Appendix B: Assessing the tax mix – further examples

Chapter 3 of this explainer describes various criteria for assessing different taxes. This appendix provides several examples that illustrate the concepts and trade-offs.

Simplicity and compliance:  Fringe benefits tax

Ideally, income tax would be simple but defining ‘income’ in a complex economy is not easy. Income can be earned through a variety of mechanisms, including in cash (such as wages, interest and rent) and in kind (known as ‘fringe benefits’ in the tax system). For example, an employee may be provided with a car rather than wages. As described in Chapter 1, as personal income tax rates increased during the 1960s and 1970s, taxpayers sought alternative forms of income to reduce their tax. Fringe benefits tax (FBT) was introduced in July 1986 to capture these in-kind benefits. The FBT rate is set at the highest marginal income tax rate, greatly reducing the incentive to receive income other than as wages.

The FBT is an ‘integrity’ or ‘back-stop’ tax, meaning that its primary purpose is not necessarily to raise revenue but to protect the integrity, equity and simplicity of those taxes that do raise the majority of revenue. While FBT may be necessary, its inclusion increases complexity and reduces certainty. Concessions in the FBT system are frequently used to encourage a type of behaviour, such as the FBT exemption for providing certain types of vehicles, or the exemptions for employees of public hospitals, health promotion charities and public benevolent institutions.

Simplicity:  Expenses and deductions

Most people who earn income also incur costs. An income tax needs to specify which costs, if any, may be deducted against income. In Australia, most expenses relating to the generation of assessable income are deductible[61], but the lines between income-producing and private expense are not always clear and they can vary between different occupations or business structure. 

For example, our tax system allows a delivery driver to deduct the costs of fuel when making deliveries but not when driving between home and work. But what if a delivery is made on the way between work and home? An income tax system that includes deductions considers such situations, generating more complexity, particularly as these deductions change over time. For example, work from home deductions evolved before, during and after COVID. With time, the complexity of the tax law increases to handle new situations.

Simplicity, equity and efficiency: Goods and services tax (GST)

Exemptions from the GST both increase and decrease complexity. No nation with a GST (or other value-added tax)[62] taxes residential rent on real estate because there is no simple way to equivalently tax the rents paid by a tenant to a landlord and the ‘imputed’ rents paid by owner-occupiers to themselves.[63]

Instead, the economic value of housing is exempt from GST but taxed through a variety of mechanisms, such as municipal rates, land taxes and stamp duties. Residential rents being exempted from the GST increases the tax’s simplicity.

By contrast, the exemptions from GST for some food introduce complexity. Businesses need to apply GST to some products and not others, increasing their administrative costs more than if every product were subject to a single rate of GST. In this case, the additional complexity is generally not experienced by households. This was a deliberate decision by policymakers, who opted for a more complex GST over a simpler GST that would have required a complex system of transfer payments to achieve a similar result for households.

Exemptions from GST also alter the prices of some products relative to others, such that consumers modify their purchase decisions. While the GST is a largely efficient tax, the exemptions are not costless for the economy.

Simplicity and visibility: The Medicare levy

Another example of complexity in tax design is the Medicare levy.[64] Introduced in 1984, the levy was intended to fund the ongoing costs of establishing the Medicare system. Its design is complex as there are exemptions for low-income individuals and households, is phased in quickly, and has exemptions for certain groups of individuals (e.g.: non-residents, Defence force personnel, and the blind). 

The Medicare levy might seem like a ‘hypothecated’ tax (a tax where the funds are directly attributed to a certain purpose), but there is no direct link between the levied monies and the funding of the Medicare system. The additional funds raised have always been pooled into the government’s consolidated revenue fund, meaning the additional complexity of administering a separate levy could be removed if the levy was simply built into personal income tax rates. Such an action would also improve transparency of marginal tax rates.

Complexity and equity in transfers

Complexity exists on both sides of the tax and transfer payments system. The example from Chapter 2 sets out 3 cases, one from contemporary Australia, receiving a transfer payment in the form of family tax benefit, another from 1950s Australia, when different tax rates applied for different family compositions, and a third from the United States, where families receive a tax credit to reduce tax liability. All of these approaches add complexity, reduce transparency and potentially introduce mechanisms to skew or improve equity outcomes.

