equity, tax reform and redistribution

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Equity, Tax Reform and Redistribution

Research Paper No.28Policy Review BranchDevelopment DivisionDepartment of Social Security

April 1985


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EQUITY, TAX REFORMAND REDISTRIBUTION

Submission prepared by the Department of Social Security for the Economic Planning Advisory Councilmeeting of 29 March 1985.

The authors of this paper are Ann Harding and PeterWhiteford.

Considerable assistance was provided by Lynelle Briggs,Judi Robinson, Roger Smith and David Cocking.*

Policy Review Branch,Development Division,

Department of Social Security April 1985.

* Many thanks also to other members of Development Division for helpful comments on earlier drafts,to officers of the Australian Bureau of Statistics, and to the Department's word processing operators,particularly Robyn Soxsmith and Sylvia Gloster.


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ISBN 0 642 51595 4 C.J. THOMPSON COMMONWEALTH GOVERNMENT PRINTER


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SUMMARY OF KEY POINTS

Interaction of the Taxation and Social Security Systems

The social security system, like the taxation system, has a major effect on income distribution. While

the two systems are often considered separately they are so closely linked and interact to such a degreethat exclusive concentration on one system alone may frustrate achievement of equity goals. The sociasecurity and taxation systems, for example, have overlapping populations and income tests. Personalincome tax and social security cash transfer mechanisms can also be alternative mechanisms forachieving equity goals. Similarly, social security recipients and other low income groups pay (and aredisproportionately affected by) indirect taxes.

This suggests that unless the taxation and social security systems are considered together whendesigning tax reforms, adverse and unintended distributional effects could easily result. A corollary isthat whether any particular tax or social security measure is progressive or regressive when consideredin isolation is less important than the effect of overall changes to tax-transfer arrangements.

Equity and the Reform of the Direct Tax System

The narrowness of the income tax base, tax avoidance and evasion and consequent revenue constraintshave directly affected the living standards of low income groups, by reducing the revenue available tofinance such redistributive measures as increases in the basic tax threshold and social security cashtransfers, and reductions in marginal tax rates. Tax reforms aimed at reducing tax avoidance andevasion, broadening the income tax base or introducing new taxes which more fully recognise theadditions to "capacity to pay" bestowed by capital gains, inheritances and gifts, employment fringebenefits and ownership of wealth must therefore be considered desirable.

Much of the tax reform debate has focussed on the need to reduce the tax burdens and marginal tax rate

of those earning average weekly earnings and above. However, the absolute or relative declines sincethe mid 1970's in the disposable incomes of low income groups and families, in comparison to taxpayerwithout children at AWE, and the higher effective marginal tax rates facing social security recipients(which exceed those of taxpayers on the highest incomes) suggest that these groups warrant priority inany tax-transfer reforms.

Equity Implications of Broadening the Indirect Tax Base

While a major extension of the indirect tax base may reduce work disincentives and increase tax paid btax avoiders and evaders, it will also create major inequities.


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Data on the expenditure patterns of households show that extension of wholesale sales tax to the majorcurrently excluded item of food would create vertical and horizontal inequities, ie. it would adverselyaffect low income households more than middle and upper income households, and at every income levewould affect those with children more than those without. Low income households with children wouldbe particularly hard hit.

Introduction of a broad-based, uniform-rate goods and services tax (GST) could also be both verticallyand horizontally inequitable. For example, on the basis of 1984 HES data, it could take up to 5 times ashigh a proportion of income from the poorest households as from the most well-off. Similarly, familieswith children could pay up to 40 per cent more of their incomes in additional tax than those at the sameincome level without children.

If the tax burden on low income groups were not to be increased following introduction of a GST, majorincreases in social security payments, other outlays, or new tax measures such as tax credits or negativeincome tax schemes would be required, as many low income groups do not pay sufficient income tax tobe compensated via personal income tax cuts.

For social security clients, the existing automatic six monthly indexation increases in pensions andbenefits based on the CPI will not provide adequate compensation because:

there is a lag of up to 10 months between price increases and the 'flow-on' to pensions andbenefits;

the CPI may not adequately reflect the effect of tax and price changes on social security clients, atheir consumption patterns differ from the 'average' captured in the CPI;

part of the compensatory payments may be lost in income tax; the real value of savings or of non-pension/benefit incomes may be reduced by a new indirect taxand those who are dissaving (eg. by running down their savings or going into debt) would lose.

In addition, many social security payments and income test thresholds are not automatically indexed.

Special compensatory initiatives may be required for families with children, the recipients of income-tested cash transfers from other Government Departments such as Veterans' Affairs and Education, andfor low income earners in the workforce without children, who do not pay sufficient income tax to becompensated via tax cuts, yet who are also ineligible for any existing social security cash transfers.


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These factors suggest that adequate compensation for low income groups from the losses associated withthe introduction of a GST would probably require:

immediate ad hoc increases in all social security rates substantially higher than the estimatedeffects of the new indirect tax on the CPI (with appropriate adjustments being subsequently madewhen any normal pension indexation increases fell due);

adjustments to the income tax threshold or pensioner/ beneficiary rebates so that part of theadditional compensatory pension increases were not subsequently returned in income tax;

some further increase in pension and benefit rates to create a "buffer zone' which would ensureprotection against losses arising from dissaving, the decline in the value of savings and/or non-pension/benefit incomes (which particularly affects the aged), and the additional indirect taxesborne by those pensioners and beneficiaries whose expenditure patterns are not average;

the adjustment of all social security income and asset test thresholds by the average increase inindirect taxes paid by pensioners and beneficiaries;

major increases in family allowances and family income supplement; and the introduction of new social security cash transfers or tax credits for low income groups in the

workforce, or rationalisation of the existing system into a guaranteed minimum income ornegative income tax scheme.

Tax Reform and Redistribution

Altering the tax mix in conjunction with any appropriate compensation measures may improve equity inthe income distribution. However, unless there is some redistribution of income to low income groupswhich improves their absolute standards of living, a key objective of tax reform in the minds of many

would remain unsatisfied. What prominence this objective is to have is one of the as yet unresolvedissues in the wider debate about tax reform.


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CONTENTS PAGE

1. Introduction 1

2. The Interaction of the Taxation and Social 3Security Systems

3. Equity and Priorities for Tax Reform 7

3.1 Broadening the Income Tax Base and Reducing 7Tax Avoidance and Evasion

3.2 Changes to Personal Income Tax Schedules 93.3 Effective Marginal Tax Rates and Poverty 17

Traps3.4 Contributory Financing of Social Security 203.5 Broadening the Indirect Tax Base 21

3.5:1Wholesale Sales Tax 223.5:2. Taxation of Services 24

3.5:3. Goods and Services Tax 26

4. Measures to Protect Low Income Groups and 32Families with From Indirect Tax Changes

4.1 Indexed Social Security Pensions and Benefits 334.2 Non-Indexed Social Security Payments 38

4.2:1. Pensions and Benefits 394.2:2. Assistance For Dependent Children 394.2:3. Other Payments 41

4.3 Other Government Transfer Payments 424.4 Low Income Groups Currently Receiving No 42

Social Security Assistance4.5 Compensation and Women 484.6 Costs of Compensation 49

5. Measures to Protect Low Income Groups and 50Families with Children From Direct Tax Changes

6. Compensation and Redistribution 52

7. Summary and Conclusions 56


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AppendicesAppendix One: Extract From Government Taxation 62

Policy Statement by the Prime Minister:31 October 1984

Appendix Two: Effective Marginal Tax Rates Faced 63by Social Security Recipients

Appendix Three: Contributory Financing of Social 67Security

Appendix Four: Additional Statistical Tables 72Appendix Five: The Incidence of Broad-Based 81

Consumption TaxesAppendix Six: Guaranteed Minimum Income Schemes 84Bibliography 86

TABLES PAGE

Table 3.1 Average and Effective Marginal Tax Rates in 111976-77 and 1984-85 for Various Categoriesof Taxpayers

Table 3.2 Real Changes in Components of 12Incomes Between 1976-77 and 1984-85

Table 3.3 Changes in Real Disposable Incomes of 14Various Family Types, 1976-77 to1984-85 (estimated): Per Cent

Table 3.4 Expenditure on Food as a Percentage of 23Disposable Income for Various Household

Compositions and Income Groups

Table 3.5 Effect of a Tax Which Increases 25Expenditure on Food by 10 Per Cent:By Household Composition and Income

Table 3.6 Additional Indirect Tax and Additional 28Tax as a Percentage of Disposable IncomeAfter Imposition of a GST Which IncreasesHousehold Expenditure by 10 Per Cent:By Household Composition and Income

