Income Tax: The Zero Option

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Since the Howard government gained control of the Senate, we have been hearing numerous proposals for reducing the top marginal rate of income tax. The excuse is that high marginal rates reduce the incentive for wealth creation and encourage tax minimization. Let’s put this excuse to the test.

A holding tax is a tax of so many percent of the value of an asset per year, payable by the owner of the asset. If income tax were replaced by holding taxes, the top marginal rate of income tax would be zero. Beat that! And if those holding taxes were confined to assets that taxpayers can neither create nor destroy nor move out of the taxing jurisdiction — assets such as land and monopolies — the taxes would cause zero reduction in the stock of assets and zero discouragement to the production of new assets. That takes care of wealth creation.

What about tax minimization? With holding taxes on assets that can’t be destroyed or moved, the only way to reduce your tax is to sell assets to other taxpayers who are more willing to pay the taxes, or to the government, which can then charge rent for use of the assets (“rent” in lieu of “tax”). So your desire to minimize your individual tax bill does not cause an overall loss of revenue, but reallocates resources to those who can most easily pay the taxes or rents on them — in other words, to those who would use the resources most productively, leading to even more wealth creation.

(As for tax evasion — that is, outright fraud — you can’t hide land from the government that has sovereignty over it, and you can’t hide a monopoly from the government that grants it or regulates it.)

So, if the politicians are really concerned about wealth creation and tax minimization, why are they fiddling with income tax rates instead of replacing income taxes with holding taxes? Could it be that they’re not telling us their true motives?

Infrastructure: No Pork Barrel Needed!

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In every marginal electorate, politicians promise to take revenue raised by nationwide or statewide taxes and spend it on projects that confer purely local economic benefits. This practice is corrupt and unnecessary — corrupt because a minority of taxpayers are bribed at the expense of the majority, and unnecessary because, if a project is economically justified, it can be funded out of the benefit that it confers — and, by implication, from within the area that gets the benefit.

If a project confers a benefit on a limited area, you can’t share in the benefit unless you live or do business in the area; and for that purpose you need access to real estate in the area. Therefore the market value of the benefit is manifested as uplifts in land values in the affected area. If the project satisfies a cost-benefit test, the total uplift will exceed the cost, so the project can be funded by clawing back only a fraction of the uplift through the tax system, leaving the rest of the uplift as an unearned windfall for owners of property in the affected area — and without burdening the taxpayers outside that area.

This funding mechanism can be set up in a revenue-neutral manner by increasing marginal land tax rates and abolishing or reducing other taxes. Then, when a certain project increases land values in a certain area, the land tax assessments automatically rise only in that area, even if the government funding the project is responsible for a much larger area, such as the State or the Commonwealth. The affected property owners can only gain, because their tax bills don’t increase unless their land values do, and their land values don’t increase unless, in the judgment of the market, the owners are better off in spite of the tax implication. Moreover, the higher the marginal rate of land tax, the greater the range of projects that become self-funding through the ensuing uplifts in land values, hence the greater the number of projects that actually proceed, delivering windfalls to property owners — and the greater the range of other taxes that can be scrapped when the new system is introduced.

In short, when a public project passes a cost-benefit test, and when its benefit is confined to a specific area and measurable in economic terms, there is “never ever” any excuse for failing to fund the project, and “never ever” any need to draw funding from outside the affected area. Voters should therefore punish any politician who claims that the government can’t afford a much-needed project in their area, or who promises to spend their taxes for the economic benefit of any other area!

The Progressive Flat Tax

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The flat tax fanatics are back. They say that if there were only one rate of income tax, the system would be simpler, and the rich couldn’t reduce their tax by converting one kind of income into another kind taxed at a lower rate. In the case of a pure flat tax — that is, a tax with one rate and no tax-free threshold — the tax rate could be lower, and the rich couldn’t claim multiple thresholds by splitting income between persons or between financial years.

But of course such reforms would make the tax system less progressive — a “progressive” tax being a tax that takes a higher fraction of income as income increases.

Well, it so happens that the more income people earn, the higher the fraction of their annual income that they tend to have tied up in assets. This fraction rises very rapidly with income; for example, if you can barely pay the mortgage on your home, you probably know of people who own numerous properties but whose salary is only slightly higher than yours.

