Changing the Tax Mix – Why Bother?

Many peopledo not support an increase in GST, or so the polls tell us.   I recall the samepopular sentiment in 1986 when GST was first introduced.   At that time therewas a natural fear about a type of tax that was unfamiliar to most NewZealanders.   Would it work?   Would politicians deliver the accompanying incometax cuts?   Who would gain and who would lose?   Would government be bigger orsmaller?   Perhaps these fears still exist even though the change being talkedabout this time is much less dramatic.

The policyoptions currently on the table involve a change in the tax mix that deliver thesame amount of revenue to the government.   Whether the total tax take is toohigh or too low – whether government is too big or too small – is a differentissue.   The aim of the current proposals for tax reform is to find a better wayto collect the same amount of tax revenue.   What is meant by a better way?   Onethat is more conducive to economic growth, fairer to those who can least affordto pay, easier to understand, more difficult to avoid and cheaper to complywith and administer.

Compared toGST, income tax is easier to avoid, more costly to administer, more complexand, as a result more unfair.   Its interaction with welfare benefits warps theincentive to work and thus impedes economic growth.   So what sort of advantagesmight an increase in GST coupled with a revenue neutral reduction in personalincome taxes actually deliver?

In somepreliminary analysis with an economy-wide model I investigated the impacts ofraising GST to 15%.   This would raise enough revenue to fund a uniformproportional reduction in all personal income tax rates of about 10%.   Forexample the 38% rate would drop to 34% and the 21% rate to about 19%.

The changesmay not look like much, but the wider economic effects are quite dramatic:

  • An increase in employment of 17,500 full time equivalentjobs.
  • An increase in real income of an average $250 per person peryear.
  • An increase in real household spending of $420 per householdper year.
  • An increase in aggregate household savings of $280m,contributing to a lift in aggregate real investment of almost half a billiondollars per annum.

These areaggregate effects, clearly demonstrating how a change in the tax mix affectseconomic growth.   But what of distributional considerations?

The mediais fond of presenting examples of people who would ostensibly be worse offunder an increase in GST.   For example it is easy for an unemployed person tocomplain that they would be adversely affected by a lift in GST.   Quite apartfrom any direct compensating increase in benefits, however, some of those whoare currently unemployed would secure a job as a result of the 17,500 increasein employment.   Superannuitants gain via the linking of superannuation benefitsto net wage rates, again in addition to any direct compensatory increase inbenefit rates.   These types of indirect effects are picked up in our economicmodelling, but are absent in most reports that I’ve seen.   They are crucial toproperly investigating the impacts of tax reform.  

In spite ofthese positive indirect effects though, a uniform proportional reduction in allincome tax rates is probably not a likely option, nor even a desirable one.   Itwould mean that the lowest 40% of households by income (who currently paylittle if any net tax) would pay more in extra GST than they would receive backby way of income tax reductions.   However, this situation would be relativelyinexpensive to amend with the lowest 40% of households requiring an additional$7 or so per week – over and above the pro-rata reduction in income tax rates.A larger reduction in the lowest tax rate or an increase in tax credits couldachieve such an outcome.

A key areaof uncertainty is the responsiveness of different households to changes in taxrates.   Lower marginal tax rates on income should increase the incentive towork, but how much is the response affected by age, the income of a partner, orthe types of jobs available?   Data released by the Tax Working Group clearlyshow that the worst distortions in the tax system occur at the lower end of thehousehold income scale.   Throwing out the mess that is Working for Familieswould make obtaining a job a much more financially attractive proposition tomany people.   This would put some households in a position where even thoughunder higher GST they would pay more tax than they do now, their total incomewould increase sufficiently to make them better off in net terms.   This is anavenue for more research.

Theuncertainties notwithstanding, it is clear that the macroeconomic gains aresignificant for what is in effect a fairly minor shuffle of the tax mix.   Onewonders what sort of gains could be generated by more fundamental reform of thetax and benefit system.   If the incomes of New Zealanders are ever going tocatch up with the incomes of Australians, tax reform is likely to be animportant step in the process.


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