THE MYTHOLOGY OF TAXATION by

Russell Mathews"

Although there has been a wide-ranging debate about the inadequacies of the Australian taxation system and about the need for tax reform, it seems to be almost impossible to effect significant changes to the system so as to achieve greater equity and reduce the harmful effects of existing arrangements on economic efficiency, stability, and growth. The reasons for this are twofold, being concerned with the mythology of taxation and the political sabotage of tax reform. It is the purpose of this paper to expose the myths of taxation and to examine the political obstacles which feed on those myths and which ultimately prevent significant reforms from taking place.

The Myths The myths of taxation relate to the broad objectives of taxation policy

and the extent to which those objectives are being achieved; the level of taxation and its relationship to public sector spending: the case for taxes based on income as the cornerstone of the tax system: the arguments against indirect taxation in general and broad-based consumption taxes in particular; the role of capital taxes: the structure of the tax system with reference to such issues as the diversity or fragmentation of revenue bases, the integration of personal and company taxes, the rate structure, and the extent to which particular taxes should be earmarked: and the question whether the process of tax reform can be effected by piecemeal adjustments as opposed to major structural changes.

The first great myth, which in varying degrees affects most of the other issues discussed in this paper, is that the stated objectives of taxation policy bear some relationship to the kind of tax system which has been developed in Australia. The pretence is that the tax system is concerned with the following objectives: equity in both its vertical and horizontal aspects; efficiency involving neutrality in relation to production decisions and consumer choice; economic incentives and their effects on levels of economic activity, stability, and growth; administrative simplicity with special reference to the costs of collection and compliance: and political acceptability.

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* Professor Mathews is Director of the Centre for Research on Federal Financial Relations at the Australian National University. This paper was first presented to a tax Seminar organised by the Institute of Public Affairs (NSW).

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Subject to the recognised constraint that some of these objectives conflict with each other and thus necessitate trade-offs, a further myth is that we give them all equal weight: that we are just as concerned with horizontal equity and efficiency as with vertical equity; that we are just as concerned with minimising disincentive effects as with promoting equity; and that political acceptability carries no more weight in determining taxation policy than economic and administrative considerations.

But perhaps the most deep-seated fictions of all are that people invariably pay the taxes they are supposed to pay; that the tax system is highly effective in the sense that actual collections are closely related to nominal liabilities; and that tax avoidance and evasion are minor aberrations in a general situation of taxpayer compliance.

The myths relating to the level of taxation are based on the notions that Australia is a high-taxed country and that the amounts of tax we pay are independent of the social security system and the level of services we expect our governments to provide. There is a myth concerned with the level of taxation which is perpetrated by governments of all political persuasions and which can best be described as the phantom tax cut. This is that, under conditions of inflation, a progressive rate structure, and an income measurement system based on historical cost accounting, the level of income tax remains the same when there is no change in nominal rates or rate brackets, and that reductions in nominal rates necessarily mean reductions in effective rates of tax.

The mythology of income taxation derives from the almost universally accepted belief that income constitutes the best measure of ability to pay tax. This spills over into what for many has become an axiom of taxation policy that is considered to be beyond challenge. This is that a comprehensive income tax imposed at high and progressive rates on a broadly defined base can be substituted for most other forms of taxation so as to achieve single-handedly virtually all the objectives of taxation policy.

It is commonly believed that the incidence of income taxes, unlike that of indirect taxes, is upon those who pay the taxes, so that company taxes are never passed on to consumers or back to suppliers of services. It is also believed that people with the same incomes pay the same taxes; that incomes from wages and salaries attract the same amounts of taxation as equivalent incomes from business profits, capital and windfall gains, and other sources of property incomes.

The notion that income reflects ability to pay taxes more accurately than any other measure is also responsible for the myth that vertical equity in the tax system as a whole can only be achieved by means of a steeply progressive income tax rate structure. The progressive income tax myth has foreclosed discussion on structural aspects of vertical equity in taxation and thus generated further examples of tax mythology. These include the beliefs that flat-rate or linear-rate structures are necessarily regressive, that the overall structure of the tax system (and of the pattern of government expenditures) is unimportant in achieving vertical equity,

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and that nominal progressive rate structures coincide with effective progressive rate structures, that is that high nominal rates cannot be circumvented by means of tax avoidance and evasion. The strength of these myths is demonstrated by the difficulty of initiating serious discussion about a flat-rate income tax or a linear-rate structure, proponents of which seem to be accorded the same credibility as Neanderthal Man and members of the Flat Earth Society.

