The Priority for Tax Reforms: A Flatter Tax Scale
The Priority for Tax Reforms: A Flatter Tax Scale
Tax cuts are in the news again. The government has signalled that it will move to cut personal tax in the 2008 budget, and the National Party also favours tax reductions.
In assessing the quality of proposals to reduce the tax burden, we should initially focus on government spending.
The government spending share of national income (the ratio of spending to GDP) is the best measure of the tax burden. Ultimately – leaving aside budget surpluses and deficits and any sales of assets – what is spent must be funded from taxation.
Currently, the government is over-taxing New Zealanders and, with public debt at low levels, taxes can be cut by reducing the budget surplus. But ongoing reductions in the tax burden require constraining the rate of growth in government spending to less than the growth rate of the economy.
The adoption of a tax and expenditure limit – a commitment to, say, holding the growth of government spending to no more than inflation plus population growth – would be the best way for a party to demonstrate it is serious about reducing tax burdens.
Given expenditure discipline, how should taxes be cut? Arguably, the aim should be to use tax policy to raise the rate of productivity and economic growth – once the government’s ‘top priority’ objective. The marked slowdown in productivity growth in recent years means living standards in New Zealand are likely to grow slowly, and decline relative to Australia.
The highest effective marginal tax rates are most damaging to productivity and economic growth. These are not just the top personal tax rate of 39% but also those generated under schemes such as Working for Families as assistance is abated.
The so-called ‘deadweight’ costs of taxation occur because taxes blunt incentives for businesses to invest and innovate and for people to work and save. They rise more than proportionally as tax rates rise – actually by approximately the square of the increase in the tax rate. If the rate of tax doubles, deadweight costs increase four-fold.
Lowering marginal tax rates would boost economic growth. In a recent study for the Business Roundtable covering 98 different countries (available at www.nzbr.org.nz), Australian National University economist Alex Robson found that, “on average, countries which significantly cut taxes on upper incomes between 1980 and 2000 enjoyed per capita growth rates of nearly three times those that did not.”
This is why getting down high tax rates is so important. Simply increasing tax thresholds – say the $38,000 and $60,000 thresholds where the 33% and 39% rates cut in respectively – is much less effective.
As the Business Council of Australia, an organisation of chief executives like the Business Roundtable, has put it, “Threshold changes are attractive to governments because they have significantly less cost than rate changes. However, these changes do not provide the benefits the economy needs. It is a change in the marginal rate that impacts on the marginal investor, the marginal decision to save, and the decision to work and for how long (in terms of number of hours and to what age).
“Threshold changes only change marginal rates for a relatively small number of taxpayers. They do not change the marginal tax rates facing taxpayers with incomes above the new thresholds.”
The Business Council recommended that all Australian tax rates be reduced to a maximum of 30%. Revenue minister Peter Dunne has also advocated a 30% personal, 30% company and 30% trust structure for New Zealand.
He has pointed to the problems created by the decision to cut the company tax rate alone to 30% next year. This widens rather than flattens the tax scale and creates additional distortions and opportunities for tax avoidance.
In its submission to the 2001 Tax Review, the Business Roundtable went further and proposed a medium-term goal of a 25% tax rate so as to seriously boost the attractiveness of New Zealand as a place to work and do business. Already Singapore has cut its income tax rates to 20% and Hong Kong is cutting the equivalent of its personal and company rates to 15% and 16.5% respectively.
Such tax-cutting strategies, even if they also include cuts to lower rates as they should, are always criticised on the grounds that they favour higher income earners. This is inevitable because they pay more tax in the first place. But such criticisms overlook the fact that lower income earners typically become higher income earners in the course of their careers, and that everyone benefits from a more productive economy. The dynamic countries that have moved to flat or flatter taxes in recent years have overcome envy-driven criticisms of such policies.
The Tax Review put the emphasis on moves to a lower, flatter rate structure, not adjustments to thresholds. It should be used as a benchmark for judging good tax policy.