THE RUDD GOVERNMENT’S MINI TAX REFORM PACKAGE

Talk to Economics and Business Educators annual conference

Bankstown, Friday, May 28, 2010

Ross Gittins, Economics Editor, The Sydney Morning Herald

This talk has been billed as an update on fiscal and monetary policies, but now
I’ve seen the budget I want to focus in on just one development, the most
interesting aspect of the budget, the Rudd government’s tax reform package - its
mini reform package. This year the budget was announced in stages and the
government’s response to the report of the Henry tax review was unveiled a bit
more than a week before the budget - though some elements of the response
were announced in the budget itself. Either way, it’s now clear that the tax
package was main measure in the budget.

Contents of the package

The package consists of one big new tax, the resource super-profits tax, which
will cover the cost of various tax cuts and increased tax concessions. The
resource tax effectively replaces the states’ various royalty charges for the use
of minerals owned by the Crown. Although the states will continue to charge
these royalties, miners will have their payments refunded by the feds. The
resource tax is expected to raise a net $9 billion in its first full year of operation.

Proceeds from the resource tax will finance a range of tax reductions:

• Company tax rate phased down from 30 pc to 28 pc

• Small business receives company tax rate cut earlier than other companies,
plus instant write-off of new fixed assets worth less than $5000

• The present tax deduction for resource exploration costs will be turned into a
‘refundable tax offset’ at the prevailing company tax rate, making it more
valuable to explorers and much more expensive to the government

• The concessional treatment of superannuation is made more concessional in

several ways, including: the 15 pc contributions tax for people earning up to
$37,000 a year is effectively eliminated and the higher cap on contributions by
people over 50 will be continued permanently for those with inadequate super.
The package will also cover the cost to revenue of the decision to slowly phase
up the compulsory contribution rate for employees from 9 pc to 12 pc between
2013 and 2019. (The cost to revenue arises because wages that formerly would
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have been taxed at the employee’s marginal rate will now be taxed at the 15 pc
rate of the contributions tax. The legal incidence of the increased contributions
falls on the employer, but economists believe it is shifted to the employee by
means of wage rises that are lower than otherwise.)

• Tax on interest income will be subject to a 50 pc discount (similar to the tax on

capital gains) up to a limit of $1000 interest income.

• As a step towards simplifying tax returns, rather than itemising their work-
related expenses (and tax agent’s fees), people may opt to claim a standard
deduction of $500, to be raised to $1000.

As well as these tax measures, the government announced that part of the
proceeds from the resource tax will be contributed to a ‘resource state
infrastructure fund’ and distributed to the states, particularly the resource-rich
states, to finance resource-related infrastructure. This measure, combined with
the resource exploration rebate, is supposed to account for ‘approximately one
third’ of the proceeds of the resource tax. In the first full year, however, they’re
expected to make up less than half that.

Timing: the resource tax isn’t due to begin for more than two years - July 2012 -
and so all the other parts of the package are begun or phased in from that date.

The Henry tax review

The tax package was produced as the government’s response to the Henry
review panel’s comprehensive review of the Australian tax and transfer system,
federal and state. It’s the first comprehensive review since the Asprey report of
1975. Just as the Asprey report set the direction for tax reform over the following
25 years, so Ken Henry’s goal was to lay down a blueprint to guide further
reform over coming decades, whether by this government or its successors.
Henry set out proposals to:

• concentrate federal and state revenue-raising on four broad-based taxes:

personal income, business income, rents on natural resources and land, and
private consumption. Other taxes should be retained only where they serve
social purposes or internalise negative externalities (eg gambling, tobacco and
alcohol taxes, petrol taxes, pollution taxes). State taxes on insurance,
conveyancing and other stamp duties and payroll tax should be replaced by a
comprehensive 1 pc land tax and a ’broad-based cash flow tax’ (a simplified
GST-type tax). (The objection to payroll tax is not that it’s a tax on labour - so is
the GST - but that its high threshold means only larger businesses are taxed.)

• change the mix of taxation to reduce reliance on taxing mobile resources (eg
business income) and increase reliance on taxing immobile resources (eg land
and resources, and consumption). The company tax rate should be reduced from
30 pc to 25 pc. State royalty charges on minerals should be replaced by a
resource rent tax levied at 40 pc.

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• introduce a new two-step income tax scale with a tax-free threshold of $25,000
(but with the low-income tax offset and other offsets abolished), a 35 pc rate to
$180,000 (but the 1.5 pc Medicare levy abolished) and (the present) 45 pc rate
above that.

• regularise the widely disparate rates of tax on income from savings by allowing
a 40 pc discount on income from interest, rent and capital gains, but also on
deductions for interest expense of rental properties.

• improve the targeting of cash transfer payments.

• reform the taxation of superannuation by abolishing the 15 pc tax on

contributions. People’s contributions should be taxed at their marginal rate, but
they should receive a tax offset designed to ensure low income earners pay no
net tax on contributions, middle income earners pay no more than 15 pc and
only high income earners pay more than 15 pc. This would greatly improve the
present inequitable distribution of the super tax concession. The tax on fund
earnings should be halved to 7.5 pc. These two measures would lead eventually
to greater super payouts, particularly for low and middle earners, making a rise
in the compulsory contribution rate unnecessary.

