Gavonomics
Economics as if production matters
Monday, December 17, 2007:
Complete solution to vertical fiscal imbalance
In Australia, as in most federations, only the Federal government may impose customs duties (i.e. tariffs on imports) or excise duties (see s.90 of the Constitution). But whereas most countries understand excises as taxes that counteract tariffs by discriminating against locally produced goods, the High Court of Australia has ruled that excises include all inland taxes on new goods. Consequently the Australian States, unlike their U.S. and Canadian counterparts, cannot impose retail sales taxes.
In 1942 the Federal government, in order to raise revenue for the war and control non-military expenditures, decided to share its various revenues with the States on the condition that the States did not impose their own income taxes. The former State income taxes, having been abolished in wartime, could hardly be reimposed in peacetime. Neither did the wartime arrangement depend on the Federal defence power; it depended solely on s.96 of the Constitution, whereby the Federal Parliament can make grants to the States under such terms and conditions as it thinks fit. So the arrangement continues to this day, except that most of the shared revenue nominally comes from the GST (which, in the teeth of s.81 and s.90 of the Constitution, is shown as a State tax in the Federal budget papers). As the Australian voters have had 65 years to get used to the absence of State income taxes, any attempt to reintroduce them would be politically suicidal.
In consequence of these peculiarities, the Commonwealth (Federal government) now collects about 82% of all public revenue collected in Australia, but is directly responsible for only about 54% of public expenditure. Meanwhile the States together collect about 15% of public revenue but are directly responsible for about 40% of public expenditure. The mismatch between the vertical distribution of taxing powers and the vertical distribution of spending responsibilities is known as vertical fiscal imbalance (VFI).
VFI is fundamentally incompatible with accountability. When the Commonwealth raises revenue spent by a State, each party will blame the other for any shortfall in delivery of the associated services: the State will say it is due to lack of funding, while the Commonwealth will say it is due to inefficiency or inappropriate use of funds.
The GST did not solve the problem, but made it worse because the revenue-sharing formula required the States to abolish some of their own taxes, leaving them with less control over their total revenue, hence more at the mercy of the Federally-imposed grants system, hence better able to blame the Commonwealth for any problems. Moreover, the revenue-sharing formula itself became a scapegoat, as various States claimed that they were subsidizing other States or not being subsidized enough by other States. Meanwhile the Commonwealth, by pointing to increased GST revenue and ignoring demand for State-delivered services, was better able to accuse the States of inefficiency or waste.
For similar reasons, giving the States a guaranteed share of income tax or of some other Federal tax would further exacerbate the problem.
Replacing tied grants with untied grants, or otherwise giving the States more discretion in their spending of Federal grants, would not solve the problem, but would merely make the claims and counter-claims more general. The States, instead of alleging insufficient funding for several specific purposes, would allege insufficient funding overall; and the Commonwealth, by giving the States more choice, would gain more scope for accusing the States of making bad decisions.
That said, the GST has one major advantage: because of its broad base, a small and politically tolerable increase in the GST rate would give a large increase in revenue, hence a large and politically advantageous improvement in service delivery. Hence, if each State were free to set its own GST rate, the Commonwealth could easily wash its hands of the matter, saying that it is incumbent on each State to collect enough GST for its needs, and to accept the political costs and benefits as they come.
Allowing each State to set its own GST rate raises certain constitutional and political problems. But, as we shall see, these are easily solved.
Problem 1: The GST, in so far as it applies to goods, is an excise and therefore cannot be imposed by the States.
Solution: Let the Commonwealth impose and collect the tax, and refund it to the State in which it is collected.
Problem 2: Under s.51(ii) and s.99 of the Constitution, the Commonwealth cannot discriminate between the States in matters of taxation or revenue. This would seem to rule out a Federally-imposed tax with different rates in different States.
Solution: Let the Commonwealth say to the Parliament of each State: "Pass a Request and Consent Act specifying the desired GST rate in your State, and we'll collect it at that rate in your State and refund it to the consolidated revenue fund of your State, subject to the same conditions as in all other States." As long as the Commonwealth makes the same offer to each State and keeps its side of the bargain, there is no discrimination.
I emphatically reject any suggestion that the "Request and Consent" procedure circumvents the intent of the Constitution. If the intent of s.90 is to give the Commonwealth complete power over the taxation of goods prior to consumption, as the majority of the High Court has held since the Parton case (1949), then that power includes the power to decide that goods in each State may be taxed according to the revenue requirements of that State. If, to the contrary, the intent of s.90 were only to prevent the States from frustrating Federal tariff policy, then the States would be free to impose their own broad-based consumption taxes, because such taxes do not discriminate between local and imported goods. The issue of discrimination between the States would then not arise. The narrower view of the purpose of s.90 and of the scope of "excises" has always enjoyed at least minority support on the High Court, and was unanimously affirmed by that Court in Peterswald (1904), although it was not critical to the outcome of that case.
