Gordon Mackenzie

David Murray’s Financial System Inquiry (FSI) may call for the removal of superannuation tax breaks but the government’s tax discussion paper, due to be released next week, is unlikely to advocate similar changes.

The FSI report recommends articulating the overarching purpose of the superannuation system so that future tax changes can be measured against the objective.

It says the purpose of superannuation is to “provide income in retirement to substitute or supplement the age pension”. This then prescribes, in theory at least, the tax breaks individuals can get from the system.

In this case, the maximum tax break an individual should get from superannuation would be roughly equal to the net present value of the age pension paid from age 65 to the median life expectancy.

The age pension is designed to keep people out of poverty after they leave the workforce. Yet how does the inquiry’s definition of superannuation fit with financial planning theory which says that people need to aim for 70% of pre-retirement income to maintain their lifestyle?

It makes redundant any discussion about whether the current compulsory contribution limit of 9.25% provides an adequate retirement income. It also implies that superannuation should attract few tax breaks.

However, this raises the question of whether the tax system should be used to encourage saving, either through superannuation or outside it. There are four reasons why the tax system should not be used for this purpose.

First, the tax revenue forgone through the concession is borne by all taxpayers, while only those using the concession benefit from it.

Second and third, tax benefits only go to the wealthy who have disposable income to save and who have access to information to maximise the benefits of saving, such as accountants and lawyers.

Finally, tax concessions don’t increase savings, they just move preferences to where people save. But the reality is that they are used.

The report observes that superannuation tax breaks distort behaviour and favour the wealthy. However, a number of its observations will be difficult for the government to implement.

The inquiry report endorses Ken Henry’s tax review recommendation to reduce the tax benefits of popular negative gearing investing as well as the over-taxation of income from deposits. It also advocates that income from large superannuation balances should attract more tax, however this has a whiff of retrospective tax about it.

Another suggestion that post-tax contributions should be further limited is also unlikely to be adopted by the government. Few people use these concessions and they benefit empty nesters who are selling down to enjoy a hipster inner-city lifestyle rather than those trying to minimise their tax obligations.

The report says the system that taxes super earnings at 15% in the accumulation phase, but not in the retirement phase, leads to asset allocation distortions, tax arbitrage and prevents funds offering “whole-of-life” financial products. However, it is doubtful whether any of these problems are tangible and important enough to warrant changing the system.

Finally, the report suggests removing the company share dividend imputation system and reviewing the capital gains tax discount. Interestingly, the report argues these incentives distort asset allocation yet both these measures were introduced with the intention of removing tax distortions.

Imputation credits were introduced to lower the cost of capital towards equity rather than debt funding. The capital gains tax discount was introduced to prevent the over-taxation that potentially arises from capital gains all being taxed in one year leading to higher marginal tax rates.

However, the report’s focus on changing interest withholding tax on foreign lending institutions should be addressed. This tax distorts the funding decisions of financial institutions and places Australia at an international competitive disadvantage. If it has to be paid then almost invariably it will be paid by the Australian borrower, not the foreign lender, so it just raises the cost of capital with little revenue to be gained

Should these tax observations be included in the tax issues paper? They seem to warrant considered discussion but with two overarching caveats.

First, superannuation is a very long-term savings vehicle and changes reduces confidence in the system.

Second, savings in the system are there based on the good faith continuance of existing tax laws. In the past 35 years, there have been only minor changes that adversely affected existing superannuation account balances.

However, the chances of the government implementing these tax changes is slight.

Though Treasurer Joe Hockey backed the report’s recommendations to lower fees for super funds, it is unlikely that many of the report’s observations in terms of tax will go ahead.

Adverse changes to the superannuation system are off the table for the first term of this government, apparently. If superannuation tax breaks are measured against the age pension, a significant proportion of the population will be adversely affected.

Changes to capital gains tax are also unlikely to go ahead as most countries differentiate between regular income and capital gains. What remains is imputation credits for company dividends. Adverse changes here would be politically unwise as they are very popular among mum and dad investors and super funds.

Gordon Mackenzie is a senior lecturer at UNSW Business School. A version of this post appeared on The Conversation.

Richard Holden

In the year ahead there will be a national discussion about the future of our taxation system. It will have important implications for economic growth and social policy. The discussion will only be productive if all options are on the table, and if participants don’t resort to what Robert Kennedy called “obsolete dogmas and outworn slogans”.

The quintessential such move in tax discussions is to label a change “regressive”. Raising the rate or broadening the base of the GST is regressive. Increasing the top marginal rate isn’t.

Case closed? Not so fast. To properly assess any tax proposal it’s vital to examine where we are now, and where we are heading.

First, let’s look at the baseline. Australia’s top 10% of earners pay 46% of total income taxes. The top 2% of earners pay 26%; the top 1% pay almost 18%. The bottom 20% pay 2.5%. This makes Australia’s income-tax system among the most progressive in the world.

And income taxes are just one component of the broader taxation-benefit system. There are other taxes and benefits designed to redistribute income, such as the Family Tax Benefit, the Schoolkids Bonus and the aged pension.

