Marginal Rate a Major Turn-Off

Over the past few years, a blizzard of argument and statistics has confronted the general public as Australia has wrestled with a major debate over taxation policy.

In that time major tax changes have occurred, yet the top marginal tax rate remains unchanged at 47 per cent. Many Australians appear to take the view that the rich do not pay their fair share of taxation. They also believe that without paying progressive rates of taxation, the tax system would become unfair.

It seems many voters are woefully ignorant about how the tax system works. According to the 2004 Australian Election Survey, only 43 per cent of respondents know that low-income earners pay a smaller proportion of their income in income tax than higher earners do. And 30 per cent think low-income earners pay a greater proportion of their income in income tax, while 8 per cent think they pay the same proportion.

Remarkably, the majority of Australians do not understand how the progressive income tax works. People who think low-income earners pay more in income tax are more likely to identify with the Australian Labor Party, more likely to think taxes have risen a lot since 2001 and more likely to strongly favour spending on social services. They tend to describe themselves as "working class" and have lower incomes.

The basis of progressive taxation rests on notions of "fairness". To disguise their unorthodox definition of fairness, economists use the terms "horizontal" and "vertical" equity. Horizontal equity means that equals should be taxed equally, while vertical equity implies that unequals should be taxed unequally. As unequals, high income earners are taxed unequally.

I have calculated, using Australian Taxation Office data, that the top 25 per cent of income earners paid 63.8 per cent of net income tax in 2003. The 3.5 per cent of taxpayers earning above $100,000 pay 25.5 per cent of net income tax. The rich therefore pay a lot more of their income in tax than do the poor.

The criticism that income-tax cuts benefit the rich at the expense of the poor and are therefore "unfair" panders to ignorance and prejudice. The people making these arguments fail to explain why progressive tax is fair, fail to explain why tax cuts are unfair, and fail to explain what would be fair. They also fail to appreciate how pursuit of fairness or "equity" as a social goal is likely to give rise to many economic distortions.

A majority of Australians (64 per cent) clearly believe there is a trade-off between taxes and work effort. The commonsense, intuitive, understanding is that high taxes make people work less. At the last election, 36 per cent of voters supported reducing taxation, while 37 per cent supported higher spending on social services. Of those Australians who want to reduce taxation, a large majority (74 per cent) recognise this trade-off, but even among those who want to increase social spending, most (56 per cent) also recognise the disincentives of high taxation.

In order to provide some indication of the extent of these disincentives I surveyed the economic literature.

The disincentive effects of high taxation are far more extensive than is generally thought. High marginal income tax rates reduce work incentives for second earners in households, self-employed people who can easily vary their hours, and high-paid autonomous professionals. High tax rates also introduce labour discrimination by affecting choices between participation in the legal economy and in the illegal, underground economy.

In fact, high tax rates, often justified on "equity" grounds, lead to higher rates of unemployment among less-skilled workers. High personal tax rates also inhibit small business development and may well contribute to the Australian diaspora.

Many Australians intuitively understand the negative impact of high taxation, even if they are ignorant of how the system actually works. Those individuals who favour high levels of taxation, however, either deny these adverse effects, or argue they are socially desirable. This latter position, however, represents a value judgement on their part and is not derived from any economic theory.

It is high time that those who argue for high rates of taxation justify the choices they wish to impose on Australia .

Professor Sinclair Davidson is an associate professor in the School of Economics, Finance and Marketing at RMIT University . This is adapted from his paper ‘Are There Any Good Arguments Against Cutting Income Taxes?’, The Centre for Independent Studies, August 2005.