The myths relating to indirect taxation are that it is necessarily inefficient, regressive, and inflationary - inefficient because it is discriminatory, regressive because it falls more heavily on the poor than the rich, and inflationary because increases in indirect taxes are reflected in increases in the Consumer Price Index.

Insofar as particular forms of indirect taxes are concerned, the conventional belief is that selective or discriminatory taxes such as payroll taxes and excise duties are passed on with little effect on the investment and production decisions of those who actually pay the taxes; and that broad-based indirect taxes such as the value-added tax necessarily involve high costs of administration and compliance.

Insofar as capital or wealth taxes are concerned, the mythology of taxation holds that, just as income taxes are supposed to be paid out of income, capital taxes of all kinds - annual taxes on net wealth and capital gains taxes as well as death duties and capital transfer taxes - necessarily involve expropriations of capital rather than payments out of the recurrent returns from capital.

A corollary is that wealth taxes threaten enterprise, thrift, and capital accumulation and necessarily pose particular problems for unincorporated businesses and farm enterprises. In its more extreme form, the myth perpetuates the 19th century view of capital taxes (recently given new life by the debate on the assets test to determine eligibility for age pensions) as an attack on the savings of widows and orphans and the deserving poor.

Finally, wealth taxes are believed to be more difficult to administer than income taxes. This is principally because of the fiction that wealth is more difficult to measure than income. This valuation problem is partly responsible for another myth, that capital gains taxation is the form of wealth taxation which comes closest to meeting the objectives of tax policy, if only because conceptually and in terms of its revenue base it is regarded as having an affinity with income taxation.

Among the myths related to the structure of taxation are the notions that a fragmented or diversified tax system is less likely to achieve the goals of taxation policy than a highly integrated one developed around a comprehensive revenue base; that personal and company incomes constitute two separate revenue sources which need to be taxed separately: that vertical equity depends on progressive rate structures for individual taxes, in particular the personal income tax, rather than on the overall structure of the tax and social security systems and the relationship between taxes and benefits from government spending; and that

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earmarked taxes are inefficient because they inhibit governments in determining their spending priorities.

On tax reform, the mythological view is that the existing tax system, for all its faults, can be patched up by a series of piecemeal reforms which attack one problem here and close a loop-hole there, while generally making marginal adjustments which maintain the pretence that the foundations of the tax system are fundamentally sound.

The Reality This list, by no means complete, is probably the greatest chronicle of

myths since Aesop’s Fables. We need to ask ourselves: why is it that so many seemingly sensible propositions are in fact myths, what is the reality behind the myths, and how is it that we have allowed ourselves to be so gullible in accepting fictions as facts?

We must first establish the reality behind the myths. Far from having a tax system that pays due regard to the stated objectives of taxation policy, we have developed a system which operates perversely in relation to every major criterion. It would be difficult to improve on the present arrangements if we deliberately set out to design a tax system that requires the poor to pay more taxes than many of the rich: if we deliberately wanted to discriminate against wage and salary earners and the proprietors of small businesses: if we deliberately decided to distort production decisions and consumer choice: if we deliberately sought to destroy incentives to save, invest, innovate. take risks, and undertake productive activity while simultaneously rewarding speculative activity and providing incentives as well as opportunities for avoiding and evading tax: and if we deliberately set out to make the tax system as complex, cumbersome, confusing, and costly to administer and comply with as possible.

Nor is it true that we give equal weight to the different objectives of taxation policy. In designing our most important tax - the personal income tax - we attach overwhelming importance to vertical equity by incorporating a highly progressive rate structure which makes it difficult, if not impossible, to achieve virtually every other objective. It cannot be emphasised too strongly that nearly every major problem that arises in formulating and implementing taxation policy results from this single cause - the progressive income tax. Problems of dealing with income splitting, taxing fluctuating incomes, taxing superannuation benefits, measuring tax allowances, indexing for inflation, integrating personal and company taxes, taxing capital and windfall gains, administering and collecting taxes (including arranging for source deductions), reducing economic disincentives, and inhibiting incentives to avoid and evade tax would be greatly alleviated, and in some cases would disappear altogether, under a flat-rate or linear income tax.