Problem 3: Under the present system, GST revenue is shared under a needs-based horizontal fiscal equalization (HFE) formula, whereby the revenue returned to each State may be more or less than what is collected in that State. Getting rid of HFE would create winners and losers, hence political difficulties for the Commonwealth.
Solution: The HFE adjustments presently incorporated into GST-sharing grants can be shifted into other grants. There is no need for winners and losers in the transition.
Problem 4: Different rates in different States would lead to increased compliance costs, because an enterprise in one State would have to claim input credits on inputs from multiple States at multiple rates.
Solution: Turn the GST, which is presently a value-added tax, into a retail sales tax, thereby getting rid of input credits, and perhaps rename it a "General Sales Tax" (keeping the same initials) or "Harmonized Sales Tax" (HST), the latter name referring to the uniformity of the tax base (but not the rate) in all States.
Indeed, getting rid of input credits would reduce compliance costs, and not only by eliminating the need to record and claim credits. Non-retail businesses would no longer pay or collect GST, and therefore would no longer need to be registered for GST purposes. The long-running legal uncertainty over the precise point at which exported goods become zero-rated would no longer matter, because none of the entities involved would be retailers. Entities with turnover below the registration threshold would no longer be forced to register simply because potential customers want to claim input credits. Non-registered (input-taxed) business customers would be treated the same as retail customers. But no tax would be collected from registered or exempt customers ("exempt" being synonymous with "zero-rated", not "input-taxed"). If some enterprises, in order to be able to treat all customers alike, decided to deal exclusively with non-exempt retail customers, or exclusively with exempt or registered customers, so be it; this would become the new retail/wholesale division. To avoid any new complications, the rules for determining which items are taxable and which are not, together with the averaging rules for small businesses with both taxable and non-taxable product lines, could all be left as they are.
Of course the overall reduction in compliance costs would lead to lower prices.
It is argued that input credits encourage entities to register for GST in order to claim input credits. By the same logic, income tax deductions should more strongly encourage entities to join the income tax system in order to claim deductions, which are allowed for a wider range of expenses under income tax than under a value-added GST. And having declared sales for income tax purposes, one cannot hide them for GST purposes, whether the GST involves input credits or not.
It is argued that input credits encourage entities to declare all sales so that they can claim all associated input credits. By the same logic, income tax encourages entities to declare all sales so that they can claim all associated deductions.
It is argued that when a retailer evades the present GST, only the value added by the retailer escapes tax, whereas under a retail tax the entire value of the sales would escape tax. But if the paper trail from the wholesaler's income tax were followed, how could the retailer escape detection? Those who point to the paper trail created by tax invoices, which are used for claiming input credits, fail to explain what is wrong with the paper trail created by ordinary invoices used for income tax. Indeed, for purchases under $75, any invoice that is good for income tax purposes is also good for GST purposes!
Moreover, input credits create opportunities for two particularly nasty forms of fraud, namely (i) faking input credits and, if caught, accusing the alleged supplier of failing to declare sales, and (ii) failing to declare sales and, if caught, accusing the customer of faking input credits or deductions. The absence of input credits would eliminate problem (i).
These observations may help to explain why the broad-based indirect tax proposed by Treasurer Howard in 1979 and 1981, like the one "preferred" by Prime Minister Hawke and Treasurer Keating in 1985, was a retail tax. Prime Minister Rudd and Treasurer Swan should note the precedents.
Ideally, the retail tax should replace not only the present GST, but also other State taxes that feed into prices of goods and services. These include stamp duties on registrations of vehicles and caravans, which would appear to be unconstitutional excise duties in so far as they apply to new goods, and payroll taxes, which not only feed into prices of goods but also discriminate against locally produced goods; thus the contention that payroll taxes are excises would find sympathy among both the Peterswald and Parton factions of the High Court.
The greater the range of indirect taxes replaced by the retail tax, the greater the reductions in compliance costs, hence prices. But there's a catch.
Problem 5: If the retail tax replaced both GST and payroll tax, it would, at least in some States, have a higher rate than the present GST. Kevin Rudd has emphatically promised that the GST rate would not increase while he remained Prime Minister.
Possible solutions: Mr Rudd could (a) forget about replacing payroll tax, (b) change the name of the GST and/or claim that he over-delivered on his promise because prices fell, or (c) carry out the threatened Federal takeover of public hospitals, thereby reducing the retail tax revenue needed by the States, and cap the tax rate to 10%.
Option (c) would require additional Federal revenue. Some of this would come from higher income tax receipts due to higher economic activity caused by lower compliance costs and the removal of payroll tax from export prices. For the rest, there's always bracket creep.
[Revised December 18, 2007. Featured in the Christmas Carnival of Australia at Adelaide Green Porridge Cafe. The above ideas were subsequently developed in Raising Australia's Market Share, first published on January 9, 2008.]