Table 4.1 Comparison of Income Tax Payments and 41Hypothetical GST Payments for Single EarnerCouples with Children at Various LowIncome Levels


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Table 4.2 Weekly Earnings of Low Income 44Employees (August 1983)

Table 4.3 Comparison of Income Tax Payments 45and Hypothetical GST Payments for Low

Income Taxpayers Without Children

Table 4.4 Weekly Earnings of Low Income 49Employees: Distribution by Incomeand Sex (August 1983)

Table 6.1 Illustrative Social Security Expenditure 53Priorities

APPENDIX FOUR : ADDITIONAL STATISTICAL TABLESContents

Table 1 Effect of a GST on Families 73in 1975-76

Table 2 Effect on the Disposable Income of 74Single Pensioners of a GST WhichIncreases Their Expenditures by10 Per Cent

Table 3 Effect on the Disposable Income of Single 75Adult Unemployment Beneficiaries of a GSTWhich Increases Their Expenditures by10 Per Cent

Table 4 Effect on the Disposable Income of Married 76Pensioners of a GST Which Increases TheirExpenditures by 10 Per Cent

Table 5 Effect on the Disposable Income of Married 77Unemployment Beneficiaries of a GST WhichIncreases Their Expenditures by 10 Per Cent

Table 6 Pension Type By Income As Assessed, 78December 1984: Per Cent

Table 7 Beneficiaries by Total Non-Benefit Income, 79November 1984: Per Cent

Table 8 Pension Type By Type of Non-Pension Income, 80December 1984: Per Cent


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1.INTRODUCTION

In the Government Taxation Policy Statement of 31 October 1984 the Prime Minister announced nineprinciples for tax reform (Appendix 1). This submission concentrates on the fifth and sixth of theseprinciples, which are:

any reform package must result in a tax system which is fairer, so that Australians are only requiredto pay tax according to their capacity to pay, and the overall system must be progressive; and

any tax reform must not disadvantage recipients of welfare benefits, and should reduce or remove'poverty traps'.

These two principles suggest that, at a minimum, social security recipients and other low income groupsshould not be adversely affected by tax reform, and that the overall equity of the system should beimproved. Accordingly, this submission identifies some of the major inequities in the current taxationsystem and the resulting priorities for reform. These inequities include:

negative aspects of the increasing interaction between the social security and income tax systemsincluding the high effective marginal tax rates facing recipients of income-tested governmentassistance and the consequent creation of poverty traps;

the decline relative to taxpayers without children at average weekly earnings since the mid-1970sin the disposable incomes of low income groups and of all families with children, due, amongstother reasons, to the decline in the real value of the tax threshold and family allowances; and

the narrow definition of income used in the personal income tax system, which fails to recognisefully the increases in capacity to pay tax resulting from receipt of such items as fringe benefits ancapital gains.

Possible solutions to these problems are then discussed.

As noted above, it is clear that low income groups should not be adversely affected by any tax changeswhich address these or other problems. Consequently, this submission also analyses those tax measureswhich would increase the tax burden of low income groups, and then discusses possible methods foreither exempting low income or disadvantaged groups and families from such taxes or for returning theadditional revenue collected from such groups to them, so that their real incomes remain the same.

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This submission's discussion of compensation for any tax reforms is not based on such questions as whiclow income groups are most deserving of compensation, but is simply based on distributional neutrality.In other words, if the tax burden upon the poor is not to be increased, then any new taxes they pay mustbe offset, so that their net position remains constant.

However, the redistribution of income, rather than just the maintenance of the current income distribution

can also be seen as an important goal of tax reform. Compensation might ensure that the living standardof low income groups do not decline after tax changes, and that they remain at the same level in anunequal income distribution. Redistribution, on the other hand, would mean improvement in theirabsolute and relative living standards. Accordingly, this submission also canvasses issues associated witredistribution rather than just compensation.

The scope of this submission is not confined to a small group but embraces well over half of theAustralian population including some 2.7 million pensioners and beneficiaries and an estimated 1.5million or more low income earners, who are principally employees. In addition, there are some 4.4million children for whom family allowances are paid.

This submission is restricted to the Federal sphere. Discussion generally excludes State and local

government taxes and welfare systems, although, for example, changes to such taxes may well be part ofany comprehensive tax reform package, and may also affect low income groups. Issues associated withbusiness taxation are also not addressed.

Part 2 of this submission discusses the interaction of the Federal social security and taxation systems, andshows that when income distribution is considered it is necessary to analyse the effects of the two systemtogether.

Part 3 analyses some of the inequities currently created by the taxation and social security systems,including the narrowness of the income tax base, tax avoidance and evasion, high effective marginal taxrates, and trends in disposable incomes of various family types since 1976-77. It also identifies some

priorities and possible measures for tax reform.

Part 4 looks in detail at the compensation required by pensioners, beneficiaries, low income groups andfamilies with children if a distributionally neutral result is to be achieved after any broadening of indirecttaxes, and estimates the costs of any compensation required because of such tax changes.

Part 5 discusses the implications for pensioners, beneficiaries and low income groups of some proposalsfor reform of the direct taxation system and possible measures to protect them from any negative effectsof changes.

Part 6 discusses whether redistribution rather than just compensation should be integral to tax reform, anestimates the costs of some redistributive measures.

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2.THE INTERACTION OF THE TAXATION AND SOCIAL SECURITY SYSTEMS

The taxation and social security systems are two key instruments which have a major effect on incomedistribution. Since their interaction affects the way in which incomes and standards of living aredistributed throughout the community, it is necessary when considering policy changes to either system t

examine both together, so that the combined effects of change can be exposed and any unintendedconsequences of change avoided. Thus, while the tax or social security systems are frequently considerein isolation, exclusive concentration upon only one system may frustrate broader equity andredistributional objectives.

The tax and social security systems can be shown to be unavoidably linked in many ways:

1. The two systems do not have discrete populations with the result that, for example, Social Securityinitiatives affect many taxpayers while tax initiatives have directconsequences for many welfare recipients. Large numbers of individuals and families haveentitlements under both the tax and social security systems. Thus, the living standards of manytaxpayers are vitally affected by their receipt of either the dependent spouse or sole parent rebates i

the tax system, and family allowances, family income supplement or additional pension/benefit forchildren currently paid through the social security system.

The interaction between the tax system and the social security system has increased markedly sincemost social security pensions and benefits became taxable in the mid 1970s, to the extent that thebasic rates of social security poverty-alleviation payments now exceed the income tax freethreshold. This is because basic rates of most pensions and benefits have been automaticallyindexed for inflation, but the tax free zone has not. This situation has necessitated special taxmeasures, such as the pensioner and beneficiary tax rebates, which have been introduced in the lastthree Budgets to ensure that those who are largely dependent on pensions and benefits do not havetheir already low incomes reduced by income tax. Another reason for increasing numbers of peopl

being affected by the interaction between the tax and social security systems lies in the rapid growtin the number of unemployment beneficiaries since the mid-1970s, many of whom have spent partof the year as social security recipients and the remainder in work.

The full extent of the overlap between the tax and social security systems is not, however, widelyappreciated. The most recent data shows that in 1980-81 some 580,000 or more than 10 per cent oall taxpayers received Australian

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Government pensions and benefits some time during the year, and paid more than $800 million intax (on both their social security and private income). Those taxpayers who received some pensionor benefit during that year thus contributed about 5 per cent of all revenue collected from personalincome tax(l). More recent figures are not yet publicly available.

2. The tax and social scurity systems can have very similar and related effects on th economicbehaviour of individuals, in particular on incentives to work and save. Just as many people naveentitlements under both systems, so too do they have liabilities. The income test on pensions andbenefits is analogous to income tax, in that both reduce the benefit to an individual of additionalincome. Once pensioners' and beneficiaries' incomes enter the taxable range, the combined effect oliability for income tax and the reduction of pension or benefit through social security income testscan produce "effective marginal tax rates" far higher than the top rate of 60 per cent applied totaxpayers on the highest incomes. ("Effective marginal tax rates" refer to the amount of income losthrough the withdrawal of assistance by income or means tests and/or the payment of tax, for eachadditional dollar of private income.) Pensioners and beneficiaries face effective marginal tax ratesof 100 per cent or more over certain private income ranges, and attempts to increase their disposabincomes (eg. through part-time work) can leave them no better off or even worse off. (Effectivemarginal tax rates are discussed in more detail in Part 3 of this paper.)

3. Many tax and social security measures can be alternative mechanism for achieving the same policyaims. Assistance to families with children, for example, can be provided through tax rebates ordeductions to taxpayers with children, or through cash transfers such as family allowances (althougwith somewhat different distributional effects). Social security cash transfers can thus beappropriately regarded as broadly equivalent to "tax credits" or "negative income taxes".

