Efficiency

‘Efficiency’ refers to how the tax system distorts economic activity. Most taxes result in some economic efficiency loss. For example, a tax may reduce incentives for people to work or invest, or induce them to alter their consumption patterns. For the tax system to be efficient, it should aim to reduce distortions as much as possible.

For example, if different types of fuel are taxed at different rates, drivers may choose to buy vehicles that use the lower taxed fuel, even if they are otherwise less appropriate for the drivers’  needs, or even pay to convert their vehicles to a different fuel.

The efficiency of the tax system is closely linked to its coverage and its rates. A system that applies a high tax rate to just a few items is less efficient than one that applies lower and equal tax rates to a broader range of items. A common mantra in tax policy design is to “broaden the base and lower the rates”.

Another important factor for tax efficiency is the extent to which people can modify their behaviour to avoid paying the tax. A business subject to high taxes may relocate to a lower taxing country, even if other costs are higher. People wishing to move house to reduce their travel time and costs may choose not to because the tax on moving (stamp duty) is too high. 

An efficient tax system has taxes that result in relatively low economic losses per dollar of revenue raised, called the ‘marginal excess burden’. Figure 3-1 shows the marginal excess burdens for each additional dollar raised in a selection of Australian taxes.[45]

Taxes that are generally considered to be efficient include GST, land taxes and resource rent taxes. GST is efficient, as it applies a uniform 10% rate to a broad range of goods and services, with some exemptions. Taxing land, when applied uniformly and broadly, is efficient as the tax base is finite and immobile. In contrast, taxation via stamp duty on conveyancing is narrower (based on ownership transactions), mobile (consumers can influence when they engage in transactions) and volatile (subject to economic cycles).

Figure 3-1: Marginal excess burden from selected Australian taxes^(a)
(cents per additional dollar raised)

Source: Understanding the economy-wide efficiency and incidence of major Australian taxes (Cao et. al., Australian Treasury) and Australia's Future Tax System Review (Australian Treasury).
(a) The welfare effect of varying each tax has been assessed using the KPMG Econtech MM900 general equilibrium model of the Australian economy. The welfare loss is the loss in consumer welfare per dollar of revenue raised for a small (5 per cent) increase in each tax, simulated individually. It is measured as the amount of lump sum compensation required to restore the representative consumers’ level of satisfaction to its original level, after returning the revenue raised by the tax to the consumer as a lump sum transfer. The extent of such compensation reflects the distorting effect of the tax on the economy.
(b) The marginal welfare effect of stamp duty conveyancing uses an updated figure based on the Understanding the economy-wide efficiency and incidence of major Australian taxes Treasury paper.
(c) The petroleum resource rent tax is modelled as a pure rent tax giving rise to a zero-welfare loss. In practice, a small increase in this tax could be expected to induce some welfare loss. However, it would be expected to rank as one of the more efficient taxes in the chart.

‘Rent taxes’ are designed to be economically efficient by taxing only the income earned above a benchmark rate of return. Applied to companies, these are often called ‘super-profits’ taxes.

Applying these marginal excess burdens to Australia’s taxes over time produces a measure of the economic efficiency of the tax system as a whole. Note that this analysis assumes that the marginal excess burdens have remained constant over time, which is a significant simplification, and means that any conclusions from such analysis need to be carefully expressed.

While the overall average efficiency of Australia’s taxes may have remained relatively stable over history, the total size of taxes (as a share of GDP) has increased over time, particularly up to 1980, meaning that the impact of taxes on the economy has increased.

Taxes levied by the Australian Government have tended to become more efficient on average, while taxes levied by states have becomes less efficient (Figure 3-2).[46] This is partly due to the relatively inefficient payroll tax being transferred from the Australian Government to the states in 1972. Declines in customs duties paid to the Australian Government have also contributed to increasing efficiency. For the states, the introduction of taxes on insurance and increases to stamp duty and taxes on gambling led to a large reduction in tax efficiency up to 2000.

Figure 3-2: Weighted marginal excess burden of Australian taxes
(reduction in economic activity for each dollar of tax levied)

Source: Australia's Future Tax System Review (Department of the Treasury) and PBO analysis.

As mentioned earlier, the introduction of the GST effectively replaced a range of indirect taxes with another indirect tax. The impact on efficiency was significant as the GST is a much more efficient tax than most of those that it replaced.

With a growing proportion of revenue collected through personal income tax, the efficiency of the system as a whole is likely to continue to slowly improve.