RSM Australia

Tax reform 2015 – a background

The Abbott Federal Liberal-National Party Coalition Government was elected in September 2013 on a platform of 'economic repair' which included promises to conduct two related white paper processes leading into the next federal election: a white paper on tax reform, and a white paper on the reform of Australia’s Federation. Whilst the topics of the two white papers are discrete, there is an unavoidable financial linkage between the two and it remains to be seen how the processes for each will advance.

The need for tax reform

The need for tax reform is clearly apparent to all who choose to consider Australia’s current fiscal position. With company tax collections trending down in the face of falls in the export price of our major export commodities; the general margin crunch imposed by increasing global competition and a slowing domestic economy, limited real wage growth and increasing unemployment as the economy fails the post-resources boom transition; increasing average tax rates on salary and wages as bracket creep taxes inflationary gains and an increasing welfare spend inherited from the commodities boom era; the current tax (and transfer) system is not sustainable.

With budget deficits foreshadowed for many years into the future adding to the nation’s already high level of international indebtedness, changes are required.

As a commodity exporting price taker, with the boom time commodity prices in the past and the terms of trade moving against Australia, we are not like the closed economies of the US or UK – we cannot support high levels of international debt and expect to ‘earn’ our way out of the financial hole. Australia is an open economy, and as such is simply not able to support the same level of debt/GDP that the larger closed economies are able to maintain.

White paper on tax reform

Treasurer Hockey will kick-start the tax reform white paper process with the release of a discussion paper on Monday, 30 March 2015. If the process follows the traditional Westminster pattern, it will consist of:

  • a discussion paper with public submissions and public consultations
  • a green paper, indicating the government’s preferred options, with limited additional scope for public input
  • a white paper, which will outline the proposed taxation changes the government will take to the next federal election

Long time coming

The release of the discussion paper on tax reform has been a long time coming. It was confidently expected to be released in late 2014, but that did not occur. The delay has been attributed, variously, to the difficulty the government has had negotiating its 2014-15 budget measures through the parliament; the general intransigence of the upper house controlled by micro-parties; and also the government’s own internal ructions at the end of 2014 and leading into 2015.

The political message from the 2014-15 budget process was that the government had failed to make out the case, or the need for the significant and far-reaching budget changes. This was perhaps based on the earlier charge that there was no budget emergency – it was just a convenient excuse for conservative politics (hopefully the complacency underpinning that view has been overtaken by the reality of the deteriorating economic news of past months, compounded by the forward projections).

On 5 March 2015, the government released the fifth intergenerational report (IGR) which provided three distinctly different projected outcomes over the future 40 year time frame, depending upon the preparedness to make political and economic changes to reflect Australia’s ‘new’ economic reality. The IGR was widely viewed as the government beginning to make its case for the need for broad ranging tax reform.

Reform options

Australia has for a long time, and continues to have, and overweight reliance on direct tax, ie. income tax. This covers both the income tax on individuals, and company income tax. In particular, Australia is out of step with the other OECD member states, other middle ranking open economies rely relatively less on company tax because of its variability. Instead, there is a relatively greater reliance upon (more) controllable tax bases – labour, land and consumption.

The thrust of tax reform 2015 will be to reduce Australia’s reliance upon direct taxation, and to increase the relative contribution of consumption taxes (referred to as ‘tax mix switch’).

It has been suggested the forthcoming reform process could fit within one of three categories:

  1. significant ‘tax mix switch’ measures proposed
  2. moderate ‘tax mix switch’ measures proposed 
  3. minor reform, tinkering around the edges

In the event the process leads to significant reform proposals, the challenge is to find the funding for the compensation that will be required to equalise those on lower income levels, assuming there will be a ‘tax mix switch’ resulting in a relatively higher level of taxation of labour income, land and/or consumption. In the current straitened fiscal environment, there is little spare money for tax relief at all, and query whether of the quantum required, should there be any meaningful level of ‘tax mix switch’.

Further, any significant tax changes will be politically challenging. If the electorate’s reaction to the 2014-15 budget measures can be seen as indicative, there is very little appetite across the electorate for radical tax change, never mind the challenges the government would face getting any changes through the unworkable upper house.

To compound these difficulties, time is not on the government’s side. The earliest date for the next federal election is August 2016, with the latest date being mid January 2017. An election in November 2016 seems a fair bet, but any time towards the end of 2016 leaves the government with little time to run a long, open, consultative white paper process (with the attendant negative press from every special interest group grabbing the daily headlines).

But a white paper ‘process’ which pre-empts the outcomes will fail the fairness test, and will not achieve the objective of bringing the electorate along with the government on the journey, so a balancing act is required and some political dexterity needs to be shown in the management of the process.