Then there’s a range of ostensibly free services such as healthcare. Finally, there are other taxes, such as the GST. The Australian Bureau of Statistics estimates that when all of this is factored in, only the top fifth of households ranked by income pay any net tax. This makes Australia’s taxation-benefit system among the most progressive in the world.

I’m for this. It’s part of what makes Australia a great country. But it can only continue if the system produces enough revenue. That’s what the debate will be about: how to maintain progressivity by taxing in the right way.

One deeply regressive thing that can happen to income taxes is bracket creep – where the dollar cut-offs for marginal tax rates do not keep pace with rising incomes. This pushes lower-income earners into higher and higher tax brackets.

Those earning a very modest A$40,000 a year are forecast to pay 25% more tax in just four years’ time because of the fixed cut-offs. By contrast, those earning A$200,000 a year would face a less than 2% increase in their tax bill. That’s the epitome of a regressive change in taxation.

Yet perhaps the most regressive part of the whole system is the reliance of many states on poker-machine and other gambling taxes. The NSW and Victorian governments get roughly 10% of their revenues from gambling taxes — pokies accounting for about two-thirds of that. This is staggering, and provides horrible incentives to pander to special interests (that means you, Australian Hotels Association).

But much, much worse is the impact that what may be the most widely available gambling in the world has on lower-income earners. It is estimated that as many as half a million Australians are problem gamblers — each losing about A$21,000 per annum. For three-quarters of them, poker machines are the cause; and lower socio-economic groups are vastly over-represented.

State governments have to pay for schools and hospitals. They need revenue, and they can’t tax incomes. So I understand why they resort to moribund, distorting, socially destructive taxes such as pokies and stamp duty.

But from a system-design perspective it makes no sense to deprive states of the revenues required to fund their mandates and then stand idly by while they use the worst kinds of taxes. To paraphrase Steve Jobs, it is “insanely stupid”.

Taxation-benefit systems are just that – systems. They are made up of many different parts – and looking at any one part in isolation is dangerous and foolish. Those who shriek, “But that’s regressive”, whenever a change to the GST is mooted should think harder.

Doing nothing is regressive because of bracket creep. Doing nothing is regressive because it leaves poker-machine “taxes” on the poor in place. Doing nothing is regressive because benefits that redistribute money to lower-income earners will inevitably shrink without a proper tax base to support them.

Our tax system needs to be reworked to provide the right incentives, to grow the economic pie and to redistribute money to the less well off. To keep Australia’s taxation-benefit system truly progressive means thinking about it holistically. Dogmatically invoking the “R-word”? Refusing to change one component to fix the system? Now that’s regressive.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Chris Evans

The international tax architecture, as it relates to the activities of multinational corporations, is horribly out of date. It should be condemned as no longer fit for purpose. 

The structure was designed more than 80 years ago in an industrial age when multinationals operated across the world as separate legal entities and the major concern was to prevent double taxation – where the same profits ran the risk of being taxed in more than one jurisdiction. 

But it cannot cope in the digital age where those multinationals are now economically and operationally far more integrated, and able to use mismatches and asymmetries between the tax rules of national jurisdictions to achieve the tax planning nirvana of double non-taxation. 

The ability of multinational companies to drive a coach and horses through the international tax rules – most recently highlighted in the media by the sort of perfectly legitimate profit shifting strategies allegedly adopted by mining magnate Glencore, apparently to reduce its tax on corporate profits of more than A$14 billion to zero – poses a serious risk to corporate tax revenues for all countries, undermines tax sovereignty and adds to the perceptions of an unfair tax system for ordinary taxpayers. 

The corporate tax base, comprising about 20% of all tax revenue and principally derived from the larger corporates, is particularly important in Australia. Changes to the tax mix (possibly even in the form of broadening the GST base) may be inevitable, but as a nation we should not lose the capacity to continue to derive vitally needed resources from the big end of town.

Although we can attempt to shore up existing international tax arrangements with unilateral and bilateral patchwork renovations – such as, by revising the thin capitalisation, transfer pricing and general anti-avoidance rules, by tightening up on tax treaty provisions, or by exchanging more information across international borders – the better resources, in the form of high-quality advice available to the multinationals and the lack of access to key information about group structures and transactions, means that revenue authorities are always playing catch-up.

All too often changes to specific and general anti-avoidance provisions by governments are too late – the stable door is being closed well after the horse has bolted.  A better and more imaginative process might be to tear down the existing regime and re-design and re-build it on a multilateral level.

Australia’s tax system is creaking under the strain of globalisation and we need to act radically and in concert with other countries to plug revenue holes.

Australian governments shouldn’t get too distracted by a planned global crackdown on ‘base erosion and profit shifting’ (BEPS) prompted by the increasing ease with which firms such as Apple and Google can shift their intellectual property and profits to the lowest tax country. It may be high profile, but in the general scheme of things the G20 and OECD approach to tackling BEPS will not get us very far. 