The fiction that people pay the tax they are supposed to pay ignores the fact of tax avoidance and evasion. The tax system has generally been

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designed without any thought to the effectiveness of particular taxes, defined as the relationship of actual collections to nominal or potential collections. Taxes tend to be judged by their nominal provisions rather than the actual revenue and other effects which they produce in practice. If tax reforms are to be effective they must start from the position that we will all avoid taxes to the extent that there are incentives and opportunities to do so; and that many of us will also evade taxes to the maximum extent possible. In designing tax systems we need to recognise that some classes of tax can be avoided and evaded more easily than others; that the forms in which taxes are imposed (rate structures, revenue bases, assessment procedures] have a major bearing on their effectiveness: and that for particular taxes some taxpayers have greater incentives and opportunities for non-compliance than others. It follows that tax reforms must have regard to tax effectiveness - the prevention of avoidance and evasion - as a major policy objective in its own right. Governments must concern themselves with the effects which are actually achieved through the tax system and not with the effects which they say they intend to achieve.

On the level of taxation, Australia is not highly taxed by the standards of other industrialised countries. In 1982183, the proportion of all taxes - Commonwealth, State, and local - to Gross Domestic Product was 31.9%, which is below that of nearly every country in Western Europe although it is much the same as the United States proportion and higher than that of Japan. The level of taxation depends critically on the level of public spending and it needs to be recognised that, in determining expenditure policies, governments to a large extent are captives of special interest groups as well as being constrained by the requirements of macroeconomic policy. Budget deficits and reductions in government expenditures are substitutes for taxes in varying degrees, which depend on macroeconomic policy objectives as well as on the more specific objectives of taxation and public expenditure policies. Many of those who argue for reductions in the level of taxation, however, simultaneously seek reductions in budget deficits and, in some cases, increases in particular forms of public spending.

But perhaps the major issue affecting the level of taxation in Australia results from the fact that some classes of taxpayers are more heavily taxed than others. Two groups in particular - wage and salary earners and small businesses - have suffered during recent years. There has been a marked shift in the burden of taxation towards wage and salary earners, chiefly because they have had limited opportunities for avoidance and evasion while, at the same time, their effective income tax rates have increased as a result of the impact of inflation on the progressive rate structure.

All individual taxpayers are, of course, affected by the latter phenomenon, which has given rise to a particular form of deception by governments which was earlier described as the phantom tax cut. In the doublespeak language of tax mythology, many so-called tax reductions are not reductions at all: they are merely lesser increases in effective tax rates

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than the increases which would have occurred in the absence of the widely publicised so-called tax reductions.

Small businesses have been adversely affected in another way, as a result of the combined effects of inflation, the measurement of taxable income by reference to historical costs of inventories and fixed assets, and the form in which company taxes are imposed. Together these create massive liquidity problems for the very firms which, if they are to prosper and grow even when economic conditions are favourable, usually have all the liquidity problems they can handle. We should not be surprised that much of the impetus for tax avoidance has come from the proprietors of small businesses, many of whom have seen cheating the tax system as a necessary response to what they regard as cheating by governments.

The notion that income represents the best measure of ability to pay is a myth because it depends on the assumption that income can be measured systematically and in a manner that is consistent for all classes of tax- payers. At this point, I must make a public confession. Having spent some 20 years of my life studying the theory and measurement of income, I have come to the conclusion that business income is unmeasurable, even for the normal purposes of business management and reporting and certainly for the purposes of taxation. This is essentially because the concept of business income is so elusive, and the measure of business income so sub- ject to differing interpretations and valuation options, as to make the revenue base a shifting phenomenon which can be manipulated almost a t will. The problem is accentuated by the difficulty of measuring income under conditions of changing prices. The consequence is that business in- come is different in kind from wage and salary income and, to a lesser degree, income from property.