• improve the taxing of roads by introducing congestion pricing that varies by

time of day, using the proceeds to replace the tax element of motor vehicle
registrations and possibly fuel taxes. Heavy vehicles should pay changes
reflecting the damage they do to roads.

• reduce the complexity of the tax system, including by using an optional

standard deduction for work-related expenses to simplify the completion of tax
returns and save on tax agents’ fees.

The package as tax reform

The Rudd government’s response to the Henry tax review was surprisingly
limited. Of the review’s 138 recommendations, the government accepted and
acted upon just a couple, explicitly rejected 19 politically controversial proposals
and failed to comment on the rest. In other words, it cherry-picked the report,
selecting just a few things it thought would bring short-term electoral benefit.

The report contained many politically difficult recommendations but one that was
particularly attractive: a proposal to introduce a whole new source of revenue by
using a federal resource rent tax to replace the states’ mineral royalty charges.
Here the government had some highly respected economists urging it to
introduce a lucrative new tax on an unpopular, mainly foreign-owned industry
and assuring it the tax would do nothing to discourage mining or hurt the
economy.

It could use the new tax to pay for various politically attractive ‘reforms’, to be
introduced after it was re-elected. The resource rent tax it announced was in line
with Henry’s recommendations, except for a spin-doctor-inspired name change
to the ‘resource super-profits tax’. The tax is being opposed by the Opposition
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and bitterly resisted by the big mining companies, which have won a fair bit of
sympathy from wider business community. This resistance has caused many
voters to wonder whether the tax would be bad for the economy, but almost all
the criticisms are unjustified. Precisely so as to ensure the tax doesn’t do the bad
things it is being accused of, it is hugely complex, meaning that many of its
critics simply don’t understand how it would work.

When you look at the other supposed reforms, however, you find they bear little
resemblance to the Henry report’s recommendations:

• It did propose a cut in the company tax rate, but to 25 pc not 28 pc.

• It did propose the instant write-off of assets, but for those costing less than
$10,000 not $5000.

• On superannuation, the report proposed that the cost of increasing the

concession on contributions by lower income earners be covered by reducing the
concession to higher income earners. The government did the nice bit but not
the nasty bit. The government did nothing about halving the tax on fund
earnings as recommended. The report specifically avoided recommending an
increase in the rate of compulsory contributions, but we got on anyway.

• The report recommended a thorough overhaul of the tax on savings, with the
50 pc discount on capital gains cut to 40 pc and the 40 pc discount extended to
interest income and the interest expense deductions on rental property. The
government introduced a 50 pc discount for interest income, but with a cap of
$1000 in interest income. It made no changes to the capital gains discount or to
negative gearing.

• The introduction of a standard deduction for work-related expenses was in line

with the report’s proposals (though it may have been more generous that the
report had in mind) and the report said nothing about introducing a new
infrastructure fund.

The economic rationale for the resource super-profits tax

The present state government royalties - which aren’t so much taxes as charges
for the use of mineral resources belonging to the community - are quite
inefficient because they are based either on quantity (a price per tonne) or on a
certain percentage of the market price. This means they take no account of the
cost of mining the mineral, which varies from site to site and may increase as the
exploitation of a particular site moves from the easily extracted to the hard-to-
extract. Thus the present royalties can have the effect of making a prospective
site uneconomic and discouraging the full exploitation of a site. This inflexibility
limits the ability of state governments to raise the rate of the royalty when world
commodity prices are high. (They may also be inhibited by perceived
competition between the states or unduly close relations with the mining
companies.)

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The beauty of the super-profits tax (and the existing petroleum resource rent
tax) is that, because they are based on taking a share of super-normal profits,
they don’t discourage the exploitation of marginal sites, nor encourage the
under-exploitation of existing sites. They are highly flexible, taking higher
royalties when world commodity prices are high, but automatically reducing the
take when world prices fall. There will be times when world prices fall to the
point where some sites are paying no royalty-equivalent (the resource tax) and
there will be some sites with high production costs that never have to pay
royalties.

Super-normal profits are profits received in excess of those needed to keep the
capital employed within the business rather than leaving in search of more
profitable opportunities. So super-normal profit represents ‘economic rent’ - any
amount you receive in excess of the amount needed to keep you doing what
you’re doing, your opportunity cost. Accountants and economists calculate profit
differently. Accountants take revenue, subtract operating costs and regard the
remainder as profit. But economists also subtract normal profit - the minimum
acceptable rate of return on the capital invested in the business - which they
regard as an additional cost, the cost of capital. The appropriate rate of return
must be ‘risk-adjusted’ ie the higher the risk of the business operating at a loss,
the higher the rate of return above the risk-free rate of return, usually taken to
be the long-term government bond rate.

(This is what’s so silly about the mistaken claim that the resource tax regards
any profit in excess of the bond rate as super profit. The risk is taken into
account not by adding a margin to the bond rate [as occurs with the petroleum
resource rent tax] but directly, by having the government, in effect, bear 40 pc
of the cost of the project, including losses.)