Ultimately there is a tension between the enhanced international collaboration required by the BEPS approach and the natural urge of each country to provide a low rate and highly competitive tax environment to attract the multinationals to locate within its borders. That tension can only lead to lowest common denominator compromise outcomes from the BEPS approach.

We may need to be a bit more imaginative in how we deal with the problem.  For example, the problem stems from the fact that multinationals are treated as if they are a series of separate entities operating in different tax jurisdictions for tax purposes. That permits them to easily shift their expenses to high-tax countries (where they are worth more to the company) and their income to tax haven jurisdictions where they will pay little or no tax. 

If, instead, a multinational was treated as one single global entity and had to make a consolidated report on all its activities to all tax authorities for the countries it operated in, then it would be a relatively simple task to stop this tax arbitrage activity. 

A portion of those consolidated profits could be allocated to each of those countries on the basis of predetermined factors, such as agreed weighted formulae based on the number of employees, amount of sales or physical assets in each of those countries. 

Each country could then tax their share of the profits at whatever rate they deemed appropriate and put an end to the extensive game-playing that presently bedevils the international tax scene.

Chris Evans is a professor of taxation in the Australian School of Business. This article is based on a presentation made to The Australian/Melbourne Institute 2014 Pathways to Growth, Economic and Social Outlook conference.

The two changes to superannuation announced in the Federal Budget, one of which is welcome news, were:

• the way excess non concessional contributions are dealt with, and
• the progressive increase of the Superannuation Guarantee will be delayed another year.

A third announcement, the 2% debt levy, is already encouraging the financial planning community to look at ways to avoid it (sigh).

In addition to these Budget changes, the Australian Taxation Office (ATO) recently put the market on notice that it will come down hard on taxpayers using leverage in a superannuation fund to circumvent the contribution limits.

Non-concessional contribution caps

The contributions caps in superannuation limit the amount of tax concessions anyone, no matter how wealthy, can receive from using a low-taxed superannuation fund. One of those limits applies to contributions which, in effect, have not been tax-deductible, and is considered a penalty. It has also been highly problematic for many.

When introduced in 2007, any contributions in excess of the limit were taxed to the member at 46.5%. While that extra tax on excess contributions was said to recapture any tax concessions that had been derived from having the excess in the fund, it was more in the nature of a penalty tax.

Indeed, through one of the other rules relating to this contributions limit, it was not unusual for people to make contributions, say, two years ago and without fully appreciating what they had done earlier, make a contribution now that resulted in an excess non-concessional contribution and a 46.5% tax bill on that excess. It is with some relief, and probably six years too late, that these rules are now changing for the better.

From 1 July 2014 it is proposed that a person who contributes non-concessional contributions in excess of the cap will be required to take it out of the fund. No more 46.5% taxes.

Super Guarantee increase delayed

The increase in the Super Guarantee payment from 9% to 12% will be delayed a year. The super guarantee will not reach 12% now until 2022. However, the increase from the current 9.25% to 9.5% in 2014/2015 will go ahead, and it will remain at this level for four years until the end of the 2017/2018 financial year.

Dealing with the 2% debt levy

I never cease to be amazed by the ingenuity of the financial planning profession (of which I am part, I feel obliged to add). Within a few days of the Government announcing taxpayers over $180,000 pa will be charged an additional 2% income tax as a levy to cover Australia’s debt position, plans surfaced on how to manage around it.

The 2% increase will mean that the highest marginal tax rate for those affected, excluding the Medicare levy, will now be 47%, rather than 45%. However, the FBT rate is staying at 45% until at least the 2014/2015 financial year. The proposed scheme to avoid the levy is to salary sacrifice into taxable fringe benefits, which will be taxed at 45% rather than 47% had it been paid in cash, until 31 March 2015 (the commencement of the new FBT year).

Leveraging around the contribution limits

There has been one other significant tax issue related to superannuation that does not come out of the budget. The ATO has put the market on notice that it is not happy with people using leverage in a superannuation fund to overcome the contribution limits.

In one extreme example, three wealthy brothers all over age 60 who each set up an SMSF then loaned $10 million to it interest-free. The three SMSFs would then co-invest in a $30 million commercial property.

There is no deeming of the interest free loan as being a contribution so there were no contribution limit problems and as each brother was over age 60, their SMSFs were in pension mode and no tax was being paid on any rent or gain on sale from the commercial property.

The only risk being run was if they died without a Death Benefit Dependent, when tax would be payable on any benefit payment.

In any case, the ATO is now signalling that this kind of structuring is problematic. Briefly, the ATO is suggesting that the rental income and indeed, any gain made by the SMSF on sale, will be taxed to the fund at 46.5%. Some tax professionals are not sure the ATOs technical analysis of these types of transactions is correct. However, they take the view that the more likely result would be the application of the general anti-avoidance rule, which would seem to directly catch this practice.

Importantly, the views expressed by the ATO are a message to the market that it does have serious concerns with using leverage to get around the contribution limits.

Gordon Mackenzie is a Senior Lecturer in taxation and business law at the Australian School of Business, UNSW. A version of this post originally appeared in Cuffelinks.com.au. This information is general in nature and readers should seek their own professional advice before making any financial decisions.

