Why progressivity of the income tax must be increased

By June 27th, 2012 Uncategorized No Comments

Dr Maheswaran Sridaran

Income inequality in Australia must be moderated. That is because income inequality causes a number of social ill effects and undermines political democracy. The reasons for moderating income inequality, which are very compelling reasons, are, accordingly, social and political, not necessarily reasons founded on economics.

A principal way for moderating income inequality is for increasing the progressivity of the income tax: that is, those with high incomes must be required to pay income tax at a much higher rate than they currently do. It is common to argue that such a policy would impede economic efficiency. In other words, some argue that such a policy will distort the decisions made by those who make up the Australian economy as to how they work, invest, and save. Such an argument may have some substance, but it is not an argument that can prevail. It cannot prevail because the reasons for moderating income inequality are dictated by societal wellbeing and political democracy, reasons which are not subordinate to economic policy. Economic policy must serve to better societal wellbeing and political democracy, which are of higher supremacy in importance to the Australian polity. Societal wellbeing and political democracy, accordingly, cannot be compromised to promote economic efficiency.

There is an argument mooted by some that a progressive income tax must be replaced with a flat tax, or that the progressivity of the income tax must be decreased. They argue that a flat tax will result in those with higher incomes paying a greater amount of income tax than those with lower incomes, and consequently the objective of progressivity is met, which is that those with higher incomes must pay more tax than those with lower incomes. Such an argument relies on an incorrect definition of what progressivity of tax means, as progressivity of tax, in its proper sense, means those with higher capacity to pay tax must pay tax at a rate higher than the rate at which those with a lower capacity pay.  Such an argument also does not stand up to close scrutiny.

The most comprehensive and most authoritative study on why a progressive income tax is necessary was carried out by two professors in the USA in 1953. The two professors were Walter Blum and Harry Kalven. Their study was published as a book titled The Uneasy Case for Progressive Taxation, which has endured as a classic in tax literature. It was a study completely free of preordained ideological preferences on the part of any of its two authors. The authors reached the unequivocal conclusion that progressive taxation in the USA is a necessity. They, however, reached that conclusion, as the title of their study demonstrates, with proper regard to all arguments against progressive taxation. They reasoned that:

… ultimately a serious interest in progression stems from the fact that a progressive tax is perhaps the cardinal instance of the democratic community struggling with its hardest problem.

What Blum and Kalven meant was that, if a nation is to remain a genuine democracy, to ensure that each person of that nation has the same political power as the other, those who are more wealthy must be prepared to part with some of their wealth, however hard and inconvenient they find doing so, so that a share of their wealth can be given to the less-wealthy, to ensure that they are afforded the same political power as the wealthy.

Blum and Kalven are not alone. Richard Musgrave, a long-time professor at Harvard University, widely regarded as the foremost public finance economist of the last century, concluded:

In my view, [the social welfare function] should reflect the … premise that the issue of distributive justice is not settled by innate entitlement to market earnings, but calls for a rule of fairness to be reached by social consensus. My voice in that consensus would reflect a view of the good society in which excessive inequality is avoided.

Musgrave reached this conclusion in a paper published in 1991 titled Social Science, Ethics, and the Role of the Public Sector. His conclusion can be paraphrased thus: To ensure distributive justice prevails in a society (that is, every member of that society being possessed with equal political power), that society must reach a consensus that there will be a transfer of wealth from the wealthy to the less-wealthy as, absent such a transfer, the distribution of wealth resulting from a free market will cause excessive inequality among those in that society.

Australia imposes a large number of regressive taxes, that is, taxes which the less-wealthy pay as a greater proportion of their incomes as compared to the wealthy. GST, for instance, is imposed on most goods and services consumed by Australians. Less-wealthy Australians spend a greater proportion of their incomes on consumption, and therefore pay a greater proportion of their incomes as GST. The wealthy pay GST of a smaller proportion of their incomes as, because their incomes are higher, they spend a smaller proportion of their incomes on consumption. GST is not the only regressive tax Australia has. There are very many other regressive taxes, imposed at all three levels of Australian government: federal, state and territory, and local.

Given such regressive taxes, in order to compensate the less-wealthy for the impact of those regressive taxes, Australia’s income tax must be more progressive. Admittedly, the highest rate of income tax must not be increased to an extent of such severity as to seriously impede economic efficiency. There is scope, however, to add a higher rate of income tax, fixed between 50 and 60 percent of taxable income, payable by wealthy individuals, and to increase the rate of income tax payable by large companies to 40 percent of taxable income. At present, the highest rate of income tax paid by individuals is 45 percent, and all companies pay income tax at 30 percent. There is scope also to introduce in Australia a progressive wealth tax and a progressive gift tax. Such measures would increase the progressivity of the Australian tax system, which is a necessity to moderate income inequality. The absence at present of any progressive tax on wealth and on gifts seriously retards the progressivity of the Australian tax system.

A doyen of free-market capitalism, Nobel-laureate economist, professor Friedrich A Hayek, conceded, in his highly influential work, The Constitution of Liberty, published in 1960, that progressive taxation is a necessity. He conceded so in the following terms:

… The task of erecting a barrier against abuse of progression is complicated by the fact that … some progression in personal income taxation is probably justified as a way of compensating for the effects of indirect taxation [that is, regressive taxation]. Is there a principle which has any prospect of being accepted and which would effectively prevent those temptations inherent in progressive taxation from getting out of hand? Personally, I do not believe that setting an upper limit which progression is not to exceed would achieve its purpose. Such a percentage figure would be arbitrary as the principle of progression and would be as readily altered when the need for additional revenue seemed to require it.

Hayek, accordingly, conceded that progressivity of the income tax is necessary to compensate for the regressive incidence of other taxes, and that the degree of progressivity of the income tax is always a political judgement, as what that degree ought to be cannot be established with any scientific precision.

On close scrutiny, therefore, there is no sustainable case—libertarian, liberal, or centrist—that can be made against increasing the progressivity of the Australian tax system, which is a necessary policy measure that must be implemented for moderating income inequality in Australia.

Dr Maheswaran Sridaran is a tax practitioner. He was previously a university academic who taught Australian tax law. His work has been published in prominent Australian newspapers and journals. These are his views and do not necessarily represent the views of The McKell Institute.




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