It follows that income is not a satisfactory measure of ability to pay tax: that, because of the opportunities for avoidance and evasion which it presents, the income tax ranks low on the overall scale of tax effectiveness and provides differing opportunities for non-compliance for different income classes and groups of taxpayers; that a nominally progressive rate structure does not necessarily make the rich pay more tax than the poor, although it is likely to make wage and salary earners pay more than other groups with comparable abilities to pay tax: that an income tax is consequently a weak instrument for achieving vertical and horizontal equity: and that a comprehensive income tax imposed at high and progressive rates is likely to inhibit the attainment of other taxation policy objectives.

The conventional view that income taxes are not passed on must also now be challenged, since it has become clear that wage and salary earners are prepared to retaliate against discriminatory income taxes by making wage claims (or seeking tax reductions) designed to maintain their after- tax incomes.

Sufficient has been said in relation to the personal income tax to demolish most of the myths which surround indirect taxation. While the

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existing multiplicity of discriminatory taxes, many of which can only be described as low-yielding nuisance taxes, undoubtedly distort production decisions and consumer choice, a broad-based consumption tax of the value-added type will enhance efficiency not only in relation to those taxes but also by comparison with income taxes. The main reasons for this are that a broad-based consumption tax, unlike an income tax, does not distort the choice between spending and saving nor does it blunt production and investment incentives in the same way.

The notion that a broad-based consumption tax is more regressive than a progressive income tax is based on the wholly unrealistic assumption that the effectiveness of the two taxes is the same. If taxpayers nominally subject to high marginal rates can avoid income tax more easily than low- income taxpayers, while the compliance of the two income classes in respect of a consumption tax is the same, the latter can be more progressive than the income tax even if it is imposed at a flat rate. This says nothing about the possibility of taxing goods and services mainly consumed by the rich at differential rates or by means of specific taxes designed to enhance vertical equity.

The myth that indirect taxes are more inflationary than income taxes derives from the fact that changes in indirect taxes are reflected in changes to the Consumer Price Index. But there is nothing inherently inflationary in a change from direct to indirect taxes for the financing of a given level of government services. Such a change, or for that matter an independent increase in indirect taxation to finance a higher level of government services, does not represent an increase in the cost of living which needs to be taken into account in the process of wage determination. For the latter purpose, a separate price index is needed which specifically excludes the effects of indirect taxation.

But there is another reason for suggesting that income taxes are likely to be more inflationary than indirect taxes. It has long been assumed that income taxes, unlike indirect taxes, are not passed on and that their incidence therefore falls on those who pay the taxes. This assumption has been invalidated by what is called wage retaliation, whereby trade unions seek increases in wages to compensate for increases in income taxes and so maintain the level of after-tax incomes. Because any such increase in wages must be sufficient to pay additional tax on the increase as well as maintain the pre-existing level of wages after tax, wage retaliation in response to an income tax requires a larger proportional increase in wages and is therefore more inflationary than retaliation against an increase in indirect taxation, which is directed only towards the recovery of the indirect taxes actually levied.

The preferred form of consumption tax is the value-added tax, mainly because it contains its own inbuilt checking mechanisms to inhibit tax evasion. The view that the value-added tax involves relatively high costs of administration and compliance ignores the evidence from countries which have such a tax to the effect that, because of the need for systematic

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tax records, it has been a major factor leading to improved accounting methods and managerial performance in small businesses. Because the value-added tax has a high degree of effectiveness, that is, a low level of avoidance and evasion, it is possible for governments to be generous in fixing the term between the collection of taxes by businesses and the time they are required to remit the taxes to the revenue authorities. In the United Kingdom, it has thus been estimated that the interest gains on value-added tax liabilities have more than compensated for the costs of collecting the taxes.

Most of the concern about capital taxes, at least insofar as they affect questions of equity and administration, arise because of the unspoken assumption that such taxes will fall on all members of the population who hold any assets. If it is accepted that the main purpose of capital taxation is to restore the vertical equity to the system that is supposed to be (but is not being) achieved through the progressive income tax, the problems of equity and administration fall into perspective. Death duties, capital transfer taxes, and annual taxes on net wealth are the preferred forms of capital taxation because they are least susceptible to avoidance and evasion, and the objective in imposing such taxes should be to set exemption levels so high as to leave only the very rich liable for tax.