Dale Boccabella

The tax treatment of family trusts (meaning discretionary trusts) regularly attracts the “tax rort” or the “tax minimisation” criticism. Rarely though are the reasons for the criticism articulated; the criticism(s) remain at the general level. This article provides a foundation for the criticisms.

The key reason for their tax unfairness lies in their flexibility and the fact that tax law permits the flexibility to go unchecked. They allow a given level of taxable income to be split across family members, and thereby accessing multiple tax-free thresholds and multiple low rate bands (income splitting). There is generally no limit on the family members that can be beneficiaries to “receive” income. In addition, if there are insufficient beneficiaries to absorb the income into tax brackets below 30%, then the income can be allocated to a company beneficiary where the company tax rate applies. This caps the tax on this income at 30% (so called bucket companies).

The discretionary trust can also vary the income allocations in subsequent years to take account of changed circumstances of beneficiaries (e.g. reduce an adult child’s allocation this year because they have just landed a high-paying job).

Some argue that the partnership and the company vehicle can also achieve income splitting amongst family members. This is correct, to an extent. But, these vehicles do not have the flexibility that is available through the discretionary trust. Where these vehicles attempt to replicate the flexibility of the discretionary trust, there are often rules that impose a tax charge on such attempts, and there are numerous tax integrity rules that may apply. The key point here is that the discretionary trust is not faced with such tax charges and is not faced with such integrity rules.

Some argue that the current position results in the tax liability “following the money”, and that this is an appropriate income tax outcome.

First, the beneficiary being taxed is very often just the legal owner of the money, and he/she has no real right to enjoy that money. That is, the legal criterion of entitlement to attract tax liability is satisfied, but it is made clear by the controller of the trust and its assets that beneficiaries are not to enjoy the money. Evidence of this strategy comes from the fact that the amount of money “loaned back” by “beneficiaries” to their discretionary trust has reached staggering sums. Thus, calling the current position one of tax liability following the money is hardly accurate.

Secondly, and accepting the legal entitlement approach as appropriate for now, the tax law in this area is actually taxing the recipient of a gift. This is what the beneficiary allocated income in a discretionary trust is getting (i.e. money for nothing). Overwhelmingly, elsewhere in the Tax Act, recipients of gifts are not taxed. Yet, for some reason we do this in the case of a discretionary trust. The Tax Act does tax providers of gifts, but not recipients. A strong case can be made that the controller of the assets in the discretionary trust and/or the person who is the source of those assets and the income thereon is making a gift to beneficiaries.

Thirdly, the tax law is failing to tax the income to the people who contributed the wealth that produced the income. Alternatively, for a testamentary trust (a discretionary trust created under the will of a deceased), the tax law fails to tax the person who controls the wealth that produced the income. In short, in numerous parts of the Tax Act, attempts at alienating or diverting income away from oneself, without the transfer of the underlying wealth that creates the income, are not tax effective. Yet, we permit this in the case of the discretionary trust.

In addition to the above, there are many other rules in the Tax Act that are inconsistent with the tax treatment accorded to the discretionary trust.

Looking outside the Tax Act, and especially in legal regimes that are required to deal with the “ownership” of assets and income in a discretionary trust, we see approaches that are quite at odds with the Tax Act. In the Tax Act, the assets of the discretionary trust are treated as being in “suspended ownership”, and the income belongs to the beneficiary to whom it is allocated.

First, under the assets test for the aged pension, assets held in a discretionary trust can be counted as assets of a person under the assets test if: (a) the assets in the trust are “controlled” by the person or (b) the person gifted the assets to the trust. The key point is that a person who has control over assets of a discretionary trust and/or who contributed those assets is effectively being treated as owning the assets and the income thereon for social security purposes.

Secondly, in the marriage breakdown area of family law, the assets of a discretionary trust could be held to be “property of the parties to the marriage”. This will be the case where a person has the capacity to control the income or capital allocations of a discretionary trust so that allocations could be made to the person. This can be the case even where the person is not the trustee of the discretionary trust, provided that he or she is the appointor (or nominator) of the trust and thereby has the power to change the trustee. Even where a party is not a beneficiary but has the capacity to become a beneficiary, and from there obtain an allocation of assets or income, it will be sufficient to make the discretionary trust’s assets property of the parties to the marriage.

These two regimes do not tolerate the “legal niceties” of the discretionary trust and/or the affront to equity that would otherwise arise if left unchecked. However, the most important of these is the social security treatment of discretionary trusts. The social security system is closely related to, or even the other side of, the income tax (i.e. negative income tax). The two systems both deal with economic capacity. Why a different approach should be taken in each system is not clear.

The above is a brief outline of the favourable tax treatment given to the discretionary trust. But even from this, those criticising the tax treatment of discretionary trusts (family trusts) have a very strong foundation for their criticism. The guiding principle should be that similarly placed activities or transactions should be taxed in a similar manner. It is very hard to see how this is occurring in the case of the discretionary trust.