And there is the interaction of the federation reform process which must be integrated into the tax reform process somehow…

Our expectations

In our view, there is neither the time, resources, nor appetite for a tax reform process with the scope of either the Ralph Review or the Henry Report. This is particularly the case, given the amount of work that came out of the Henry Report which has yet to be subject to any serious public consideration.

But if the options are broadly those already set out in the Henry Report, the challenge is to bring together the special interest groups sufficiently to create a working majority that would provide a tax reform package with a reasonable chance of acceptance at the next federal election.

Leadership and a ‘mature national conversation’

Prime Minister Abbott has made it clear that he will not go to the next election with a swag of tax policies for which there is no public support – no matter how economically necessary those policies may be. This is where the need for political leadership intersects with the maturity of the Australian electorate: can the vested interests sublimate their own ‘wants’ to the greater good? Is the electorate capable of having a discussion, or at least a reasonable, informed debate, about the inherently personal topic of taxation and the closely related topic of social welfare spending? Assuming this is possible, and the political leadership is forthcoming, how will the upper house intransigents react? Difficult times ahead are assured.

Who wants what?

Individual tax rates

1.  Increase in tax rates. The government has already increased the top marginal tax rate, in what is said to be an interim measure. History suggests these interim measures have a habit of becoming permanent, given the inability of the government to legislate the 2014-15 budget savings measures, the temporary tax increases are likely, both economically and politically, to be around for many years.

2.  Bracket creep. The insidious and odious process by which inflation moves taxpayers into higher marginal tax rate brackets, when their real incomes have not increased. Put another way, this is taxation of inflationary income gains. Past tax cuts have been about reversing (to a limited extent) bracket creep – they have done no more than move people back down the rate scale to where they would have been, had there been indexation of the marginal tax rate scales. The 2015 IGR assumes that there will be no income tax cuts until 2020-21, when it is expected the tax/GDP ratio will have recovered to the historical level of 23.9% of GDP.

It has been suggested that the annual additional revenue collected by the government from bracket creep is in the order of $3-4bn, an amount which cannot simply be sourced elsewhere. So notwithstanding the need for less reliance on direct taxation, it seems the government’s fiscal repair job is inextricably tied to direct taxation, by way of the (nearly) invisible bracket creep.

Business – big end of town

3.  Tax mix switch: reduction in company tax rate. To be funded by an increase in the total tax take from labour, land and/or consumption.

Business – SMEs

4.  Not so focused on the company tax reduction, because most SME business does not operate through a company structure.

5.  Recent calls have been for broader concessions – accelerated depreciation is a particular request – which will benefit all SME structures. In common with big business, however, is the SME business sector request for a ‘tax cut’, albeit delivered by different means.

Business – general

6.  Dividend imputation. When introduced, this was lauded as a move of genius – in one fell swoop it reversed the large Australian corporate focus on reducing tax payments. Suddenly, listed corporates were rewarded for paying fully franked dividends, and executives responded accordingly – looking for ways to pay tax and generate franking credits. The Henry Report pointed out Australia and New Zealand are the only two countries still operating a full imputation system, and the current Murray Report has questioned the regime, specifically that it distorts normal investment behaviour, and directs investment towards equities to the detriment of the investor and the economy.

A reduction in the value of franking credits (or the elimination of dividend imputation entirely) would give the government significantly more revenue – out of the pockets of investors, not corporates – but with what consequences for financial markets? What would be the implications for investors? What would be their reaction to reduced income (in an already difficult income period), and the ‘reverse wealth’ effect?

A significant source of additional revenue for the government, but a move with economic consequences that would be very hard to foresee, and even harder to model.

Consumption tax base

7.  GST. The centrepiece of ‘tax mix switch’, but politically the most hazardous topic. There are two aspects to possible GST reform:

  • broaden the GST base, by removing the big GST – free items of health, education and food; and/or
  • increase the GST rate from the current 10%

Either change would demand compensation for lower income Australians, as noted above, but the source of that compensation is not immediately obvious.

But the politics of GST require all state governments to agree to any such significant changes, and the federal government is on record as saying it will not take forward any GST changes unless it has the support of all state governments – any other position would be political idiocy: even with an electoral mandate won at the next federal election, any state government could veto the proposed GST changes.

Social welfare lobby

This broad aggregation of bodies have put forward various revenue raising suggestions, most of which revolve around eliminating or restricting the large so-called ‘tax expenditure’ items.

8.  Negative gearing. This should either be abolished, or the investment losses should be ‘quarantined’ and carried forward for recoupment against future positive investment income only. The Henry Report recommended a schedular approach, whereby all investment income would be taxed as a class, and investment related expenses allowed up to the limit of the total investment income, but investment income losses (excess of investment expenses over investment income) would be quarantined and not permitted to be offset against labour income.

When negative gearing was disallowed in the mid-1980s, it was hastily reversed as a ‘strike’ in new building promptly followed. However, questions have always circulated as to whether the policy was ever given a fair chance to stabilise, and even if it did, whether circumstances today require a different view.

