We should be grown up about GST

by John Daley and Danielle Wood

Published by The Australian, Monday 14 September

Reform of the GST is at the forefront of our current politics. This week we’ve heard three different versions of what a higher GST might look like.

NSW Premier Mike Baird said an increase in the GST to 15 per cent could address healthcare funding shortfalls and enable income tax cuts. South Australian Premier Jay Weatherill said it could fund tax cuts or healthcare, but not both. And Tony Abbott has said there are strong efficiency arguments for taxing spending more and taxing earning less, but only if the overall burden of taxation is reduced.

So, who is right? It is true that lower taxes on income, funded by a higher GST, will encourage economic growth. Broad-based consumption taxes such as the GST are relatively efficient. They are more difficult to avoid, and do not discourage savings as income taxes do. And swapping income taxes for consumption taxes could increase incentives to work.

So lower income taxes, funded by a higher rate of GST — or, even better, a broader one — are likely to encourage economic growth. But it is fantasy to think that this outcome can be achieved without increasing the overall tax burden.

Almost all players in the GST debate assume a higher GST means higher welfare payments. If the GST increased to 15 per cent, a household in the bottom fifth of income earners could buy 3.5 per cent less than it buys today. Income tax cuts provide almost no benefit to this household because welfare payments provide most of its income. So unless the government is prepared to cut the standard of living of the poorest 20 per cent, benefits will have to rise.

The bottom fifth of households pay about 12 per cent of the GST collected. If they could be targeted directly, only $3.6 billion in additional welfare payments — or 12 per cent of the $30bn raised from a 5 percentage point increase in the GST — would be required to ensure they are no worse off.

But this is unlikely to be enough. The welfare changes will not be perfectly targeted. Modellers will find the precise households going backwards overall. And welfare groups will argue that over time these increased welfare benefits will be eroded, particularly since Newstart is indexed to inflation rather than to earnings. The response to the May 2014 budget suggests the politics of such changes is unworkable.

Instead there will be need for some overcompensation, to ensure there are few households worse off, and to provide a cushion against the erosion of welfare benefits over time. A reasonable guess is that about 20 per cent of any increase in GST should go towards benefits — about $6bn a year.

It is also difficult to see how the GST could be increased without some net contribution to state government budgets. Why would they share in the political pain if it doesn’t help the bottom line? This is why Weatherill and Baird are at the negotiating table. And given the size of the Abbott government’s cut to hospital funds promised to the states — up to $5bn a year for the next few years, increasing to more than $10bn a year after 2020 — $5bn a year is probably the minimum price premiers will put on their support.

Does this leave room for income tax cuts, as Baird suggests? Yes, but perhaps less than the PM would like. The $19bn in GST revenue left after increased welfare spending and payments to the states could fund a reduction in tax rates from 19 to 15 per cent for the bottom tax bracket, 32.5 to 28 for the second and 37 to 34 for the third, assuming thresholds are unchanged. Along with increases in welfare, cuts of this magnitude would leave most people earning under $80,000 better off.

Tax cuts should be focused on the low and middle rates in part because this is where the impact on workforce participation will be greatest. People most likely to respond to tax changes are second-income earners who are deciding how many hours to work. Reducing tax rates in the lower brackets will increase the pay-off for working more hours. It will also counter the effects of bracket creep, which disproportionately fall on middle income earners.

But the GST is not a magic pudding. If some of the revenue funds additional spending on welfare and hospitals, then net government expenditure will be higher. Unless the deficit increases, overall taxation will also be higher. If tax cuts are focused on lower income earners, where they will do most to increase participation and economic growth, then those with higher incomes will pay less income tax, but more tax overall than they do today.

Some might claim that the budgetary costs of lower tax rates for everyone could be covered by faster economic growth and the resulting boost in tax receipts. The US has tried this strategy, and the results are not encouraging. Big tax cuts may have spurred economic growth, but not enough to plug the hole they created in government budgets.

Increasing the GST while reducing income tax rates would be an important tax reform. If done right, it could strengthen the economy and help those on low incomes. It could also contribute to funding hospitals. But as a political reality, these reforms will increase the overall level of taxes. Grown-up tax reform would not pretend otherwise.