At the very least, the issue requires a close and independent examination. To the author’s surprise, the Henry Review did not do this. The government’s tax white paper on the tax system should not repeat that failure.

Dale Boccabella is an associate professor of taxation law in the School of Taxation & Business Law in the Australian School of Business, The University of New South Wales, Sydney, Australia

Dale Boccabella

Abolishing the sacred cow of negative gearing – where losses can be used as a deduction against other income – is considered by governments of all persuasions as electorally unpalatable.

But this part of the income tax system is one of the few areas left which confers this highly favourable treatment. In many other important areas of our public finance and income tax system, negative gearing is effectively abolished in favour of quarantining of losses.

Negative gearing is allowed on passive rental property and share investments and for “large” businesses. Both the pros and cons of negative gearing are well-known. Its most immediate advantage is allowing taxpayers to use a loss on one investment as a deduction against a profitable investment, or other source of income. But it is accepted that it undermines the progressive nature of the income tax, does little to increase housing supply stock and is a significant cost to government revenue.

In contrast to negative gearing, quarantining is where the loss on an investment cannot be used in the year it is made, but can be used in future years, against profits from the same investment from which the loss arose. Usually, but not always, if the investment is sold while there are quarantined losses, these can be used to reduce the taxable profit on exiting the investment.

In our tax system, quarantining is used when determining whether a taxpayer is liable to pay the Medicare levy surcharge; for loan repayments under the higher education loan program (HELP); and assessment of income under the child support regime, particularly Family Tax Benefit Part A and B.

Quarantining also applies when the tax office is assessing means-tested concessions such as the dependent (invalid and carer) tax offset, or senior and pensioner tax offsets.

Small businesses that make a tax loss in a non-corporate form are not permitted to use that loss against other profits (so-called non-commercial loss rules). While these measures are in part a response to the ridiculous hobby tax loss claims of the past, these rules apply quarantining to genuine small businesses, including those in the start-up phase. Quarantining also applies to certain boating activities.

In the social security system, quarantining applies where a particular benefit is means tested, such as Seniors Health Care Card, or the parental income test for dependant youth allowance. Like the income tax though, quarantining is not universally applied under this legislation (for example, it does not apply to the income test for aged pensioners). Also, the current paid parental leave scheme also uses quarantining in its relevant income measurement.

So one can see that quarantining applies in numerous areas of our public finance system. The starting point for debate should focus on economic capacity. By allowing negative gearing, the loss is being treated as a genuine signification of reduced economic capacity to either contribute income tax (or other contribution), or to receive welfare assistance. On the other hand, if quarantining applies, the loss is not regarded as signification of reduced economic capacity to either contribute tax or to receive welfare assistance.

Unfortunately, there are credible arguments both ways. And the fact that countries around the world do not take a uniform approach to the issue under their respective income tax systems supports this.

However, our public finance framework ought to be internally consistent so that similar things are treated in a similar manner, unless there is a sound explanation for differential treatment. This should be the case within the social security and income tax system, as well as across both, as the social security system is the mirror of the income tax system, or a negative income tax.

Both systems have economic capacity at their foundation. Those with sufficient economic capacity make an income tax contribution, and those who lack it receive payments (and other non-money benefits) for economic support. Given the shared foundation of the income tax and social security systems, or that they are really one system, it is hard to see why a different measure of economic capacity should be used within each system or across systems.

Another lesser dimension is that tolerating negative gearing in parts of the income tax and social security systems, but not tolerating it in others parts of those systems, adds complexity. Differential treatment of the same thing necessarily adds to administration and compliance costs.

In the end, there is a real argument that negative gearing should either be restored in the areas where it is currently prohibited, or should be scrapped across the board.

Given where the debate is now, I doubt anyone will seriously argue the former. That tends to leave movement towards the latter, because no one would seriously argue that the current differential treatment is a principled position with credibility.

Dale Boccabella is an associate professor in the School of Business Law and Taxation at the Australian School of Business. This post appeared on The Conversation.

http://theconversation.com/why-its-time-to-quarantine-negative-gearing-24265

Dale Boccabella

In the lead-up to Australia’s crucial federal budget in May, it could be argued that requiring the National Commission of Audit to identify revenue trends that could pose a risk to the budget’s structural integrity could encompass tax expenditures.

While the commission’s terms of reference expressly mention levels of direct government expenditure, such as grants and transfer payments, there is no express reference to tax expenditures and secretariat Peter Crone has confirmed that it will not deal with them.

Tax expenditures are “expenditure programs” of the Commonwealth that are delivered through the tax system, rather than the direct expenditure side of the budget. They mainly take the form of deductions, rebates, exemptions and concessional valuation rules.

The essence of tax expenditures is that they involve under-taxation compared to the nation’s benchmark income tax system. What the benchmark should be within our income tax is debatable, so not everyone will agree with Treasury’s view on that. Treasury mainly works with the idea that most gains and profits should be fully taxed under a benchmark system, and that is why tax-free gains made on the sale of family homes is listed as a very large tax expenditure.

