High time to look at equitable version of flat tax

In an interview before the election on October 9, Prime Minister John Howard agreed Australia’s highest marginal rate of personal income tax 48.5 per cent including the Medicare levy was too high. He would like to be able to bring it down, “provided we have the capacity”. But he was not in favour of a flat tax, which he described as regressive.

The claim that a flat tax is regressive, and therefore objectionable, is as common as it is wrong. The term flat tax is popular shorthand for a single, uniform, proportionate rate of tax. Under such a tax, high-income earners still pay more of their income in income tax than do low earners, but in contrast to the present system, the highest and the lowest each pay exactly the same proportion of their income in tax.

Plainly, a pure flat tax is not progressive. But it is not regressive, either. It would be regressive only if high earners paid proportionately less of their income than low earners as would happen, for example, if all income earners were subject to a poll tax. In the language of logicians, progressive and regressive are contraries, not contradictories.

Crucial to any well functioning liberal democracy is widespread voluntary compliance with the tax system. This depends on the system being morally just, and perceived to be just, in both design and administration. The biggest single structural injustice in our personal income tax system is its progressive character.

There is an ancient jurisprudential principle of justice under which “like cases must be treated alike, and different cases differently, the latter in proportion to their relevant difference[s]”.

Conformity is essential if the income tax system is to embody both “horizontal equity”, or equity across the breadth of taxpayers, and “vertical equity”, or equity as between high and low earners. A single, proportionate rate, or flat tax, is the arithmetically perfect way of achieving vertical equity. It is the only objective way of satisfying the second limb of this principle of justice and treating different cases differently, in proportion to their relevant differences.

If you layer a flat rate of income tax on top of a tax-free threshold, a flat tax on taxable income morphs into a mildly progressive tax on total income.

The prospect of a flat tax produces in critics the same horror reflex as mention of a voucher system for education. The very suggestion that something is it, will lead to it, or really is it under another name, is a discussion terminator. Critical faculties are numbed by the odium attached to the label. And if that doesn’t work, all you need add is that it has been favoured by Friedrich Hayek and Milton Friedman.

The more modest idea of reducing the highest marginal rate of personal income tax, and also raising the income level at which it cuts in, has support not only among economists, but also on both sides of politics. Predictably, this growing consensus does not extend to the Greens, the clerical left, or the welfare lobby.

Such changes would to some extent reduce the progressiveness of our income tax scale, and shift us further towards a flat tax. This has been the general direction of income tax reform for some time, although “bracket creep” has effectively neutered this, as taxpayers are moved remorselessly on to the available higher marginal rates.

There is no great clamour for a flat tax. This is partly because it is “only fair” that higher income earners pay a higher proportion of their income in tax, or so we are told.

Yet contrary to popular belief that high earners are tax shirkers, research by Sinclair Davidson for the Centre for Independent Studies showed that, in 2001, the top quarter of income earners paid more than 64 per cent of all income tax. In a system under which 75 per cent of taxpayers together contribute less than 36 per cent of income tax revenue, it is hardly surprising there is no clamour for radical change.

Instead of stumbling towards a flat tax while denying the morality of the end point, we should embrace it as a long-term goal, while reducing our overall dependence on income tax and streamlining its operations especially its concessions enabling an acceptable flat tax rate to be achieved.

Lauchlan Chipman is the author of The Very Idea of a Flat Tax, the latest in the Centre for Independent Studies series, Perspectives on Tax Reform, released today