Against a background of a housing shortfall in the 100,000s, playing with property funding would seem to be a high risk political strategy. On the other hand, limiting negative gearing for existing house purchases, but allowing it for new housing stock, may be considered to have a relieving effect on skyrocketing house prices in inner suburbs. Similarly, restricting negative gearing on investment portfolios may take some heat out of the current stock market.

But the risks in the fiddling around with Australia’s property and equity markets, in the current environment of low consumer and investor confidence, would bring from Sir Humphrey the usual observation of 'courageous policy, Mr Treasurer'.

9.  Superannuation. From the media reports over the last several years, it does seem the current superannuation system – or at least some aspects of it – are unsustainable. But further changes to the system will have the effect of discouraging participation. SME business owners remain sceptical of superannuation as a government ‘play thing’, and another raft of grandfathering provisions will further complicate a system which is notoriously complex already.

The ability to further restrict concessional contributions is already putting at risk the long term goal of superannuants living independently of government support.

Taxing those with ultra-high superannuation balances will face the same problems as taxing the ultra-wealthy: the amount of tax gathered is hardly worth the effort (and the community costs of collection would probably outweigh the tax collected).

Lump-sum payouts have been a target of superannuation reform for many years, and it may be this time round they are either limited, or forbidden entirely, with access to retirement savings being only by way of pension/annuity streams. This would be a move against ‘double dipping’, although there is little more than anecdotal evidence of the phenomenon – everyone has read about it, but very few people actually know anyone who has deliberately spent their retirement balance, just so they can spend the remainder of their lives as pensioners of the state.

Also at risk may be the current arrangements whereby those whose superannuation funds are in ‘pension phase’ pay no tax on the income of the fund. How this would be addressed, equitably, is a question for the ages, and the targets will not be restricted to the ultra-wealthy, but will hit the ‘grey army’ of retirees who work very hard extracting a living through the judicious management of their superannuation investments. (Refer above to the possible restrictions on, or the removal entirely of dividend imputation – the effect of which will be felt immediately by superannuants.)

10.  CGT 50% discount. Another ‘tax expenditure’ in the sights of the welfare lobby. Some may recall that, when CGT was first introduced, it contained an indexation regime to (try and) restrict taxation to real gains, and not to tax inflationary gains. Indexation was a complex and patently unfair system which failed in its objective, and clearly taxed inflationary gains (the CGT equivalent to bracket creep).

The indexation regime was replaced with the 50% discount, which arguably has gone the other way – it is too generous. Where an asset is held on capital account for a year and a day, only half the nominal gain is subject to tax, which does far more than limit tax to only real gains, but can provide tax shelter for significant real economic gains.

There may be room for a middle course, such as that which operates in the US with a sliding scale of discount – increasing discount as the asset is held for longer periods, but stopping short of the reintroduction of the prescriptive indexation regime.

11.  SME CGT reliefs. There are some calls that these reliefs are too generous, although these seem less compelling than the CGT 50% discount. The SME CGT reliefs have been fine-tuned by governments of both persuasions, and there seems to be bipartisan support for the concept that the SME sector does need special reliefs to reflect its ‘special circumstances’, and in some way to even up the savings concessions provided to employees. To interfere with the already incredibly complex provisions of the SME CGT relief provisions would alienate another key electorate – small business – which is the very engine room the government is relying upon to invigorate the economy and generate employment growth.

12.  Main residence exemption. Another popular topic for revenue raising is to remove the CGT exemption on the main residence. This is mentioned for completeness, but for no other reason. It would be political suicide, and no government could realistically be expected to propose such a change. In any event, there is no empirical evidence that such a move would be good for the economy.

The federation reform process 

13.  The key objective is to review the federal-state workings after 115 years of Commonwealth. Allocation of responsibilities between the different levels of government is an aim, as is making the appropriate level of government solely accountable for spending decisions. This would require addressing the vertical imbalance that exists, and an early example suggestion would see the federal government hand over (eg.) 10% of all personal income tax raised in a particular state, to that state government, to fund spending by that government. By streamlining the delivery of governmental functions, significant savings are expected from the avoidance of duplication and ‘cost shifting’ strategies that currently operate, particularly in health and education.

Summary

It is very easy to find reasons why each and every tax reform ‘opportunity’ will not work; yet, the overarching need for tax reform remains.

The tax reform process is one of the most challenging facing Australia today, and rather than approach it from entrenched positions, we should all be prepared to at least think about the alternatives. After all, these discussions will impact the Australia of tomorrow – for our children and those who follow, or closer to home, for the standard of our own lives in retirement.

RSM will be actively participating in the tax reform process, and we will be inviting you to participate through regular updates and surveys. 

RSM in Sydney - providing accountanting, auditors and consultants for sydney Businesses