If an annual wealth tax is to be introduced as a substitute for the higher marginal rates of income tax, the number of people affected by such a tax would be of the same order as those now liable for marginal income tax rates of 46% and 60% - a relatively small proportion of all taxpayers. Even for those people, the presumption would be that the rate of tax would be low enough to ensure that it could be paid out of income.

Capital taxes (other than the capital gains tax) do not pose difficult problems of administration and compliance. There has been a long history of death duties and capital transfer taxes, while European countries which have an annual wealth tax have indicated that it is more easily administered than the income tax. One of the principal reasons for capital taxation is that it is more difficult to conceal wealth or distort the revenue base than is the case with income.

Although there is a case in equity for capital gains taxes and many see them as necessary to prevent income tax avoidance, in the form in which they are usually imposed they are the least satisfactory of all capital taxes. This is because they can be so easily avoided or evaded; fictitious capital losses can be contrived even more easily than fictitious income losses. If capital gains are to be taxed, therefore, they must be incorporated in a cash flow revenue base.

Most of the myths associated with the structure of taxation flow from a failure to recognise, first, that the design of the overall tax and budgetary framework is at least as important in achieving the objectives of taxation policy as the form of individual taxes: and, second, that elements of structural design offer the best means of reducing incentives and

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opportunities for tax avoidance and evasion and thereby enhancing the effectiveness of the whole system.

It follows that a tax system based on a comprehensive income tax with high and progressive rates will not be as effective, equitable, or efficient as a diversified system of several broad-based taxes imposed at relatively low rates on different revenue bases; that the fragmentation of the tax system should not extend to the use of different taxes, such as personal income and company taxes, to exploit what is essentially the same revenue base; that a combination of a linear income tax and an annual tax on net worth will be more effective, equitable, and efficient than a highly progressive income tax; that a broad-based consumption tax is to be preferred to a variety of low-yielding taxes on particular forms of goods and services; and that earmarked taxes will sometimes be more effective in achieving policy objectives than taxes which are paid into general revenue.

The myth that tax reforms can best be effected by a series of gradual and piecemeal changes is perhaps the most difficult of all to deal with. We should not delude ourselves that the kinds of tax reforms which are needed in Australia can be effected by partial adjustments designed to patch up the existing system, with all the added complexities, inconsistencies, and inequities that such a process is likely to entail. The whole system is so rotten that nothing less than a complete restructuring will restore equity and achieve the other reforms which are necessary.

So much for the reality behind the myths. How is it that we have become so deceived about the characteristics and consequences of the present tax system? The principal reason is that we have tended to judge the tax system by the qualities it is supposed to have - the myths - rather than by the qualities it actually has - the reality. Many of the myths were not always myths but for various reasons - higher levels of taxation overall, high and rapidly increasing marginal tax rates and, above all, widespread incentives and opportunities for tax avoidance and evasion - the tax system that we thought we had has gradually been converted into a different system without our realising what has been happening. A crisis of tax effectiveness and equity has emerged by stealth, because we continue to judge the tax system by its nominal provisions and not by the way it works in practice.

The Structure of a Reformed Tax System In this paper, it is not possible to do more than briefly outline the form

which a reformed tax system should take. Among other things, consideration must be given to the respective roles of Commonwealth, State, and local governments in a reformed system. This and other problems are considered in greater detail in other papers, some of which are listed below. The principal elements of a reformed tax system should include: (a) The substitution of a linear cash flow tax for the progressive income

and company tax, at a rate lower than the existing standard rate but

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with an exemption level related to the level of social security payments. The tax base would include all cash receipts net of outlays: capital expenditures and purchases of inventories would thus be deducted but proceeds from the sale of assets would be included. Concessional allowances for non-tax purposes - so-called tax expenditures - would be eliminated so as to broaden the revenue base and reduce opportunities for tax avoidance, while maximum opportunity would be taken to tax earnings at the source through pay- as-you-earn deductions for interest, dividends, and other forms of property income as well as wages and salaries.

(b) The substitution of a destination-based value-added tax for the existing wholesale sales tax, payroll taxes, and other selective or partial indirect taxes not required for particular allocative or distributional reasons (such as special taxes on sumptuous consumption). Because the effective rate of tax on income flows would be reduced and separate taxes on companies eliminated, the value- added tax would also be a partial substitute for income and company taxes.

