Why stop at 15%?

Next Friday the rate of GST will go up to 15% and for most there will be compensating or better reductions in income tax.  But why stop there?  Why not completely replace the income tax system with a goods and service tax system?

I have previously presented here (Dominion Post, 7 August 2010) that New Zealand could significantly improve its economic performance simply by changing the mix of things that we produce.  Essentially I am saying that Adam Smith's invisible hand is not working that well for us. Why not? There are a number of candidates: the small size of our economy and our distance from markets might limit the impact of competitive pressures; we may have allowed our government get too big (back in 1974 government expenditure represented 28% of GDP, today it is around 45%); and our regulatory system perhaps confers privilege and competitive advantage to incumbent firms.  Each of these is likely to contribute and potentially be very important, but my focus today is on a fourth area, the income tax system.

Income taxes are known to distort incentives to work, to train, and invest.  However, the distortion that is most harmful to economic performance is the tax on capital income such as taxes on dividends and interest.  The logic for zero capital taxes is based on observations that:

  • the supply of capital is highly responsive to changes in the cost of capital,
  • capital taxes produce large distortions in consumption decisions, and hence discourage saving,
  • capital taxes also produce large distortions in the funding of different capital projects, and
  • as capital accumulation is central to the creation of aggregate output, this has sizeable impacts on economic growth prospects.

Capital equipment tends to be long lived, specialised to the production of dedicated outputs, large and lumpy in size and cost, and intertwined with the organisation of surrounding economic activity.  This means that capital taxation can be extremely harmful to economic performance, even at very low rates of tax, as the problems resulting from a tax distorting capital decisions compounds over time.

Income taxes are typically designed to have their strongest impact on the top income earners, the vast majority of whose income comes from capital.  So, if the primary aim is to raise revenue, the secondary one is to redistribute income.  But are progressive income tax systems efficient and effective ways of achieving these ends?  Not if the rich can effectively reduce their tax liability, and not if the imposition of taxes leads to economic inefficiencies that reduce prospects for economic growth.  So why not dump income taxes entirely and replace them with expenditure taxes?

A comprehensive expenditure tax system based entirely on a VAT/GST type tax system, with the abolition of income taxes, has many desirable attributes.  It addresses ability to pay via its link to voluntary spending decisions.  It is administratively simple to run and, as it can be based on existing GST systems, we already have the required infrastructure in place.  It has minimal impacts on economic decision making, as it does not tax either capital or direct labour income.  The lack of tax on income removes all the burdens of calculating, collecting and policing the collection of income tax.

GST type taxes are perceived by many to be regressive taxes.  In fact, expenditure taxes are equivalent to proportional income tax schedules, those who spend more pay more tax.  It does not, however, impose a higher tax rate on higher spenders.  Yet there are other, more direct, ways of transferring income from rich to poor households.  Indeed, a flat tax system with a universal income entitlement can easily be designed that would be more effective in transferring income than the current tax system.

A remaining issue is that reliance on GST as the prime source of government revenue will require very high tax rates.  Back of the envelope calculations suggest that a GST rate of 40 to 45% might be required to replace the existing income and company tax rates.  This largely reflects the fact that this is how much it takes to fund the current level of government activities.  But a higher GST rate will increase incentives to evade paying GST than is currently the case.  But in net the amount of tax evasion should be lower under a comprehensive expenditure tax compared with income tax systems. To begin with the need to register in order to claim back tax on expenses provides a self-enforcing element to value added tax systems.  Secondly expenditure taxes are more effective in taxing the proceeds from illegal activities.  Finally, the removal of an income tax system, where most evasion and avoidance activity is currently, would free considerable resources to police the GST system.

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