On the other hand, the generous tax treatment of discretionary trusts (family trusts) is not included in the tax expenditure statement – but there are good reasons why it should be. The negative gearing loss on rental properties and share investments is not included either. For 2012-13, the Commonwealth has around 280 tax expenditures under the income tax, worth around A$100 billion. This is around 6% of GDP. Direct expenditure of the Commonwealth for the same period was around A$360 billion, which is about 24% of GDP.

The point is that tax expenditures are significant in size. While characterising tax expenditures is problematic, they deliver concrete economic advantages and, in numerous cases, significant advantages to their recipients in the form of deliberate non-collection of taxation.

Given this, why aren’t tax expenditures expressly within the terms of reference of the commission? After all, keeping tax expenditures out of the its deliberations necessarily means it is not looking at all government expenditure items.

Does this matter? Yes, because any deliberations and ensuing recommendations may not be based on full information. If the commission will not examine the full scale of government assistance being received by a sector or a category of taxpayer, how can a credible recommendation be made about the level of direct assistance that should be scaled back?

Attaining the goals of fairness, equity and efficiency through our public finance system dictates that all the main value exchanges between a sector or taxpayer grouping and government should be taken into account when determining whether the current level of “expenditure” is appropriate.

A good example is housing, where there are both substantial direct payments provided to taxpayers (such as housing grants and rental assistance) and considerable tax expenditures (such as negative gearing). How can the commission make fair and efficient recommendations about the proper level of rent assistance and pensions in the direct expenditure system when it does not consider the level of assistance provided to homeowners and others through tax expenditures? There are many more examples in both the private and business sphere.

The commission’s response is that tax expenditures will be taken into account in the tax review, promised by Treasurer Joe Hockey. The problem with this is that direct expenditures are hardly ever comprehensively examined in tax reviews, which means the same partial or disjointed examination problem is present again. Further, the tax review and associated measures are some way off, whereas the 2014 budget is just months away.

It is hard to predict what the political landscape will be in three to four years time. Indeed, given the risk of an inevitable voter disenchantment following any savage budget cuts, it is very unlikely that the government will have the same reserves of political capital to move on tax expenditures with a similar degree of vigour that will be brought to bear on direct expenditures.

In any event, the directive in the commission’s terms of reference to aim for savings that will deliver a surplus of 1% by 2023-24 is a strong indication the government intends for savings to mainly come from reducing direct expenditures, and not reducing tax expenditures.

Yet the problems of not dealing with tax expenditures are compounded because the political dynamics are quite different between examinations of direct expenditure programs and tax measures.

What can happen is that the proposed removal of a tax expenditure can easily be seen and presented as a tax increase. The failed attempt to remove the tax expenditure on the car fringe benefits tax in the lead-up to the 2013 election is a recent case in point.

The “age of entitlement is over” doctrine outlined by Hockey implies that before entitlements are reduced (or less likely, increased), a fairly accurate account of the level and spread of entitlements will be established.

It is hard to see how such accuracy can be attained if tax expenditures are not subjected to the same standard of scrutiny and the same political accountability mechanisms that are applied to direct expenditures.

Dale Boccabella is an associate professor in the School of Business Law and Taxation at the Australian School of Business. A version of this post appeared on The Conversation.

Helen Hodgson

In an ideal (and economically efficient) world, tax policy would not influence the investment or consumption choices taxpayers make. In reality, this neutrality is rarely achieved.

External factors influence choices, which then fail to conform to rational economic models; or the tax system may be deliberately used to intervene in the market to counteract inefficiencies.

In Australia owner occupiers compete with investors for housing property; and there is also competition within these groups. A small increase in the number of superannuation funds and foreign investors purchasing property can have a significant impact on demand; while first home owners are finding it increasingly difficult to enter the market. Each of these groups is impacted differently by the tax system.

Owner occupiers are the major beneficiaries of tax concessions on housing.

The latest tax expenditure statement costed the Capital Gains Tax (CGT) exemptions on owner-occupied housing at A$30 billion, on a par with concessional taxation of superannuation at A$30.25 billion.

The Henry Review acknowledged that these tax expenditures can be justified as both contribute to people’s living standards in retirement.

However the CGT main residence exemption distorts the market as owner occupiers invest more in their residence, diverting capital from other more productive investments in the expectation of tax free capital gains.

Investors also benefit from the CGT discount, but negative gearing has a more immediate benefit. Negative gearing is the product of two of the basic design principles of our tax system.

Firstly, expenses are deducted from income in calculating the income or loss from an activity, and secondly we apply a global system under which income from all sources is aggregated to determine a taxpayer’s income for a year. Therefore, in the absence of any specific restrictions, losses from one activity can be applied to reduce the tax payable on income from other sources.

The tax statistics for the 2010-11 year show that 2.5 million rental property schedules were lodged by individuals, showing nearly A$30 billion of rental income received during the year.

The deductions claimed against this income amounted to A$37.8 billion, of which A$22 billion was interest on loans. A further A$1.8 billion was claimed as capital works deductions, which allows a write down for the capital cost of a building used to earn rental income.