(c) The introduction of annual taxes on net wealth, at a modest rate above a generous exemption level, together with the reintroduction of death duties on very large estates and capital transfer taxes. Local governments would continue to impose property taxes.

(d) Greater reliance on earmarked taxes involving, for example, the introduction of a national superannuation scheme, the extension of earmarked health levies, and the funding of education expenditures by specially designated taxes.

(el The partial substitution of redistributive expenditure policies for tax progression.

Political Obstacles to Tax Reform The first political barrier to tax reform results from the difficulty of

getting any kind of consensual or bipartisan approach among the political parties themselves. While the major parties all pay lip service to the need for reform, they tend to take opposing views about most of the elements of the reform package outlined above. Both the Australian Labor Party and the Federal Opposition accept in varying degrees the mythology surrounding the income tax. However, the Labor Party is ideologically committed to capital taxation while accepting the myths attaching to indirect taxation; and the Opposition parties are opposed to all forms of capital taxes but are prepared to support the greater use of indirect taxes.

Political parties necessarily tend to have short time horizons, and there is little doubt that, irrespective of the ultimate social and economic benefits that tax reforms may bring, in the short term they will impose political costs for the government which introduces them. This is especially likely in Australia with its two- or three-year election cycle. Major structural changes to the tax system will require careful planning and the

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establishment of new administrative and assessment arrangements. For example, several years of planning and preparation must precede the introduction of a value-added tax. It should be noted parenthetically that resistance to change is by no means confined to elected governments. Many special interest groups have a vested interest in retaining the existing tax arrangements, not least the taxation authorities and other government officials who operate the system and who, like the governments they advise, tend to accept the adage that an old tax is a good tax because it is one that they have become used to.

Even if a courageous government is prepared to grasp the nettle and announce a program for the phasing in of a comprehensive reform package, however, it seems inevitable that the opposition will see great political advantages in opposing the reforms. This means that, although all political parties may express support for the social and economic objectives of taxation policy that have been identified earlier, they invariably regard a political criterion - political acceptability - as the overriding requirement which must be met by any proposals for tax reform. Because changes to the tax system make some people worse off even if most are made better off, political acceptability is a difficult objective to achieve. Few governments can withstand the attacks of determined and self-interested pressure groups.

The amount of political noise which is generated in opposition to proposals for tax reform usually varies inversely with the rationality of the counter-arguments or assertions which are advanced, the justice and reasonableness of the opposing claims, and the strength of the case for continuing to favour the narrow sectional interests which those who resist change seek to protect to the detriment of the wider public interest. The debate about tax reform too often degenerates into an attempt to manipulate the political system, often by the same people who have previously succeeded in manipulating the tax system to their own advantage and thereby made the reforms necessary.

Many people - politicians, public servants, special interest groups - thus have a vested interested in preserving the mythology of taxation. A necessary condition for tax reform is that the myths be exposed so that the wider body of taxpayers can see the tax system for what it actually is and not according to the mythology that surrounds it.

FURTHER READING Mathews. Russell (1980). “The Structure of Taxation” in Australian Institute of Political

Science, The Politics of Taxation. Hodder & Stoughton. Sydney. - (19821. “The Commonwealth-State Financial Contract” in Australian Institute of

Political Science. A Fructured Fedmution? Australia in the 80s. George Allen & Unwin, Sydney.

(1983a). Federal-State Fiscal Arrangements in Australia, Paper presented to Workshop on ”Australia’s Federal System, Resource Developments and Resources Trade”. Reprint No. 5 7 . Centre for Research on Federal Financial Relations, Australian National University, Canberra.

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- (1983b1, “Policy Issues in Australian Taxation”, Taxation Reform, University of New South Wales Occasional Papers 8, Public Affairs Unit, Sydney. - (1983c), “Tax Effectiveness and Tax Equity in Federal Countries” in Charles E.

McClure, Jnr (ed.). Tax assignment in federal countries. Centre for Research on Federal Financial Relations in association with the International Seminar in Public Economics. Distributed by ANU Press, Canberra.

(1984aL “The Case for Indirect Taxation”, Australian Tax Forum. Vol. 1, No. 1, March. - (1984b). Issues in Australian Fiscal Federolism, Paper presented to Liberal Party Seminar. Thredbo, 6 May.

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