It Depends on What You are Trying to Achieve
Speculation about tax reform in the upcoming federal budget abounds. That presumes a lot about the problems the budget should solve and whether the tax system is the right solution.
- Pre-budget speculation has tended to start from the presumption that more revenue is needed. The justification is sometimes the perceived need to fund spending priorities that are assumed – perhaps erroneously – to be rising. In other quarters, minimising the deficit or government debt appears to be the objective. Whatever the objective, it should be scrutinised not assumed.
- Speculation about changes to the capital gains tax (CGT) regime highlight the potential to increase revenue, but there is no guarantee of this. For example, switching back to the pre-1999 regime or the simplified version of it we have previously suggested will only boost revenue if asset price growth exceeds 5%.
- There are many possible objectives that fiscal systems – tax and spending – can address, often different objectives in different parts of the system. “Boost revenue” is not the only possible goal, and tweaking the tax system is not the only solution to a policy objective.
Speculation is building as budget night approaches. While the government must deal with the immediate issues in front of it stemming from the Middle East conflict, many observers are focused on the maxim “never let a good crisis go to waste” and hoping for broader reforms – usually the same ones they were advocating before the conflict erupted. The question of what the budget should do rests, however, on the deeper question of what problems the government is trying to solve.
For example, recent discussion has been focused on an assumed need for extra revenue. Tax reforms are dissected for how much more they might raise, while revenue windfalls from higher commodity prices are downplayed. Underlying this view are other presumptions – seemingly widespread across different levels of government and the bureaucracy – that “people expect more from government nowadays” and that governments should strive to meet those expectations. Absent from these discussions are the questions of whether the government’s effort and resources are being deployed effectively, and whether it can stop doing some things altogether.
A related presumption underlying the search for more revenue is the belief that population ageing is shrinking the workforce, even though this is not true in Australia and most other advanced economies outside North America.
A separate pathway to the search for more revenue comes from a different premise: that the federal fiscal position is weak and large revenue measures (and/or spending cuts) must be found to reduce the deficit significantly. It is good to have strong public finances. It keeps government borrowing costs low and leaves plenty of space to spend in a crisis. Yet the presumption that government finances are parlous and in need of repair sits oddly with Australia’s actual federal fiscal position, which is stronger than many of its peers.
Take the recent speculation about removing the CGT discount. It has been touted as a revenue-raising measure, but there is no guarantee of this. One could consider moving back to the pre-1999 system of adjusting the gain for growth in CPI and applying the full marginal rate to the remainder. Alternatively, one could consider the simplified version we suggested in 2023, where the adjustment is 2.5% per year the asset is held – the midpoint of the RBA’s inflation target – regardless of actual inflation over the holding period.
Applying a full marginal rate to an adjusted return still taxes mobile capital more lightly than other income, as economic theory would suggest. It has an advantage over the current system of not privileging capital gains-producing assets over income-producing assets at the margin. Because assets that can be leveraged are especially advantaged by the current system, switching back to the pre-1999 system or our simplified alternative would also promote financial stability. It would increase the effective tax rate on capital gains during booms in real asset prices, and our simplified proposal would also lean against periods of high CPI inflation.
What it will not do, though, is necessarily boost revenue. If asset prices rise by less than 5% per year, revenue is lower. For example, a 4% rise, less 2.5% deduction, means tax is paid on 1½% of capital gains. The current system of half the marginal rate on the full gain would be the equivalent of taxing 2% of gains if asset prices rose 4%yr. Revenue is only higher than the current scheme if asset prices rise by more than 5%. And even in that case, the increase in revenue might only be small once people have adjusted to the change and the other possible design decisions associated with it, such as grandfathering and limits on the number and type of assets eligible for the discount.
Absent from the current discourse is any discussion of the proper role and size of government, or the level of government that is best placed to take on the functions required. As Westpac Economics colleague Pat Bustamante has previously shown, the size of government in Australia has increased substantially over the past decade. When private demand indirectly induced by public spending is included (think legal work for construction companies working on public infrastructure projects), the footprint of public demand has risen from 27% to 35% of GDP over the past decade.
Much of this expansion is desirable. We should want to care for disabled and elderly Australians properly and have high-quality childcare available at an affordable price. That takes resources, and private markets alone are unlikely to deliver enough of these services. Likewise, with population growth running around 1½%, both pre-pandemic and currently, we will always need more public infrastructure. Both types of spending also have positive spillovers. Social care spending allows those who were providing informal care to enter paid employment. And done well, infrastructure spending can boost skills and productivity and open up new opportunities through better logistics.
The question of what should or will happen in the budget boils down to which of the many possible objectives government wants to prioritise. Is it addressing the growing income tax burden in a system of fixed tax brackets, or minimising the deficit, or making the tax system more responsive to the economic cycle, or providing more services to meet the public’s expectations, or doing so more efficiently? What about national and economic security? The budget is a complex beast and different design decisions can address different objectives. This is not like monetary policy, where there is only one instrument and at most two objectives, inflation and full employment, which are in any case correlated at least some of the time.
Global economic and geopolitical developments pose challenges, while new technology and an expanding, ageing workforce create opportunities. We should not assume that tweaking the tax system is the answer to every issue. Your fiscal priorities should relate to your public policy objectives.
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