This issue is important, because perceptions of the income redistribution effected, of its cost, and othe level of government involvement may be influenced by the instruments used. For example,social security outlays are generally seen as representing a cost to taxpayers and as contributing tothe size of the government sector. By contrast, similar "tax expenditure" measures effected in the

taxation system (by reducing income tax liabilities)

(1) Commissioner of Taxation, (1982: 25, 127) and Guilfoyle, 1982.

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are often not regarded as a cost to anyone, and tend to be seen as reducing the size of thegovernment. But both cash transfers and assistance through reductions in tax liability have similarimplications for the Budget deficit or surplus. Neither cash transfers nor tax assistance, however, ithemselves, add to or detract from the "size" of the government or public sector in the sense ofinvolving the government in "using-up" real resources (apart from any administrative costs).Rather, they simply redistribute disposable income between individuals and families.

Perceptions of social security outlays as a "cost" while tax concessions are perceived as "costless" iunfortunate, as it means that tax expenditures may be subject to less scrutiny than social securityoutlays, irrespective of the actual merits and efficiency of direct expenditures in comparison to taxexpenditures.

4. Indirect taxes raise prices and directly affect all taxpayers, including all social security recipients.Indirect tax measures which are not co-ordinated withsocial security initiatives may, for example, lead to any pension increases designed to improve thereal position of pensioners being eroded by indirect tax increases.

The preceding examples suggest that the tax and social security systems must be considered together

when designing tax reforms, to ensure that tax initiatives are adequately coordinated with social securityprograms and do not have unintended distributional effects. Cuts in income tax, for example, would be olimited assistance to maximum-rate pensioners and beneficiaries who currently pay little or no incometax. A cut in income tax may, therefore, widen the gap between low income families and others.Similarly, while the extension or introduction of capital taxes could in itself be a progressive measure, ifthe new revenue was used solely to increase the disposable incomes of taxpayers through personal incomtax cuts, the poorest groups in society would receive little or no benefit. Thus, a nominally progressivetax change could actually be to the relative disadvantage of low income groups. Redistribution is,therefore, not simply a matter of collecting more tax revenue or collecting the same revenue in a moreprogressive manner, but also relies critically on which groups receive the benefits from revenue.

A corollary is that whether any particular tax or social security measure is nominally progressive orregressive when considered in isolation is less important than the effect of overall changes to tax-transferarrangements. Recent studies suggest that while taxation in Australia and other member countries of theOrganisation for Economic Co-operation and Development (OECD) has contributed little to incomeredistribution, cash transfers (and, to a lesser extent, the social services) have been an effectiveredistributive tool

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(Harding, 1984; Saunders, 1984). Harding also found that the net effect of Australian federal taxation anoutlays on social security, education, health and housing was to make the income distributionsubstantially more equal. This has direct implications for tax reform. It suggests, for example, that whilthe introduction of any new indirect tax could raise the price of many goods and services and thus lowerthe real living standards of all households (but particularly low income groups and families), the effectson these groups could be largely offset through extensive social security and other outlay or tax

initiatives. Such measures, introduced in conjunction with a regressive tax, could therefore increaserather than decrease overall equity in the income distribution. Thus, it is the overall effect of tax andsocial security changes that is crucial.

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3. EQUITY AND PRIORITIES FOR TAX REFORM

The taxation system and, in particular, the personal direct tax system have been extensively criticised inrecent years for failing to achieve their equity objectives. While submissions to the Economic PlanningAdvisory Council (EPAC) have also highlighted other issues, such as efficiency and incentives, the need

for greater simplicity, or the reduction of income tax burdens, equity concerns have nevertheless beencentral to the debate on tax reform, not least because of the inter-relationship between equity and theseother objectives.

The two major avenues for tax reform that have been suggested by these earlier submissions (office ofEPAC: 1984) have involved either:

reforming personal direct tax arrangements, with initiatives aimed at one or more of the following- broadening the direct tax base or introducing new taxes on capital gains, wealth and capital

transfer taxes and more effective taxation of 'in-kind' employment fringe benefits;

- further reducing tax avoidance and evasion;

- changes to the personal income tax schedule, eg. to provide income tax cuts to relieve the taburdens and reduce the marginal tax rates of pay-as-you-earn (PAYE) taxpayers; and

- introducing a levy or some other form of contributory financing of social security; or reforming the indirect tax base.3.1 Broadening the Income Tax Base and Reducing Tax Avoidance and Evasion

The income tax threshold and marginal tax rates are designed to ensure that income tax is progressive.Yet the most recent data on the incidence of personal income tax on households in 1975-76 suggests thatincome tax is only mildly progressive at the bottom and top ends of the income spectrum and roughlyproportional for middle income groups (Warren, 1979). Prominent critics have argued in recent years ththe actual progressivity of the income tax system is now even lower or non-existent, due to such factors athe narrowness of the income tax base, tax avoidance and evasion, and tax concessions (eg. Head, 1984;Mathews, 1983). This has direct implications for equity.

As income tax should ideally be levied according to "capacity to pay", a decision must be made about theappropriate measure of capacity to pay. In Australia, income has been the main

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measure used, but it has been narrowly defined and comprises mainly money income from wages,salaries, profits, dividends, interest and rent. The exclusion from the definition of income of most capitagains, imputed income from capital and other types of income such as inheritances and gifts, together witproblems with the assessment of employment fringe benefits (1) and the partly related growth in taxavoidance and evasion, raise major issues of equity:

first, to the extent that excluded items are concentrated in the hands of high income earners, theiromission from the tax base reduces vertical equity. For example, a recent study of fringe benefits(Jamrozik et al,1981) found that they are mainly received by those on high salaries and thatincome tax minimisation was one of the most important reasons for their growth;

second, the narrowness of the direct tax base also introduces horizontal inequities, as those withsimilar total incomes or capacity to pay may face different effective tax burdens, because theyderive part of their income from capital gains, substantial inheritances or employment packages.Similarly, some would consider it inequitable that while the narrow income tax base means thattaxpayers generally are able to escape tax on assets, pensioners' entitlements are assessedaccording to a wider definition of economic welfare, which includes both income and assetholdings;

third, the narrowness of the direct tax base and consequent tax avoidance has presumably raisedpersonal income tax rates over those which could have prevailed had the tax base been broader,thereby affecting all taxpayers, including low income groups;

fourth, increases in the tax free zone have been made more difficult, because less revenue has beeraised (which has reduced the capacity to finance this and other redistributive measures), andbecause the benefits of raising the tax threshold could flow through to tax avoiders and evaders aswell as others; and

(1) Employment benefits include low interest loans, payment of health expenses, entertainment andother allowances, and the generous tax treatment of superannuation contributions and benefits. Inmost cases, the value of these to the recipient is defined as assessable income and thus is legallytaxable, but in practice tax is often partly or fully evaded because of administrative and practicaldifficulties involved in measuring their value(Groenewegen, 1979:98)

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consequently. the tax burdens of pensioners, beneficiaries and other low income groups haveincreased as their money incomes have increased faster than the tax threshold, and their incomeshave moved further into the taxable domain (fiscal drag). The actions that governments have taketo protect pensioners and beneficiaries (through the introduction of special tax rebates and makingsome additional payments non-taxable) have increased the complexity of the system and have

raised effective marginal tax rates for these groups over the private income ranges where thespecial rebates are tapered away. They have also introduced issues of equity between those whoderive their income from pensions and benefits and other equally low income earners inemployment.

On both horizontal and vertical equity grounds, therefore. there is a clear case for broadening the incometax base or for introducing new taxes to more fully reflect the additions to capacity to pay bestowed bycapital gains and capital transfers, the ownership of wealth, and fringe benefits.

3.2 Changes to Personal Income Tax Schedules

Much of the tax reform debate has focussed on the need to reduce the personal income tax burdens andmarginal tax rates of wage earners, particularly for those at average weekly earnings (AWE) and above(eg. Boyd et al. 1984: Spry, 1985). While this may be considered a problem. it should be noted that thetax burdens of those at AWE have not increased substantially since the mid 1970s (1). Average tax rates

(1) There are, of course, always difficulties associated with examining a series of data over time, andlooking at trends in the disposable incomes of pensioners, beneficiaries and other taxpayers is noexception.The choice of the base year can have a significant influence on the results, in this submission, 1976-77 habeen chosen for a number of reasons. First, major changes were made to the tax schedules in 1975-76 an1976-77 which make accurate comparisons of tax liabilities before and after these years much more

difficult. In 1975-76 concessional deductions for specified expenditures were replaced by tax rebates, anin 1976-77 child tax rebates were replaced by family allowances. Second. 1976-77 was the first full yearof current arrangements of assistance for families, of automatic indexation of the basic rates of pensionsand benefits, and of the taxation of most pensions and benefits. Consequently, there is some consistencyover this period in the provisions affecting pensioners and beneficiaries and families generally. While1976-77 represents a peak year for assistance to low income families with children, the levels ofassistance available then. while still relatively low, were closer to the levels of assistance providedthrough the tax and social security systems in a wide range of overseas countries. It therefore provides arelevant base for analysing trends in the disposable incomes of these particular groups.

