The taxing question of redistribution

investment - 12 April 2005 - 3330 views

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The flat income tax was not the sole element of Douglas�s economic package, but it is the best remembered. In order to compensate for the transition costs of adopting a single tax rate, Douglas also intended to introduce a Guaranteed Minimum Family Income for low-income households, and shift to user-pays for health and education services for higher income earners. The proposed changes were driven by a desire to create a simpler, growth friendly tax system, without producing too many �winners or losers� overall.

In the 2004 Budget, the current Labour government introduced its own comprehensive family support package, but ignored the opportunity afforded by the large fiscal surplus to revamp the existing tax system. Instead of using �Working for Families� to mitigate the transition costs of a flatter tax system, the government opted for more complication, more administration, and a larger chunk of the population trapped by high effective marginal tax rates.

As we enter an election year, and with large projected surpluses still very much on the public radar, taxes are likely to be a point of political debate. The debate, however, will likely focus on the trivia of the tax system: what the top rate should be, what the thresholds should be, how much of a tax cut the government can afford. What has been lacking for the last 17 years is a willingness to address fundamental questions about why we have a tax system, and how it should function.

In this article we re-examine the case for a flatter tax system. We are not attempting to put the case for a smaller government, nor are we arguing that one income group deserves to be made better off at another�s expense. Instead, we intend to explain why the tax base necessary for any chosen level of government expenditure (and indeed any chosen level of income distribution) would be more efficiently gathered through a flat tax system.

A completely flat tax system is not incompatible with government�s social aspirations � whereas the current taxation system is incompatible with their economic growth ambitions. Progressive tax systems may be a popular notion � even a cornerstone of modern democracies � but ultimately they are intellectually dishonest. Despite popular opinion to the contrary, progressive taxation is not:

• an effective way of redistributing income; or
• an efficient way of raising tax for government spending.

Redistribution reconsidered

Progressive tax systems are seen as desirable because they directly redistribute income by taking proportionately more from high income than low income people (whereas a flat tax system would have no direct redistributive effects).

The extent to which the government should play a role in redistributing income is a complicated moral and political issue. However, regardless of what level of redistribution a democratic society finds acceptable, a progressive tax system is not an efficient way of achieving the desired reallocation of income. Why?

• Because there are many more tax payers in the lower income brackets than in the top one, taxing the top band at a higher marginal rate only ever produces small reductions in the amount of tax needed from individuals in the lower income brackets.
• Lower tax rates on the bottom income bands are inefficient because they also give tax reductions to those on higher incomes (who in fact receive more benefits in nominal terms, because their income exceeds the upper limit of the band). In order to recoup the lost tax revenue from high income earners, a much higher top marginal rate of tax is required than would otherwise be the case.

The last broad based review of New Zealand�s tax system, the McLeod tax review of 2001 (from which the above arguments were drawn), concluded that redistributive aspects of the current progressive tax system were slight. So why do we persist with one?

The role of the tax system should simply be to finance the government�s spending plans in the most efficient way. Once expenditure has been decided on, only one single tax rate is required to balance the books. There is no need to complicate the financing process by trying to coerce social policy goals into the system. If redistribution is required, the government can design its social policy in a manner that concentrates the benefits on lower income deciles (the status quo in New Zealand), and in this manner achieve the desired social outcome.

The tax system: flatter is better, but flat is best

All taxation distorts the incentives that people face when they make decisions about work, savings, and risk taking. These distortions lead to a smaller economy, and slower economic growth. But taxation is required for the provision of public goods and services. The aim of a good tax system, then, is to collect the necessary revenue with the minimum of distortion.

However, the complicated nature of the current tax system encourages high income earners to devise ways to avoid the higher marginal rates - by splitting their income through trusts, or through incorporating as businesses. Meanwhile, the government is forced to create a larger tax administration to combat such schemes. These efforts represent a loss of time and resources that could be put to more productive use.

Another deficiency of a progressive tax system is that higher marginal tax rates are required than would otherwise be the case. Flattening the tax system and reducing marginal rates of tax would increase the incentive to work, save, and take enterprising risks. It would also lessen the appeal that emigration holds for highly paid, highly mobile workers.

A progressive tax system results in extra deadweight losses for any level of tax burden, and this inefficiency rises with the degree of progressivity. This is a reason why a flatter tax system is always preferable to the current structure. But the endpoint of such logic � a completely flat tax system with one single rate of income tax � has additional advantages:

• As the tax system becomes flatter, the remaining redistributive benefits of a progressive system are outweighed by the substantial efficiency gains a single rate of tax offers (by eliminating avoidance issues and administration costs).
• The decision to embrace a progressive system leads to complexity in deciding which of an infinite range of progressive systems is most preferable. Whereas a flat tax rate is a simple and transparent principle � it makes it easier for governments to resist calls to alter the tax regime for the benefit or detriment of one specific group.
• A flat tax makes it easy to explain to the public the level of taxation needed to fund the cost of alternative fiscal policies.
• There are significant potential economic gains to be made by reorienting high value resources (e.g. lawyers, accountants, and IRD staff) to more productive tasks.

Making flat tax mainstream

The immediate stumbling block for advocates of a flat tax system is that the transition to such a system would produce a large number of short-term losers, whereas the short-term gains would be concentrated on the rich. For instance, if we introduced Douglas�s flat tax rate of 23% today (a move that would be fiscally neutral overall), everyone with an income less than $51,500 would have to pay more tax.

There are two effective solutions to this problem. The first is to accept that the shift to a flat tax system must inevitably be a drawn out process, involving many smaller reductions in the progressivity of the tax scale. The second is to offset the losses of lower income workers with added financial assistance and/or access to services (free health and education), funded either by reducing government services to high-income groups (as Roger Douglas envisioned) or through the fiscal surplus. Given that the government is currently enjoying record surpluses, and has already detailed an extensive programme of income support for low income families, conditions are currently ripe for starting the shift to a flatter tax system.

The next hurdle that a flat tax proposal must overcome is convincing New Zealanders that it would lead to benefits for all in the long-run, if only for a few in the short-term.

A flat tax system is not a panacea for lifting New Zealand�s long run growth rate. But reduced marginal tax rates and the removal of opportunities for tax avoidance would encourage faster growth, and a more productive use of New Zealand�s resources � the benefits of which are shared among everyone.

If the prospect of participating in a richer economy in the future is not attractive enough by itself, then it is necessary that the government take steps to ensure that there are no short-term losers. This would either involve some of the surplus, or increasing use of user-pays and means-testing of government provisions for high income deciles.

The first step is acknowledging that there is no prima facie justification for a progressive tax system. But the status quo has considerable inertia, and there is currently no political appetite for difficult debates. We can only hope that another 17 years do not need to pass before the idea of serious reform can once again be mentioned.

You are invited to forward any comments, requests for elaboration to Chris Worthington. If you have any design related comments about this page please email webmaster@infometrics.co.nz.