Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

Top tax rate, low priority

Australian Financial Review

24 February 2005

The call for tax reform issued by Reserve Bank Governor Macfarlane in his recent appearance before a House of Representatives Committee is of interest as much for what he did not mention as for what he did. Macfarlane identified as major problems the distortions that promote speculative investment in housing and the high effective marginal tax rates faced by low income earners. He did not mention the top marginal rate of income tax, for the very good reason that reductions in the top rate are a low priority on any serious agenda for tax reform.

The absence of a substantive case for a reduction in the top marginal rate is reflected in the frequency with which spurious arguments are advanced. It has regularly been asserted, for example, that bracket creep over the last couple of decades has lowered the point at which the top marginal rate applies, so that middle-income earners now pay the top rate. This assertion is true only in the trivial sense that the abolition of the 66 per cent top bracket in the 1980s meant that 47 per cent become the top marginal rate. The point at which the 47 per cent rate cuts in has barely changed, relative to average earnings, in thirty years.

The income tax scale is less steeply progressive than it was in the past, not more. As observed by Peter Saunders (AFR 21/2/05), the big change that has taken place is the failure to adjust the minimum threshold in line with increases in prices and incomes.

An even more important negative change has been concessional treatment of capital gains, introduced at the height of dot-com mania in 1999. Far from encouraging productive investment, this measure has fuelled the growth in speculative housing investment deplored by Mr Macfarlane.

Then there are comparisons between the top marginal tax rate for individuals and the company income tax rate. Such comparisons are misconceived since, under dividend imputation, company tax payments are fully offset by imputation credits when income is distributed. The tax treatment of companies and trusts opens up all sorts of opportunities for tax avoidance and evasion, but most of these opportunities would exist even if company and personal tax rates are aligned.

Finally there is the claim that Australia has higher marginal tax rates, cutting in at lower multiples of average earnings, than other developed countries. This claim got a run in the latest OECD report on the Australian economy. However, a comparison of the summary of the report with the content of the main body suggests that the OECD position reflected pressure from the Australian Treasury, or perhaps the Treasurer’s office, as much as its own analysis.

The OECD’s own figures belie claims that Australia is an outlier. Of the 30 OECD countries listed in the report, 13 have top marginal tax rates (including social security taxes) in the range 45 to 50 per cent, 8 above this range and 9 below it. Similarly, in terms of purchasing power, the income level at which the top rate comes in is very close to the OECD median.

The real issue, though is not whether we are near the OECD average, but whether cuts in top marginal rates would boost growth. Econometric evidence on this point is inconclusive, but a look across the Tasman is instructive.

Readers may recall that New Zealand was hailed as pathbreaking miracle economy when Sir Roger Douglas cut the top marginal tax rate to 33 per cent in 1988. A rapid resurgence in economic growth was confidently predicted, even in the face of initially disappointing results. It was only after a decade of woeful economic performance that talk of the Kiwi miracle was finally abandoned. The Clark government elected in 1999 raised the top rate to 39 per cent. The economy promptly recovered and has grown strongly ever since.

It would be absurd to suggest that higher tax rates were responsible for the macroeconomic recovery in New Zealand after 1999. But, on the evidence, it is equally absurd to suggest that variations in top marginal tax rates have a significant effect on economic performance. Good macroeconomic management, rather than adjustments to tax rates, is the main prerequisite for sustained growth.

The main risks to our continued economic expansion come from weak labour force participation, excessive investment in the non-tradeable housing sector and a generalized focus on capital gains at the expense of production. These, and not the complaints of high income earners, should be the main targets of tax reform.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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