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which measure the proportion of total income paid in tax, are a better guide to tax burdens than marginaltax rates. While the highest marginal tax rates facing single taxpayers at AWE have increased from 35per cent in 1976-77 to 46 per cent now, their average tax rate remains almost unchanged at around 22 percent (Table 3.1). Similarly, the average tax rate for single income couples with children earning AWE haalso remained constant at about 17 per cent. Average tax burdens for those at 150 per cent of AWE andtheir marginal tax rates have increased only marginally. In contrast, the average tax rate of single

pensioners with real private incomes of $30 (in 1984 dollars) has increased from zero in 1976-77 to abou5 per cent now, while their marginal tax rate has jumped from zero to almost 70 per cent. Marriedpensioners with small non-pension incomes have been similarly affected.

Because increasing average tax rates may merely reflect increasing real incomes, many would considertrends in real disposable incomes a better guide to the fortunes of various taxpayers. Table 3.2summarises movements in some of the key determinants of disposable incomes since 1976-77 and showsthat there have been real increases in:

general community incomes, reflected in movements in AWE; most tax rebates; and the basic rates of indexed pensions and benefits (although these have been influenced by the

Medicare effect and other factors - see later discussion).

However, there have been real declines in the tax free zone, cash transfers for children, unemploymentbenefits for single adults without children and the young unemployed, and in the pension tree areas.

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TABLE 3.1 AVERAGE AND EFFECTIVE MARGINAL TAX RATES IN 1976-77AND 1984-85 FOR VARIOUS CATEGORIES OF TAXPAYERS

1976-77 1984-85

Effective EffectiveAverage Marginal Average MarginalTax Rate Tax Rate** Tax Rate Tax Rate**

% % % %

Single Taxpayer 21.9 22.7at AWE

35.0 46.0

Single Income 16.6 17.7Married Couple withChildren at AWE 35.0 46.0

Single Taxpayer at 28.2 30.6150% of AWE

45.0 47.33

Single Income Married 24.7 27.2Couple with Childrenat 150% of AWE 45.0 47.33

Single Pensioner with 4.9$30 Private Income

69.59

Married Pensioner 2.6Couple with $50Private Income 79.38

1. Based on estimated annualised AWE for 1984/85 of $20430 and for 1976-77 of $9339.(Following changes to the AWE series in 1981 there are difficulties in comparing AWEestimates before and after this change. The 1976-77 figure has been calculated by theDepartment of Social Security. using a methodology suggested by the ABS.)

2. The effect of any health care levies has been excluded; annual tax scales used.3. Private income levels of pensioners and beneficiaries are the free areas applying in 1984-85;

deflated by CPI to determine equivalent real private incomes in 1976-77.4. These figures are slightly different to those presented in earlier editions of this paper because of

revised AWE estimates.Denotes no income tax liability.Shows effective marginal tax rate on next dollar of income; includes effect of social security income test

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TABLE 3.2 REAL CHANGES IN COMPONENTS OF INCOMES BETWEEN 1976-77 AND 1984-85

Income Component(l) Percentage ChangeSince 1976-77 InReal Terms

Pensions and Benefits % Additional pension/benefit for children - 9 mothers/guardians allowance(2) -20 Standard rate of pension and sickness

benefit(3) + 8 Married rate of pension and benefit(3) + 9 Single adult rate of unemployment

benefit (for those without children) - 4 single junior rate of unemployment and

sickness benefit- standard rate -36- for those in receipt of benefit for -316 months and over

Single pension free area -23

Family allowances -23

Tax Measures Dependent spouse and daughter-

housekeeper rebates:

- for those with children + 6- for those without children -15

Sole parent rebate +14 Basic tax threshold -17 Single pensioners' tax threshold -1 Single beneficiaries' tax threshold -14

Wages Gross Average Weekly Earnings(4) +12

1. Family Income Supplement is not included in this table because it was introduced only in 1983.2. Based on movements in higher rate of mothers/guardians allowance.3. These increases are effectively overstated because of declining inflation rates and the Medica

effect (see discussion in text).4. Based on an estimate of Average Weekly Earnings of $392.90 a week for 1984-85; excludes an

health care levies.

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All the variables identified in Table 3.2 interact to affect disposable incomes. The net results are shown Table 3.3, which sets out changes in real disposable incomes since 1976-77 for a wide range of familycompositions and income levels. It shows, for example, that both the relative position and the real livingstandards of many sole parent pensioners whose only source of income is social security payments havedeclined substantially since 1976-77. This is because the 8 per cent real increase in the single pension

rate and a 14 per cent increase in the sole parent tax rebate have not been sufficient to offset the verysubstantial real reduction in cash transfers for children. The table also shows that, despite an increase intax burdens resulting from the declining value of the income tax free zone, the real disposable incomes overy low income working families with children have substantially improved because of the introductionin 1983 of the family income supplement. Without this payment, the position of a two parent, two childfamily where only one spouse works for 50 per cent of AWE would have remained relatively unchangedsince 1976-77. These examples illustrate that cash transfers have had a greater impact on the livingstandards of many low income groups than have changes to taxation arrangements in recent years.

Many taxpayers on AWE have fared relatively well in terms of trends in real disposable incomes since1976-77. For example, the disposable incomes of single taxpayers on AWE have increased by 10.9 percent, while those of single income married couples without children earning AWE have increased by 9.3

per cent. It should be noted that the gains made by all social security recipients are overstated, partlybecause of the effects of indexation lags in a period of declining inflation, and partly because of the"Medicare" effect. Basic rates of pensions and benefits have risen in real terms, partly due to the lag inthe indexation adjustment of pensions and benefits. Because the rate of inflation has been declining inrecent years, the indexation increases that are made to pensions and benefits in any year are higher thanthe CPI increases in that same year.

Second, following the introduction of Medicare, the CPI actually declined in the six months to June 1984because of the sharp decline in health insurance costs, and no indexation increase was consequently due pensions in November 1984. Most pensioners received no offsetting benefit from Medicare and thedropping of health insurance costs, as they already received free health care. In recognition of this, an

increase in pensions was announced in the 1984-85 Budget partly to compensate pensioners for theestimated CPI increase which would have occurred if Medicare had not been introduced. These factorsshould be borne in mind in comparisons of disposable incomes of social security clients and others in1984-85.

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TABLE 3.3: CHANGES IN REAL DISPOSABLE INCOMES OF VARIOUS FAMILY TYPES,1976-77 TO 1984-85 (ESTIMATED): PER CENT

HOUSEHOLD TYPE PENSIONER/BENEFICIARY

(with no private income)

NON-PENSIONER/BENFICIARY

Beneficiary with Nil Private IncomePensioner

with NilPrivateIncome

AdultSickness

AdultUnemp-loyment

JuniorUnemployment andSickness

Wage and

Salary Earnerwith PrivateIncome of50% AWE (1)

(2)

Wage and

SalaryEarner withPrivateIncome of75% AWE

Wage and

SalaryEarner withPrivateIncome of100% AWE

Wage and

SalaryEarner witPrivateIncome of150% AW

Single Person +8.4 +8.2 -4.3

-36.0

-31.3 +6.8 +9.7 +10.9 +8.3

Sole Parent,One Child +1.6 - - - - +9.0 +10.3 +8.0

Sole Parent,Two Children -1.2 - - - - +7.7 +9.2 +7.2

Sole Parent,Three Children -3.4 - - - - +6.3 + 8.0 +6.4

Sole Parent,Four Children -4.9 - - - - +5.0 +6.9 +5.6

+4.7 +7.7 +9.3 +7.2Married Couple, NoChildren- One Spouse Working- Both Working (3)

+8.6 +8.4 +8.4 - +7.5 +5.6 +6.8 +9.7

+13.1 +8.4 +9.8 +7.7Married Couple,One Child- One Spouse Working- Both Working (3)

+5.7 +5.5 +5.5 - +14.5 +4.8 +6.2 +9.2

+18.2 +7.2 +8.8 +6.9Married Couple,Two Children- One Spouse Working- Both Working (3)

+3.1 +2.9 +2.9 - +19.6 +3.8 +5.3 +8.5

+22.4 +5.9 +7.6 +6.1Married Couple,Three Children- One Spouse Working- Both Working (3)

+0.8 +1.7 +1.7 - +23.7 +2.6 +4.4 +7.7

+26.1 +4.6 +6.5 +5.3Married Couple,Four Children- One Spouse Working- Both Working (3)

-1.0 +1.5 +1.5 - +27.4 +1.6 +3.4 +6.9

1. At this income level, PIS would be payable where there were children.2. At this income level sole parents would be financially better off on supporting parents benefit.3. Distribution of income assumed to be 60:40 per cent4. Average weekly Earnings is estimated to be $392.90 a week for 1984/85. Includes all rebates, familyallowances and family income supplement. Excludes health levies.