There is no particular bias in the tax system to make negative gearing more beneficial for real estate than other investments: the drivers for that decision come from outside the tax system.

For example, lenders may be prepared to lend a higher proportion of the purchase price on real estate when compared to other forms of investment, thus the purchase can be more highly leveraged and the eventual capital gain will represent a higher return on funds invested. However this does presume the investor has the cash flow, often from other sources, to service the loan.

Negative gearing would be less attractive if the capital gain on the sale of an investment was taxed in full.

Negative gearing is a negative cash flow, but it produces an annual tax benefit that would be clawed back if the capital was taxed when the property is sold. But CGT is generally only paid on half of the capital gain as a discount is applied when calculating how much is included in taxable income. Therefore there is an asymmetry as the full amount of any mortgage interest is allowed as a deduction when incurred, but only half of the capital gain is included as income.

The Henry Review recommended (Recommendation 14) that a 40% discount should be applied across all forms of non-business investment income, including capital gains, with a corresponding reduction in the amount of interest that could be claimed each year. This would reduce both the bias to investments that produce capital gains over income, and the incentive to leverage off negative gearing deductions.

The group of prospective purchasers that is most affected by housing prices is notably absent from the discussion of tax incentives.

First home owners don’t have access to tax deductibility to subsidise interest payments, and without a windfall on the sale of another property they may have difficulty accumulating a deposit.

The effect of first home owner subsidies, however, is mixed: although it boosts the deposit the subsidy can itself be inflationary as vendor price expectations rise to take account of the subsidy.

The remaining group, renters, also face increased rents as the owners of rental properties seek a return on the capital they have invested in the property.

It has been argued that any changes to negative gearing would result in increased rents, based on rental increases between 1986 and 1988 when the Hawke Government quarantined negative gearing deductions. But this is largely discredited as the evidence shows there were other issues that increased demand in the Perth and Sydney markets over this time.

These current policies all affect demand, resulting in increased housing prices as investors and cashed up owner occupiers bid up the cost of housing.

What is needed is a set of policies that would stimulate the supply of housing, for example the National Rental Affordability Scheme which provides tax incentives on new housing development.

Ultimately tax reform in relation to housing will require the government to make some hard decisions.

The two issues that need to be reformed are the main residence CGT exemption and removing the ability to offset investment losses against other income. Such reform will not be successful without public support, and neither the Labor nor the new Coalition governments have been prepared to act on these proposals.

Helen Hodgson is a Senior Lecturer, School of Tax and Business Law at the Australian School of Business.  A version of this blog post appeared on The Conversation.

Dale Boccabella

The push from the states to reduce the GST threshold on imported goods is being driven by a desire for a bigger pool of GST revenue and they will get their way, despite the inevitable backlash from consumers.

Australia’s $1,000 GST low value exemption on imported goods is significantly higher than comparable countries such as the UK ($25), Canada ($20), Singapore ($330) or New Zealand ($320). More importantly, the $1,000 threshold is too great a departure from the zero-threshold that applies to consumer purchases from Australian bricks and mortar retailers.

What may further anger consumers is the approach governments take to border security charges and tax collection costs under a lower threshold, given that parcels flowing through the international mail stream into Australia are subject to manual, labour-intensive processes.

Under current law, there are no Customs and Border Protection import charges levied on imported items valued at or below the $1,000 threshold. However, somewhere between $40 and $48 is charged to goods above $1,000. Also, the Department of Agriculture, Fisheries and Forestry levies a $15 charge on items above $1,000 to support its biosecurity obligations.

Julian Lorkin interviews Dale Boccabella from UNSW about the push to reduce the GST threshold on imported goods.

As the 2012 report from the Low Value Parcel Processing Taskforce noted, the present approach to border charges involves cross-subsidies, infringes neutrality and undermines the government’s cost recovery principles. Accordingly, if the government decides to lower the GST threshold (to, say, $300), it will be faced with the decision as to the level of charges (if any) that will apply to the import.

In addition, GST collection costs for the newly taxed items are very likely to be passed on to consumers. The most likely outcome is that the express carriers and Australia Post will be required to collect and remit GST to Customs, and from there, be allowed to recoup these costs from the consumer.

Part of the reason for placing this burden on the express carriers and Australia Post is that goods can be released to consumers from Customs-controlled premises before the GST is collected, thereby allowing for quicker delivery. This would also avoid the need to store “tax unpaid goods” at mail gateways and licensed premises, which already have significant capacity problems.

All up then, a consumer who purchases a $500 item from an overseas supplier could end up paying a lot more – say, $650-$750 – to actually obtain the item. The cost will be even higher if GST is levied on transport and insurance costs, which is currently the case for goods above $1,000.

The question of whether the lower threshold would also apply to customs duty will also need to be addressed, but this would not be a significant cost as most items only have 5% duty on them.

The other political issue involves the timing of a change to a lower threshold. On the one hand, the bricks and mortar retailers and the states would prefer a lower (permanent) threshold implemented as soon as practically possible. But border security agencies such as Customs, as well as the express carriers and Australia Post, would like anywhere between 18 months to three years to implement it properly.