So a pure flat tax on asset values — that is, a certain small percentage of the value per year, with no tax-free threshold — is highly progressive because “progressiveness” is defined in terms of income, not assets. With no threshold, there is no possibility of juggling assets to claim multiple thresholds. What if your income was high in the past but is now low — e.g. because you have retired — leaving you asset-rich but income-poor? No problem: you can defer the tax until you sell or bequeath the asset; deferral takes the place of thresholds. If the flat asset tax is confined to assets that taxpayers can neither create nor destroy nor move out of the taxing jurisdiction — assets such as land and monopolies — taxpayers’ efforts to minimize their tax by rationalizing their asset holdings do not affect the total stock of assets and therefore do not cause any overall loss of revenue. So all the advantages claimed for a pure flat (income) tax are retained.

We don’t have to choose between flat taxation and progressive taxation. By taxing assets instead of income, we can have a tax that is both flat and progressive!

IR Reform: Banks and P.A.Y.E.

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IR Reform: Let Banks Collect P.A.Y.E. Tax

The Howard government’s industrial relations agenda attacks the wages and conditions of workers as if this were the only way to reduce the cost of hiring. What about the administrative costs imposed by government? For example:

* If you become an employer, you must also become a tax collector and tax agent, deducting and remitting pay-as-you-earn income tax from employees, and issuing group certificates.

* If you become an employer, you must also become a superannuation agent, paying 9 percent of your employees’ wages into personal superannuation funds. You may even have to give a choice of funds — just like the independent brokers, except that you don’t get any commission!

Why should all this be done by employers? Why not by banks and other financial institutions? After all, financial institutions ought to have more knowledge of tax and super than most employers, and could do this work with greater economies of scale than even the largest employers. And unlike employers, financial institutions charge fees for their services!

So instead of deducting tax from a worker’s wages, the employer could simply deposit the gross wages into the nominated bank account, and the bank would deduct tax from all deposits made by the employer. And instead of making a super contribution on top of the worker’s wages, the employer could roll the super contribution into the gross wages, and the bank would deduct the super contribution.

If you have more than one employer, the simplification would be even greater. Instead of claiming the tax-free threshold from one employer, letting the others deduct tax at the top marginal rate, and sorting out the mess at the end of the financial year, you would tell all your employers to deposit your wages into a common bank account, and the bank would deduct tax and super from the total deposits made by those employers.

So prospective employers would no longer be deterred by the complexities of personal tax and superannuation.

Infrastructure: Free Riders On The Tollway

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The Mitcham-Frankston tollway, also known as EastLink, will reduce commuting times in suburbs serviced by the tollway and in suburbs serviced by alternative routes, such as the untolled Springvale and Stud roads, whose congestion levels will be reduced by EastLink. The market value of this benefit (net of tolls) will be manifested as uplifts in land values in the lucky suburbs (because you have to live or work in those suburbs to get the benefit). So owners of property in those suburbs will benefit from EastLink even if they don’t use it and don’t pay the toll on it. But people who live in rental accommodation and who commute via EastLink will pay for it twice — they’ll pay the toll and their rents will go up. How equitable is that?

To satisfy the “beneficiary pays” principle, road projects must be funded out of the uplifts in land values that they cause. If a project satisfies a cost-benefit test, the total uplift will exceed the cost, so the project can be funded by clawing back only a fraction of the uplift through the tax system, leaving the rest of the uplift as an unearned windfall for the property owners.

This system can be set up in a revenue-neutral manner by abolishing payroll tax and other job-destroying State taxes, and strengthening land tax. From then on, desirable infrastructure pays for itself through the increase in taxable land values that it causes. The higher the marginal rate of land tax (or the fraction of properties to which that marginal rate applies), the greater the range of projects that become self-funding through the ensuing uplifts in land values, and the greater the range of other taxes that can be scrapped when the new system is introduced.

Property owners can only gain from this arrangement, because their tax bills don’t increase unless their property values do, and their property values don’t increase unless, in the judgment of the market, the owners are better off in spite of the tax implication. Indeed, if projects pay for themselves, they are more likely to proceed, so property owners are more likely to get the uplifts in land values. The tax means the owners get only a fraction of the uplifts, but a fraction of something is better than 100 percent of nothing!

So is there ever any need for tolls? Yes — on certain routes, at certain times of the day, tolls can prevent congestion by encouraging travel at other times. But they are not needed 24/7, and they are never needed for funding.