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In stark contrast to the gains made by middle income taxpayers earning AWE, the real disposable incomeof significant numbers of social security clients have actually declined since 1976-77, and they mighttherefore be regarded as deserving priority in any tax/social security reform package (especially as theMedicare and declining inflation effects mean that their cuts in disposable income are actuallyunderstated). These groups include:

single adult unemployment beneficiaries (-4.3 per cent); sole parent pensioners with two or more children (-1.2 to -4.9 per cent for those with four

children); and

married pensioner couples with four or more children (-1.0 per cent for those with four children).one of the most significant trends revealed in Table 3.3 is an increase in horizontal inequity, as shown bythe relative shift in the tax burden towards those with children. Taxpayers at AWE without children havefared better than those at the same income level with two or more children, while social security clientswith children have been similarly disadvantaged relative to those without children. In addition, twoincome families with combined incomes at AWE or below who are not eligible for FIS have fared badlycompared to single income units at the same income levels.

overall, therefore, trends in disposable incomes since 1976-77 suggest that groups who have suffered adecline in their disposable incomes relative to single taxpayers earning AWE and who might therefore beconsidered most in need of assistance from tax-transfer reform are:

all pensioners and beneficiaries with children, particularly sole parent pensioners; all wage and salary earner families with children, whose income is above the level which would

entitle them to family income supplement (or who do not take up their entitlement to FIS);

single and married pensioners and beneficiaries without children; and two income families with combined incomes at or below AWE.While any changes to the personal income tax schedules following tax reforms should address thesetrends, there are also other major issues of concern. Because most pensions and benefits have beenindexed for inflation while the tax threshold has not, increasing numbers of social security recipients havfaced tax liabilities.

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In 1983-84 some beneficiaries with children faced income tax liabilities on their basic rates of incomesupport payments; some applied for tax relief under the special hardship provisions of taxation legislationbut this remains an inadequate way of dealing with the problem (eg. because many beneficiaries may notrealise that they can apply for relief). In addition, there is some evidence that low income groups areexperiencing severe difficulties in paying current or previous income tax assessments, and may not befully informed of relief provisions (see case studies in Victorian Social Security Consultative Committee

1985).

This general problem has been ameliorated to some extent by introduction of the beneficiary andpensioner rebates, and by making payments for the children of beneficiaries non-taxable, but beneficiariewith minimal amounts of private income may still be liable for income tax (eg. in 1984-85 full-year singlsickness beneficiaries and married beneficiaries without children will pay income tax when their privateincome exceeds $1 a week). under the existing income tax schedules, almost all unemployment andsickness beneficiaries will pay tax in 1985-86. To some extent this subverts the purposes of the socialsecurity income test free zones, or "free areas", which permit small amounts of non-pension/benefitincome without reduction in social security payments. These are designed to allow recipients tosupplement their poverty-alleviation payments without reductions in their payments, and to encourageself-help.

While increasing the pensioner and beneficiary rebates provides a partial solution to this problem, furtheincreases in the rebates raise major issues of equity between social security recipients and low incomeworkers receiving the same income but with higher tax liabilities, and also extend high marginal tax ratesover a wider income range and thereby further discourage self-help. The high effective marginal tax ratefacing recipients of income-tested assistance are explored in detail in the next section.

Finally, because of the special rebates, most pensioners and beneficiaries who are wholly or largelydependent upon their income support payments do not currently pay any personal income tax. As a resuany tax changes which reduce the tax liabilities only of those who pay sufficient income tax to gain thefull benefit of the tax cuts could make the income distribution more unequal. To prevent this, equal "tax

cuts" would need to be given to social security recipients in the form of higher payments. In addition,depending upon the magnitude of the tax cuts, additional assistance may have to be channelled to lowincome groups in the workforce who pay insufficient tax to take full advantage of any tax cut.

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3.3 Effective marginal Tax Rates and Poverty Traps

In designing and administering redistributive mechanisms there are other important issues apart from theincidence of tax-transfer arrangements to consider. Continuing emphasis on achieving progressive policresults can create its own problems; while income-tested programs are designed to concentrate assistanceon those most in need, the combination of income-tested programs together with income tax can produce

high effective marginal tax rates (EMTRs)(1). This is widely regarded as unfair, as well as havingadverse effects on disposable incomes and incentives to work and save. It may also create incentives toavoid or evade income tax and social security income tests. In some cases, overlapping income tax andincome tests can produce 'poverty traps'. These are situations when EMTRs reach a level where lowincome groups seeking to increase their income find themselves only a little better-off, no better-off oreven worse-off than if the attempt to secure additional private income had never been made.

It is not widely appreciated that social security clients frequently face effective marginal tax rates far inexcess of those applying to taxpayers with the highest incomes. In recognition of these problems, thePrime Minister has stated that tax reform should reduce or remove such poverty traps. For example,single unemployment and sickness beneficiaries will face EMTRS under prevailing tax scales of 62.5 pecent on non-benefit income between $20 and $70 a week and of 100 per cent above that point until

benefits cut out. Where there are children, the rates rise to 125 per cent over the range where non-taxabladditional benefit for children is withdrawn - in other words, the incomes of beneficiaries with childrencan actually fall over certain income ranges if they attempt to earn additional income. Some details ofeffective marginal tax rates currently faced by pensioners and beneficiaries are at Appendix 2.

Other circumstances where EMTRs can approach or exceed 100 per cent are:

where 'sudden death' income tetsts exist, ie. when assistance is suddenly terminated when incomeexceeds a specified level, rather than being graduallly withdrawn via a tapered income test. Thisoccurs in the case of the income test on Pensioner Health Benefits (PHB) cards, which provide arange of direct and indirect financial benefits such as free pharmaceuticals and concessional

telephone rental. A number of concessions are also available from State governments and otherauthorities, and are often linked to eligibility for the PHB card, including property rates and localtransport concessions. The maximum value

(1) As noted earlier, this is the amount of income lost, through the withdrawal of assistance by incomeor means tests and/or the payment of tax, for each additional dollar of private income.

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of benefits linked to the PHB card following the introduction of Medicare is estimated at about $2028 a week, and the average value some $8-12 a week (Cox and Foster, 1985:6). Where non-pensioincome exceeds the income limits governing eligibility for cards the full loss is incurred. Theincome limits for those without children are currently $60 a week for single persons and $98 a weefor pensioner couples, and are indexed twice a year. Not surprisingly, the income test canencourage pensioners to "minimise" their private income to below the PHB card cut-out point;

when families are entitled to several forms of income-tested assistance. Many social securityrecipients, for example, also receive income-tested public housing or education assistance, andoverlapping income tests frequently produce EMTRs which approach or exceed 100 per cent; and

where effective marginal tax rates may be less than 100 per cent, but where unavoidable costsassociated with working may be greater than the increase in net income. For example, a sole parentpensioner with one child who has the opportunity to increase private income from, say, $50 to $100a week, by working four days part-time rather than two, will increase his or her disposable incomeby only $22 a week. This net gain may not be enough to cover the additional costs associated withchild care, travel to work, etc. Thus, the sole parent may feel 'trapped' into a situation where theopportunity and desire to work are present, but the economic rationality to do so is not.

A large number of pensioners and beneficiaries actually experience high EMTRs. Numbers of peopleexperiencing EMTRs of 100 per cent and over are far smaller, but this may simply reflect a behaviouralresponse to the presence of a severe poverty trap. For example, some case studies suggest that thebehaviour of sole parents can be affected by high EMTRS (Victorian Social Security ConsultativeCommittee,1985).

By definition, it is unavoidable that those receiving income-tested payments will face higher effectivemarginal tax rates than usual over the income range where payments are being withdrawn. In the end, itis a matter for judgement as to the extent to which the problems of high effective marginal tax rates and"poverty traps" can be resolved when balanced against other concerns. The goal of reducing effective

marginal tax rates in order to increase incentives to work and save may conflict with other goals, such asthe provision of more adequate payments, target efficiency, containing the cost of programs and moregeneral equity concerns. The conflict between these competing objectives can be easily illustrated in thecase of unemployment benefit. For example, if it was decided to liberalise the benefit income tests toequate with pension income test conditions in order to reduce the higher marginal tax rates facingbeneficiaries, then married unemployment beneficiaries would be entitled to assistance until their privateincome exceeded 90 per cent of AWE.