Timing will depend on the time required to upgrade computer systems, and increasing staff numbers to deal with the higher volume requiring manual data capture in the international mail stream, as well as required staffing changes to deal with increased volumes of items requiring GST assessment and collection.

The movement of cargo was severely disrupted and border security compromised during a two-month period when the import component of the Integrated Cargo System was introduced by Customs in 2005. This happened due to the lack of pre-testing of new systems and software, a lack of industry readiness and training, and lack of staged implementation of the change. The government will want to avoid repeating such a failure.

The Taskforce noted three things. First, it would not be practical to just lower the threshold without any system changes and considerable preparation. Second, depending on issues such as who will collect the GST from the Australian consumer – there are a number of options, or a combination of options – and the extent of system changes required, initial reforms could be implemented within two years.

Third, once a decision is made to lower the threshold, reductions in the threshold to its long-term level should take place in stages. This allows all relevant parties to review how the first stage was implemented, and it allows for adjustments to systems in readiness for the extra volume numbers associated with the further reduced threshold.

All this suggests that a lower threshold cannot be introduced very early in the first term of the Abbott Government, even though the prevailing political wisdom is that distasteful reforms need to be introduced very early in the term of a new government.

Further, the desirable staged reduction in the threshold to its ultimate long-term level may push implementation of this reform agenda into a new federal parliamentary term, which raises the prospect that part of the reform would have to run the gauntlet of an election.

Jean Baptiste Colbert once said: “The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing.” The low value import threshold issue is likely to be the Abbott Government’s first real test on “public” tax reform. It is hoped that substantial consumer hissing will not divert it from sound decision-making.

Dale Boccabella is an associate professor of taxation law at the Australian School of Business. Boccabella, and colleague, Kathrin Bain, will present a paper on the GST low value import threshold issue at the January conference of the Australasian Tax Teachers Association in Brisbane, 20-22 January 2014. A version of this post appeared on The Conversation.

Dale Boccabella

The government may cost consumers an extra 10% for their Christmas presents next year if they shop for them on the net overseas – but the overall benefit to Australia brick and mortar retailers is questionable.

Every day we open the papers to see the brick and mortar retailers are once again urging the government to lower the $1,000 threshold upon which GST can be charged to goods bought online from offshore retailers. The federal government has promised an announcement on this early in the new-year.

However I feel there are two big questions. Why would the Federal Treasurer support a lowering of the import threshold when just last year the Parcel Processing Task Force numbers indicated that it would be very costly to administer a lower threshold on imports, and indeed collecting, on some suggested thresholds, could cost so much it would largely outweigh the tax collected.

And, secondly why would the Federal Treasurer support a lower threshold unless he can somehow be assured that the State Governments will bear the political kickback that will necessarily flow from this? Last week, as they have been doing for some time, retailers pushed hard for GST to be levied on online purchases made overseas. However, this probably alienated their potential customers. Polling from Essential Research shows Australians are opposed to any lowering of the GST threshold for goods purchased online from overseas providers. Voters aged 35-54 are particularly hostile, with 57% opposing such a move.

While the government could argue that raising the threshold is an equity measure, even the consumer bible Choice has discredited some of the big retailers’ campaign, citing a measly 12% of Australian online shoppers buying from offshore retailers to save on duties and taxes. Instead most want and enjoy the increased choice of products, and want to buy products that simply aren’t available in Australia.

It is clear however that Australian retailers would love to see a tax on large overseas internet sales through a lowering of the $1,000 tax-free threshold. However, given the difficulties of collection, it is not clear that it will help raise much revenue; indeed the idea that it would ‘help fund roads and hospitals’ really seems to be a red herring: collecting the tax would cost so much that it would be completely out of proportion to tax collection costs of other taxes.

Consumers like being able to shop around for cheaper prices. However the new move as part of a promised GST review has raised retailer’s hopes again of imposing GST on what are called ‘low-value imports’.

In terms of a taxing point or collection point, this is also difficult. Australia could make every online retailer in the world register for Australian GST if they export Down Under. While technically feasible in today’s world of tax cooperation, this is unlikely and would simply be too complicated. Only requiring the big online suppliers to register and collect GST would create a bias and it would be unfair.

Much more likely, the obligation to collect and pay the tax would be collected in Australia, similar to what currently happens with items above the $1,000 threshold. This system is slow and labour intensive, especially for parcels coming into Australia through the international mail stream (as opposed to the express carriers). Quite frankly, consumers importing low value items will be annoyed with the extra delays and the extra costs that will inevitably be passed on to them.

It is far from clear what the Treasurer’s response will be early in the new year, but one likely response is that the government needs to do even more work on the issue.

Dale Boccabella is an Associate Professor of Taxation Law at the Australian School of Business.

Dale Boccabella, and colleague, Kathrin Bain, are presenting a paper on the low value threshold issue at the January 2014 conference of the Australasian Tax Teachers Association in Brisbane. The paper will explore the current state of play including developments in administering a lower threshold and the political ramifications of the various options.