Tax compliance and the ‘tax gap’

Determining the size of a tax policy gap is dependent on judgements on which tax-minimising activities ought not to exist. Judgements like this are likely to be controversial, as some may view an activity as a legitimate and desirable feature of the system while others may take the opposite stand. 

For example, following changes to the taxation of superannuation in 2006, most superannuation earnings after retirement are not subject to tax. This means that an individual can accrue large superannuation capital gains before retirement but not pay capital gains tax when the assets are sold the day after retirement, realising those gains. There would be different views about whether this is or is not an intended consequence of the 2006 changes.

Another example is the tax-free income threshold, currently $18,200. An individual earning $90,000 in one year would pay around $11,500 tax. If that individual earned that same amount but through a trust, and the trust paid them, their spouse, and 3 adult children with zero taxable income, $18,000 each, then no tax would be incurred. Some may consider this an intended feature of the tax system while others do not.

Tax gaps are closely connected to both simplicity and equity. A portion of the tax gap can be attributed to misinterpretation of complex tax laws, particularly regarding individuals and small businesses, who may not have the resource available to obtain the best tax advice. Policy tax gaps may be unintended consequences of the complexity of tax law.

Non-compliance may reduce horizontal equity in the tax system, where individuals with the same income may pay different amounts of tax depending on the form of that income and the ease of being able to avoid the tax. Underreporting of income affects vertical equity, where individuals with different actual incomes may pay the same amount of tax.

Income taxes are particularly prone to both forms of tax gap because of complexity and also the difficulty in defining and identifying the tax base of income-less-expenses. That is, the taxes which are most relied on to provide equitable tax outcomes are also those where the administration challenges are most significant.

Taxes which are less prone to both forms of tax gap are those where the tax base is simple to understand and hard to alter behaviour to avoid paying, such as taxes on land. Compliance challenges are also reduced for taxes where the agent remitting the tax is not the entity liable for the tax. For example, the GST is remitted by businesses but borne by consumers. Withholding taxes on wages are also remitted by businesses on behalf of employees. Both taxes have relatively low measured tax gaps and are likely to operate largely as intended by the law.

Tax visibility and compliance

The majority of taxes in Australia are not paid directly by individuals, but indirectly by businesses on their behalf. The most common mechanism for the payment of income tax, pay-as-you-go withholding tax on wages, is remitted to the ATO by employers, with the amount taken out of wages before it is paid. The employee never receives the ‘tax’ part of that money. At the end of the year, the employee submits a tax return which reconciles the various incomes and deductions, often resulting in an additional payment or refund. These amounts on assessment typically receive more attention than the tax paid throughout the year by the employer.

Taxpayers are typically pleased to receive a refund, despite the refund representing an interest-free loan to the government during the year. Similarly, taxpayers are unhappy to pay more on assessment, despite this effectively meaning that they had received an interest-free loan from the government. Taxpayers react more strongly to the taxes they directly pay than those that are paid on their behalf.

The taxation of corporate income in Australia is based on a system called dividend imputation, where company tax is effectively a pre-payment of tax on behalf of the shareholders.[65]

For indirect taxes, such as wholesale sales tax, payroll tax, excise and GST, the tax is remitted to the ATO by businesses. The impact of the tax is passed on to consumers through the prices of the goods and services. Chapter 1 mentioned the introduction of wholesale sales tax in 1930, chosen by the government in part as being less obvious to consumers.

A key advantage of taxes being remitted to the ATO by an entity not directly affected by the tax is that the incentive for non-compliance is relatively low. A disadvantage is that those affected by the taxes (either directly or indirectly) may be unaware of their impact. In some cases, these people may have made alternative decisions.

Only around 20% of tax is paid by individuals directly, rather than by businesses on their behalf. The largest of these taxes are: tax on unincorporated business income and investment income[66], vehicle registration tax, stamp duty on the purchase of real estate, and municipal rates and land tax.

While land taxes are otherwise attractive, being simple, highly efficient, difficult to avoid and equitable (depending on the details of the design), they are also highly salient because they are paid directly by the landowner rather than through an intermediary.

A related issue is the perception that some taxes are dedicated to particular spending. Examples are fuel excise, which may be perceived to still be linked to the upkeep of roads[67], and the Medicare Levy, which may be perceived to be linked to funding of health spending. In reality, almost all tax is paid into consolidated revenue.