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A range of possible options (in ascending order of magnitude of cost) to address the problem of povertytraps include:

relief measures targetted to specific problems - for example, abolition of the separate income test fosupplementary rent assistance, so that rent assistance was withdrawn under the general pension

income-test, or increases in the income disregard for those with children to better reflect child carecosts;

general relaxation of social security income tests liberalisation of income-tests could involvestandardisation and increases in the free areas, and/or reductions in the withdrawal rate. Relaxationof the income test would address the major underlying source of problems, but the costs could behigh;

changes to the income tax system - The present special rebates could be maintained or increased,and if the taper on these rebates was abolished, there would be a reduction in marginal tax rates atlow income levels. More general tax initiatives which might be justified on broader equity grounds(eg. increases in the tax free zone or a reduction in the first rate of income tax) would also have theside effect of reducing EMTRS for some pensioners and beneficiaries, if only modestly. Forexample, the reduction of the first rate from 30 to 25 per cent in the 1984-85 Budget reducedmarginal tax rates for social security recipients by between 2.5 and 5 per cent;

greater integration of the tax and social security systems - some smoothing and lowering of effectivmarginal tax rates could be achieved through partial integration of the two systems. The AspreyCommittee, for example, discussed in 1975 a proposal involving the outright abolition of the meanstest then current and the introduction of a separate tax rate scale for social security recipients.Alternatively, withdrawal of social security payments could be achieved through social securityincome tests with all social security payments being made non-taxable. Neither of these twoalternatives, however, allow for substantial reductions in EMTRs . While offering some

administrative advantages, these options would also involve a number of problems and may involvenothing more than rationalisation and redistribution of EMTRS within the existing recipientpopulation. A major lowering of withdrawal rates could only be achieved by providing assistance new recipients and by incurring additional costs ; and

the introduction of a guaranteed minimum income (GMI) scheme - full integration of the tax andsocial security systems implies some form of GMI, although the form of this could vary. Appendix6 describes alternative GMI approaches, but it should be noted that a GMI generally

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implies very much greater costs than those of the existing social security system. The mainrationale for a GMI is to ensure that all those on low private incomes receive support, not just thosewho satisfy existing categorical requirements. Full integration also requires detailed considerationof complex issues, such as the appropriate tax and social security income unit.

3.4 Contributory Financing of Social Security

A possible option for tax reform is the introduction of a social security levy (similar to the Medicare levyor of social security contributions. A number of reasons have been advanced for such a change.

First, there may be a greater willingness to pay tax if it is specifically earmarked for social securityoutlays, because taxpayers may feel that they will eventually reap the benefits of these tax payments.Alternatively, the costs of social security will be made more visible, and will be felt by all taxpayers. Inthe context of tax reform, a further reason advanced for change is that the Australian revenue structure isout of step with other countries, Australia and New Zealand being the only OECD countries withoutexplicit social security contributions. However, the financing issue cannot be considered separately fromthe social security benefit structure. The Australian system is designed to provide flat-rate povertyalleviation payments rather than payments related to previous earnings. This reflects a different emphasi

upon the various objectives of social security, and it is not at all certain that an earnings-related system ispreferable to the Australian one unless it is considered desirable to strike a different balance betweenthese objectives.

Appendix 3 provides a more detailed discussion of these issues.

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3.5 Broadening the Indirect Tax Base

The Australian federal indirect tax system currently features:

very heavy excise taxes on a small number of goods (tobacco, alcohol and oil-based products); lower differential-rate wholesale sales taxes of 7.5, 10, 20 and 32.5 per cent, applied to a wide rang

of goods, with widespread exemptions for "necessities"; and

the general exclusion of services from the tax base.Hence, even though indirect taxes make a significant contribution of some 26 per cent of total Australiantaxation revenue, less than 40 per cent of private final consumption expenditure is subject to taxation(Treasury, 1983). Clearly, greater taxation of consumption expenditure could provide an important sourcof additional revenue. In particular, those consumers who are currently able to avoid or evade personalincome tax, and who use these additional resources for personal consumption, could pay more tax if thescope of indirect taxes was widened. Some argue that this result would be more progressive than currentarrangements (Mathews, 1983).

Nevertheless, flat-rate taxes on consumption and expenditure will be regressive unless adequatecompensatory measures are simultaneously introduced. This is because consumption tends to decline asincome rises - that is, low-income earners spend proportionally more of their income on goods andservices than do high income earners, who typically save more. (Savings are, of course, only subject toconsumption taxes when spent.) A tax on consumption, therefore, tends to fall relatively more heavily onlow-income groups.

There is evidence, for example, that existing sales taxes in Australia are regressive, despite the differentiarate structure, which taxes 'luxuries' more heavily and exempts necessities. Warren shows that in 1975-7sales taxes took about twice the proportion of the income of the lowest income group as of the highest

(1979:23).

In addition, consumption taxes also produce horizontal inequities, because on average and at almost everincome level families with children spend proportionately more of their income on goods and servicesthan those without children. As a result, consumption taxes bear more heavily on families with children.As Mathews points out, however, consumption taxes at the same time may improve horizontal equitybetween wage and salary earners and other income recipients (1983:10).

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There are three major options for indirect tax reform. These are:

alterations to the existing wholesale sales tax, eg. extension of the base to currently exempt itemssuch as food and clothing, or changes to the rate structure;

the taxation of services; and introduction of a new goods and services tax, such as a value added tax or a retail sales tax. The

abolition of wholesale sales or other taxes might accompany the introduction of such a broad-basedconsumption tax.

3.5:1. Wholesale Sales Tax

Among the most important items exempted from the existing wholesale sales tax base are virtually allfood and clothing, drugs and medicines, building materials, and fuels and power. Of these, the only oneslikely to yield substantial additional revenues are taxes on food and clothing (Treasury,l974).

Calculation of the effect of taxing such goods requires information about how much money is spent onsuch items by households at different income levels and of various family compositions. The most recensource of such information is data from the 1984 Household Expenditure Survey (HES) conducted by theAustralian Bureau of Statistics (ABS). Only data from January to June 1984 are currently available, andthe estimates are subject to large sampling variability and are affected by seasonality. While all data usein this paper have standard errors of less than 25 per cent and most of the data have standard errors of lesthan 10 per cent, it must be emphasised that usage of the survey for this purpose is subject to reservationand qualifications, and that the following analysis only provides broadly indicative estimates of the effecof various indirect tax options.

Full analysis of various indirect tax options on the basis of the 1984 HES data has not yet been completeHowever, Table 3.4 shows expenditure on food as a percentage of disposable income for various

household compositions and income levels. It indicates that lower income households spend a greaterproportion of their disposable income on food than upper income households, and would consequently bmore adversely affected by inclusion of food in the sales tax base.

It also suggests that the proportion of income spent on food increases with family size.

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TABLE 3.4 EXPENDITURE ON FOOD AS A PERCENTAGE OF DISPOSABLE INCOME FOR VARIOUS HOUSEHOLDCOMPOSITIONS AND INCOME GROUPS

ANNUAL HOUSEHOLD INCOME (GROSS)

HOUSEHOLD $4000 $6000 $8000 $9000 $10500 $12500 $15000 $20000 $25000 $35000 MORE MCOMPOSITION TO TO TO T0 TO TO TO TO TO TO THAN

$5999 $7999 $8999 $10499 $12499 $14999 $19999 $24999 $34999 $44999 $44999

Single Adult over 18 27 23 25 22 23 21 17 14 13 11 13- no children

Single adult over 18 35 35 33 29 26 23 22 18 19 16 17with children

Married couples. 59 32 30 34 26 24 24 21 15 14 12- no children

Married couples * * 37 44 23 24 26 23 18 15 13- 1 child

Married couples * 52 45 32 35 31 25 23 19 16 15

- 2 children

Married couples. * * * 35 20 32 31 37 21 20 163 or more

children

Note: This table is based on sample survey figures which art subject to standard error: Most have a standard error of less than 10 per centand all have a standard error of less than 25 per cent.

* Too few households to give statistically valid resultDisposable Income is average weekly income minus income tax payments.

