Cut Taxes And Watch Economy Soar

The Treasury Secretary, Ken Henry , in a recent speech to Australian Business Economists , argued for higher levels of economic growth to meet our pressing demographic challenges.

Fundamental tax reforms can assist in meeting high growth targets. It is worthwhile recalling the words of John F. Kennedy: "It is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now."

It is widely accepted that taxes have a multitude of effects on the economy. First, and foremost, they raise revenue for the state. They provide finance for physical and institutional infrastructure which facilitates economic development. The American jurist Oliver Wendell Holmes jnr said he "bought civilisation" with the taxes he paid.

Others argue that tax should equalise after-tax income in an economy. Taxes are a necessary evil.

Only anarchists would propose no government. Government, like any other monopoly, has the incentive to overcharge for service. Government, like any other multifunction conglomerate, is likely to expand its operations beyond its core business. To the extent that taxes are coercive payments, citizens end up paying too much for some services they don't want or don't value.

The solution to this problem is tax competition. . There has been substantial tax competition between nations in the past 24 years. Between 1980 and 2000 personal marginal tax rates declined, on average, by 20 per cent in the Organisation for Economic Co-operation and Development. Australia managed a 15 per cent reduction over that period. Total tax, as a percentage of gross domestic product, rose in those economies over that period.

This does not constitute a tax transfer from the rich to the poor. For example, the US Internal Revenue Service reports that the top 1 per cent of income earners paid 19.05 per cent of all federal income tax in 1980 and this increased to 33.89 per cent in 2000. Their average tax rate fell from 34.47 to 27.45 per cent over the same period.

In my Centre for Independent Studies monograph, I show that despite tax reforms which appear to favour the rich, the top 25 per cent of Australian taxpayers are paying an ever greater share of income tax.

Tax revenues are up in Estonia, Latvia, Lithuania and Russia economies that recently introduced low, and flat, tax rates. Increased tax revenue following a cut in tax rates is predicted by the much-maligned Laffer curve. This concept has few academic friends but appears to function well in the real world.

If modifying tax rates affect revenue raised, the important question becomes: What is the optimal tax rate to maximise revenue?

In a 1991 paper for the Dallas-based National Centre for Policy Analysis , economist Gerald Scully estimated governments would maximise revenue when the income tax rate was 22.5 per cent . He also figured a government wishing to maximise growth needed a marginal income tax rate of 11.9 per cent .

Scully used data from 1960-1980 for his analysis. During that period Australia's marginal income tax rate was far higher than 22.5 per cent .

These data, however, are old. Using data from the World Bank and the 2002 Economic Freedom Report, I performed some back-of-the-envelope calculations based on the Scully procedure. The state maximises revenue when the marginal income tax rate is 35 per cent , while economic growth is maximised when the marginal income tax rate is 30 per cent .

My guesstimates of a growth-maximising tax rate are much higher than Scully's, but they remain much lower than the present 47 per cent .

Tax is an emotional issue that brings out the best and worst in people. ABC TV viewers would be aware of the fate of Charles I, a king with poor tax policies (who got the chop). Many a great nation and empire has been laid low by bad taxes. Angry taxpayers can be fatal to political elites. It is for this reason that both the coalition and Labor Party have taken notice. After the recent budget speeches, one thing is clear: tax relief is bipartisan policy. It is also sensible policy.