Most taxes on an economic activity have the effect of discouraging that activity.
This is clear in the case of the existing royalty charges. But resource rent taxes
(including the resource super-profits tax) have been carefully designed to have
minimal effect on the taxed activity. Because the return on capital remains
above its opportunity cost, activity should not be discouraged, meaning there
should not be any adverse effect on employment or economic growth. Indeed,
because of the more favourable treatment of marginal projects, there should be
more employment and growth.

Economic theory says a resource rent tax should not add to the prices being
charged by the taxed firms because it does nothing to add to their costs (as
opposed to the effect on their after-tax profits) and because the firm is already
charging as much as the market will bear. In practice, it may not be charging as
much as it could. So a better argument is that our mining companies are price-
takers on the international market, with Australian producers’ share of the world
market not big enough to have much effect on the world price.

The fact that resource rent taxes have been explicitly designed not to do all the
bad things the vested interests accuse them of doing explains the strong support

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for such taxes from economists. The resource rent tax is actually the proud
invention of Australian economists, available to be copied by other countries.

The package as short-term macro management

The tax package is roughly revenue neutral over the next four financial years. It
can be thought of as detachable - should the resource tax not be passed by the
Senate, none of the measures it finances would go ahead, thus leaving the
budget little affected.

This means it’s wrong to imagine the resource tax would play a significant part in
returning the budget to surplus. The budget is projected to reach (negligible)
surplus in 2012-13 for three reasons:

• the effect on the budget’s automatic stabilisers of the economy’s expected

return to strong growth

• the always-planned completion of the government’s temporary stimulus

measures

• the government’s adherence to its ‘deficit exit strategy’ of allowing the level of
tax receipts to recover naturally as the economy improves (ie avoid further tax
cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1
pc of GDP has been achieved.

The fact that the government now expects the return to surplus to occur three
years’ earlier than it expected in last year’s budget is explained by the much
milder recession than it expected and the much stronger forecasts for the next
four years. Various factors caused the recession to be so mild, including the V-
shaped recovery in China and the rest of developing Asia, and the consequent
bounce-back in coal and iron ore prices.

In view of the government’s commitment to limiting the real growth in its

spending to 2 pc, it’s worth noting that virtually all the things on which it intends
to ‘spend’ the proceeds from the resource tax are tax cuts and tax concessions.
That is, the package has been structured so as to add little to the government’s
difficultly in meeting its 2 pc target. The qualification to this is the plan to put
about $700 million a year into the new state infrastructure fund. My guess is that
contributions to the fund have been designed to be the ‘swing instrument’ - that
is, to be reduced or even eliminated should collections from the resource tax fall
short of projections.

The package as long-term macro management

Because the resource tax is designed to be heavily influenced by the ups and
down in world commodity prices, receipts from it are likely to be highly variable
over the years. By contrast, the cost to revenue of the tax cuts and concessions
it finances is likely to be far less variable. For an accountant-type, as Peter
Costello appeared to be, this would be a worry. The tax package will make the
budget balance much more cyclical. For an economist, however, this is a virtue:

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by introducing the resource tax the government has added a new and powerful
automatic stabiliser to its budgetary armoury.

Because Australia is such a major producer of mineral commodities, the cycle in

world commodity prices is likely to align pretty closely with our business cycle.
Whenever we’re in a resources boom, close to full capacity and with the Reserve
Bank worried about inflation pressure, the resource tax will take more revenue
from the boom sector and send it to the budget. Provided this extra revenue isn’t
spent or used to repeatedly cut income tax (as it was in John Howard’s day) it
will act as a drag on the economy, reducing inflation pressure and hence the
need for higher interest rates. Whenever we’re in a resources bust, the economy
has turned down and unemployment is rising, resource tax collections will
collapse, the budget will go more quickly and more deeply into deficit and this
will be the automatic stabilisers working to help prop up the private sector and
put a floor under the downturn.

The tax package can be seen as an attempt to improve the economic managers’
ability to manage the economy during resources booms: to chop the top off them
and make them less inflationary, but also to ensure we have more to show from
them when they’ve passed. The contributions to the state infrastructure fund are
a way of requiring the miners to contribute more towards their own additional
infrastructure requirements.

More significantly, the linking of the resource tax with an increase in compulsory
superannuation contributions should ensure at least some of the income from
the boom is saved rather than spent. Empirical evidence suggests the
introduction of compulsory super has done more to increase national saving than
conventional analysis led us to expect. (The practical weakness in the argument
is that the super increase is being phased in so slowly - the first tiny increase
takes place in July 2013 and the last in July 2019 - the boom could be long past
its peak by then.)

Ceteris paribus, an increase in national saving will cause our current account
deficit and foreign liabilities to be lower than otherwise - always remembering
that the resumed resources boom is expected to cause the CAD to be high for a
protracted period. The small cut in company tax may make Australia more
attractive as a destination for foreign investment, particularly equity investment.
Combined with the higher national saving and potential for interest rates to be
less high than otherwise (less weight on monetary policy), it’s possible to see
this leading to a lower exchange rate than otherwise.