Sources Unpublished 19B4 HES Data PA


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While this emphasises that, at all income levels, the imposition of a tax on food would disadvantage those withchildren relative to those without, Table 3.4 also shows that the effects would be especially severe for those onlow incomes with dependants. The cost of food in married couple households with two children accounted forover 50 per cent of the disposable income of households with incomes between $6000 and $8000. This meansthat a sales tax which raises food prices by 10 per cent could effectively take about $6 a week from suchhouseholds' incomes, and raise the proportion of disposable income spent on food and associated taxes to

around 60 per cent.

Table 3.5 shows the effect of a tax which increases expenditure on food in various households by 10 per cent.For example, it indicates that a tax which increased expenditure on food by 10 per cent would add about $6.80a week to the food bill of married couple households with one child earning $9000 to $10500 a year; thisrepresents about 4.4 per cent of their disposable income.

While the preceding analysis examined the possible extension of the sales tax base to include food, it wouldalso be possible to increase tax revenues by increasing rates of tax on currently taxed items. It is difficult,however, to calculate the effects upon low income groups with any precision, as this would depend upon themix of tax rates and schedules adopted. Perhaps in an attempt to make sales tax less regressive, "luxuries" arecurrently taxed at 32.5 per cent, but necessities, which take a greater slice of the income of low income groups

than of others, are exempt from tax. However, as Warren (1979) and Kakwani (1983) have shown, sales tax iscurrently regressive, and there seems to be little scope for imposing additional taxes on the very limited numbeof goods which are disproportionately consumed by high income households. Thus, if the sales tax base werechanged or rates of tax increased, particular attention would have to be paid to low income groups and familiewho would probably be disadvantaged. Compensatory mechanisms would be similar to those described in Par4 for a goods and services tax.

3.5:2. Taxation of Services

It is difficult to predict precisely the effects on equity of the taxation of services, because detailed data from th1984 HES about expenditure upon services by income level are not yet available. on first glance, it seems

unlikely that the lack of tax on professional services (lawyers, architects accountants and stockbrokers, etc), foexample, bestows major benefits upon the poor. However, data from the 1975-76 HES suggested that thegeneral taxation of services might be regressive. Kakwani, for example, has calculated that taxing childminding, legal fees, medical and dental services, dry cleaning and other clothing and footwear services; rail,bus, train or taxi fares; vehicle servicing; postal, telephone and telegram services;

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Table 3.5 EFFECT OF A TAX WHICH INCREASES EXPENDITURE ON FOODBY 10 PER CENT: BY HOUSEHOLD COMPOSITION AND INCOME

Household Composition Average Food New Tax New Tax Asand Gross Annual Income Expenditure Payments of Disposable

Income

$pw (1) $pw %

Single adult, over 18, no dependants

- $4000 - $5999 25 2.50 2.7- $9000 - $10499 37 3.70 2.2- $15000 - $19999 47 4.70 1.7- $35000 - $44999 69 6.90 1.1

- mean 43 4.30 1.7

Single adult, over 18, with dependants

- $4000 - $5999 38 3.80 3.5- $9000 - $10499 53 5.30 2.9- $15000 - $19999 66 6.60 2.1- $35000 - $44999 102 10.20 1.6

- mean 65 6.50 2.2

Married couples, no dependants

- $4000 - $5999 48 4.80 5.9

- $9000 - $10499 59 5.90 3.4- $15000 - $19999 65 6.50 2.4- $35000 - $44999 88 8.80 1.4

- mean 69 6.90 1.8

Married couples, I child

- $4000 - $5999 (2) (2) (2)- $9000 - $10499 68 6.80 4.4- $15000 - $19999 73 7.30 2.6- $35000 - $44999 94 9.40 1.5

- mean 82 8.20 1.9

1. Rounded to nearest dollar2. Too few households to give statistically valid result3. Disposable income is average weekly income minus income tax payments.Source: Unpublished 1984 HES data

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beauty, health and hair services; education, some financial services and sports services generally would all beregressive (1983a). The only major services on which expenditure was more unequally distributed than incomwere meals in hotels and restaurants, air fares and freight, live theatre, overseas holiday fares and packages,holiday packages in Australia, professional subscriptions, and domestic services (excluding child-minding). Ittherefore seems likely that the taxation of many services would be regressive, particularly as tax avoidance and

evasion would be likely to be even further encouraged in such areas as domestic services.

moreover, if a tax on services was introduced, those services provided or financed by governments might needspecial consideration. For example, if new taxes increased the price of such services as public transport, childcare, home help, legal aid and "meals on wheels", which assist considerable numbers of low income groups,Kakwani's research suggests that the effects could be regressive.

3.5:3. Goods and Services Tax

The possible introduction of a broad-based tax on goods and services such as a value added tax or a retail salestax, has received some attention in Australia. The impact of these or other forms of goods and services tax(GST) on low income groups will depend on:

what items are taxed - a comprehensive or selective tax base; the rate structure - the same tax rate for all goods and services, or zero rating and differential rates; whether other taxes are abolished, eg. wholesale sales or payroll tax; the treatment of excise taxes, eg. abolished or added onto a GST; other compensatory changes in the tax system, eg. reductions in personal income tax or introduction of

capital taxes; and

more broadly, any compensatory changes in government outlays, eg. increased social security spending.On the question of a selective or a comprehensive tax base, it seems clear, as outlined earlier, that inclusion offood in the tax base of a GST would most penalise low income earners and families with children. Althoughthe 1984 HES data has not yet been fully analysed, the inclusion of most other currently exempted goods andservices in a GST base would also seem likely to particularly disadvantage families with children and those onlow incomes.

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It is difficult to calculate the impact on low income groups of a uniform or differential rate GST without detailabout the composition of the base and tax rate. In addition, modelling the effect of the possible simultaneousremoval of other taxes such as wholesale sales tax is very complex. Therefore, purely for illustrative purposesthe following examples generally examine the effects of a GST which raises household expenditure by 10 percent. This makes no assumptions about the rate of GST which would produce a 10 per cent expenditureincrease, or about the movement in the CPI.

Table 3.6 provides a rough example of the impact of a GST which raises the total expenditure of all incomegroups by 10 per cent, assuming that the same basket of goods and services were to be purchased. The tableshows that if a GST added 10 per cent to prices, married couple households without children with income of$6000-$8000 per year could pay on average an extra $19 a week in indirect tax. A household of the samecomposition but with income of $35,000-$45,000 could pay an additional $51 in indirect tax.

While the high income household would thus pay more GST in absolute terms, the new tax as a percentage ofdisposable income may provide a more appropriate indicator for gauging the impact of the GST on householdThus, in the above example, while the new indirect tax would take about 14 per cent of the income of thepoorer household, it would take only 8 per cent of the income of the high income household. Similarly, in thecase of sole parent households, the new GST would account for about 16 per cent of the disposable income of

those receiving $8000-$9000 a year, 9.5 per cent for those receiving $15,000-$20,000 a year, but only 8.5 percent for those receiving $25000 to $35000 a year.

In more practical terms, if there were no compensatory measures, these figures imply that a GST which raisedexpenditures by only 10 per cent could trigger off a financial crisis in poorer households while being fairlyeasily accommodated by high income households. The 1984 HES found that households whose principalsource of income was wages and salaries, self-employment or superannuation were, on average, saving part oftheir incomes. However, households principally reliant on government cash benefits whose head was aged lesthan 65 years were on average dissaving. For example, households principally reliant on unemploymentbenefits had average incomes of $183 a week and expenditures of $244 a week. In the case of sole parents,income averaged $170 a week and expenditure $201 a week. This suggests that the income of these groups is

already inadequate relative to their needs, and that the imposition of any additional indirect taxes withoutcompensatory measures could be expected to drive poorer households into debt, lead to the further run down osavings, the forced sale of assets or more attempts to cut back on consumption of goods normally consideredessential by Australian society.

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TABLE 3.6: ADDITIONAL INDIRECT TAX AND ADDITIONAL TAX AS A PERCENTAGE OF DISPOSABLE INCOME AFTER

IMPOSITION OF A GST WHICH INCREASES HOUSEHOLD EXPENDITURE BY 10 PER CENT: BY HOUSEHOLDCOMPOSITION AND INCOME.

