expenditure tax based on direct taxation of labour income with an exemption for saving and the so‑called post‑paid expenditure tax based on the taxation of a direct measure of expenditure or of goods and services. Apart from the point of taxation, a key difference between these two approaches is the generally accepted view that only under a post‑paid expenditure tax are the returns to pure economic rent and good luck taxed.

Proponents of the expenditure tax argue this approach delivers greater economic efficiency because taxing the return to saving under an income tax results in future consumption being taxed more heavily than present consumption. This reduces the incentive of individuals to save, which can in turn reduce the level of investment in the economy, the size of the capital stock and the return to labour. It can also affect equity issues, by increasing the level of tax on those that wish to save for items such as education and retirement. Proponents of an income tax have generally argued that the efficiency gains from an expenditure tax are diminished by the need to levy the tax at a higher rate to achieve a given revenue target and that an income tax is more equitable because the distribution of wealth is greatly skewed.

Since the Meade Report (1978), where the arguments in favour of expenditure taxes were considered clear, more recent literature has cast doubt on the premise that expenditure taxes are necessarily superior to income taxes. However, the view of the literature is that capital income should be taxed at a lower rate than labour income solely from the perspective of efficiency considerations (Diamond and Banks 2008).

A second key theme in the tax literature has been concerned with the definition of the tax base, particularly in terms of its comprehensiveness. It is generally accepted that within any appropriately defined base, a broad tax treatment will impose fewer efficiency costs on the economy, because of the neutral treatment of alternative sources of income or expenditure and a lower average tax rate for a given revenue objective. In practice it is extremely difficult to assess the comprehensiveness of a tax base defined as broadly as labour income, capital income or consumption. Where different rates are applied to different goods, a judgement needs to be made as to whether these represent different sub‑components within the labour, capital and consumption tax bases, or deviations from the comprehensive base. There are parallels between this and the benchmark issues surrounding the identification of tax expenditures (see Box 2.7).