ANNUAL HOUSEHOLD INCOME (GROSS)

HOUSEHOLD $4000 $6000 $8000 $9000 $10500 $12500 $15000 $20000 $25000 $35000 MORE MCOMPOSITION TO TO TO TO TO TO TO TO TO TO THAN

$5999 $7999 $8999 $10499 $12499 $14999 $19999 $24999 $34999 $44999 $44999

Single Adult over 18 11 14 19 18 22 23 25 32 37 53 78

- no children 11.5 11.5 12 10 11.5 10.5 9 9 8.5 8.5 8.5

Single adult Over 18 13 18 26 26 20 34 30 34 41 74 82- with children 12 13.5 16 14 13.5 14 9.5 9 8.5 11.5 8.5

married couples. 30 19 15 30 26 26 32 40 42 51 61- no children 36 13.5 11 14 13 11.5 11.5 11.5 9 8 7

Married couples * * 24 30 22 31 32 39 40 52 69- 1 child 17 20 10 13 11.5 11.5 8.5 8 7.5

married couples * 25 26 24 25 32 35 37 42 54 75- 2 children 20.5 17 13.5 12.5 13 12 10.5 9 9 8

married couples. * * * 24 25 31 35 44 46 37 73or more 12.5 12.5 12.5 12.5 12 9 9 8children

Note, This table is booed on sample survey figures which are Subject to standard error, Mat have a standard error of less than 10 per centand all have a standard error of less than 25 per cent.

* Too few households to give statistically valid result

Disposable Income is average weekly income minus income tax payments.

Source: Unpublished 1904 HES Data

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Table 3.6 also shows that because on average households with children generally spend more of their incomethan those without children, a GST would correspondingly hit them harder. For example, at almost all incomelevels a GST which added 10 per cent to the total expenditures of all households would affect sole parenthouseholds more than single adults. Unfortunately, sample cell sizes from the 1984 HES six monthly data are

not large enough to trace the effects of a GST on low income families with children; however, the 1975-76HES data showed that the proportion of income consumed increased sharply with the number of dependants atlow income levels (Appendix 4 : Table 1).

These effects of broad-based consumption taxes upon low income earners have confronted all policy-makers,and most OECD countries have adopted a differential tax rate structure in order to reduce or overcome theequity problems. It is hoped that by subjecting "necessities of life" to zero or very low rates of tax and"luxuries" to rates above the standard rate, that a proportional or perhaps even progressive consumption taxmay result.

However, such an approach raises major problems, as the 1975 Taxation Review Committee and, morerecently, the New Zealand Government explained when rejecting differential rates in favour of a uniform rate

(Douglas, 1984). One of the central issues is the difficulty in objectively defining luxuries and necessities,especially given changing social mores. This is well illustrated by the current Australian sales tax, whichimposes "luxury" tax of 32.5 per cent on hair brushes, shampoos, ballpoint pens and cigarette lighters. Inaddition, any neutrality and economic efficiency gains resulting from the shift to a GST are immediatelyreduced or eliminated by differential tax rates as, for example, high taxes on luxury goods distort consumptionpatterns and put these items even further beyond the reach of low income earners.

Low or zero rates on necessities also drastically reduce the size of the potential tax base. For example,Treasury has estimated that almost two-thirds of the additional revenue that could be received from extendingthe coverage of sales tax would come from taxes on food and clothing (1974;10). Most of this additionalrevenue would come from middle and high income households rather than the poor. While the extra tax wouldtake a greater proportion of the income of the poor, middle and high income households spend about two tothree times more on food in each week in dollar terms (ie. as Table 3.5 showed, single adult households withincomes between $4000-$6000 a year spend about $25 a week on food, while those on $35000-$45000 a yearspend about $70). Thus, in this sense, the exemption of necessities from any tax base could be said to assistmiddle and high income earners more than the poor. In addition, the exemption of food assists those buyingcaviar and fillet steak as much as those buying bread and sausages. It could, therefore, be more efficient to taxall goods and services, and return the relatively small amount of total revenue collected

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from low income households to them, through such mechanisms as social security cash transfers. Additionalproblems raised by the exemption of necessities are that in order to raise a given amount of revenue higher taxrates must be imposed on the remaining non-necessities (with resulting greater efficiency losses) and that thepossibilities for tax avoidance and evasion are immediately increased.

Nonetheless, many would consider such reductions in efficiency, simplicity and revenue an appropriate price t

pay for reductions in regressivity, especially if it appeared that the final result could be to make indirect taxesproportional or progressive. Two major overseas studies have attempted to measure the incidence of valueadded taxes. They conclude that in most of the European countries studied, the VAT is proportional orprogressive in effect (OECD, 1981; Adams, 1980). These studies have been extensively quoted as suggestingthat the widely held belief that indirect taxes are regressive is wrong (eg. Sandford, 1981; Office of EPAC,1984; 16-17). However, these results must be subject to very severe reservations, given the data deficienciesand methodology employed. A detailed critique is contained in Appendix 5. Perhaps the major conclusionwhich can be drawn from these studies is that while a differential tax rate can be less regressive than a uniformstructure, some degree of regressivity (and a consequent need for compensating measures for low incomegroups or families) will almost certainly still exist.

An additional consideration is that preliminary results from simulations by the Economic Planning Advisory

Council based on the 1984 HES suggest that exemptions and differential tax rates may not only be aninefficient but also a relatively ineffective method of attempting to protect the poor (Warren, 1985). Similarlyafter analysis of the 1975-76 HES data, Kakwani concluded that his results "cast doubt on the commonly heldbelief that indirect taxes can be made more progressive by making a distinction between luxuries andnecessities" (1983a:76). It is not clear whether a more equal distribution of income in Australia than in otherOECD countries or differing consumption patterns have affected the results, but this research indicates thatthere are almost no goods and services disproportionately consumed by middle to upper income groups, andthat differential tax rates consequently will not produce a proportional or progressive indirect tax. It is possiblhowever, that heavier taxes on mildly regressive goods and services (such as women's footwear) and lessertaxes on very regressive goods and services (such as children's footwear) would be less regressive than auniform rate GST. Such a tax would, of course, be far more difficult to administer, eg. in the above example,

an arbitrary decision would have to be made about when girls become women. It would also open up avenuesfor tax avoidance and evasion.

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Overall, therefore, it may be that a uniform, broadly-based indirect tax is preferable, if compensatory measuresare adequate. If compensatory measures appear unlikely to sufficiently protect the real living standards of thepoor and families with children, differential rates of tax, and zero rating or exemption of food must beconsidered, despite the relatively minor gains in equality and major losses in efficiency that would result.

In conclusion, there are strong efficiency reasons for reforming the indirect tax system in itself and it is possib

that replacement of sales tax by a new GST which raised the same amount of revenue would not have majorequity effects. However, any major shift in the tax mix towards indirect taxes appears certain to havesubstantial adverse effects on equity. As the main reasons advanced for tax reform appear to arise from theperceived failings of the current direct tax system, the most direct solutions to the problems of the direct taxsystem may lie in its reform - that is, in broadening the personal income tax base to reduce opportunities foravoidance and evasion, taking account of the additions to resources bestowed by capital gains and capitaltransfers, taxing more effectively the fringe benefits associated with employment, and addressing the morecomplex issues of privileges flowing from the ownership and inheritance of wealth.

It has been argued that broadening of the indirect tax base is an alternative solution to one of these problems,that of tax avoidance and evasion (Mathews:1983). This avenue of tax reform is therefore desirable on equitygrounds to the extent that the current problems of the direct tax system arise mainly from avoidance and

evasion and not other sources; that reforms of the direct tax system through, say,anti-avoidance and evasionlegislation cannot be sufficiently successful in practice; and that broadening the indirect tax base will actuallyhave a greater impact on tax avoiders and evaders than any other alternative.

Whether this is the preferable avenue of tax reform is not certain. However, changes to the indirect tax baseprovide only an indirect means of achieving the equity objectives of tax reform, and are a very blunt instrumenof redistribution. In addition, broadening the indirect tax base raises very major equity problems in itself.While these specific problems can be partly addressed through a mix of income security and other outlay andtax changes, these changes may amount only to compensation for the effects of indirect tax changes.Redistribution could still remain as an unfulfilled objective.

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4 MEASURES TO PROTECT LOW INCOME GROUPS AND FAMILIES WITH CHILDREN FROMINDIRECT TAX CHANGES

Any individual tax reform measure that may be considered will inevitably involve winners and losers - ie. sompeople will be required to pay relatively more tax while others will pay relatively less. one of the major

arguments for a shift towards a broad-based indirect tax is to increase the tax paid by current tax avoiders andevaders. However, such a change would also sharply increase taxes paid by pensioners, beneficiaries, and othlow income groups, as well as by all families with children. It would thus shift the tax burden towards some othe poorest groups in our community. This could not be considered a desirable product of tax reform. On thecontrary, the relative or absolute declines in the disposable incomes of families with children and of lowincome groups, discussed earlier in Part 3, strongly suggest that tax reforms that do not involve someimprovement in the position of these groups are questionable. At the very least, their current real livingstandards must be protected through appropriate compensatory measures.

The Prime Minister's tax reform principles indicate that the tax burdens on individuals in low income groupswill not be increased by tax reforms. Accordingly, this section discusses possible compensatory initiatives forp

equity, tax reform and redistribution

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