Rebasing consumption taxes

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1 Rebasing consumption taxes A paper for the Festival of Outrageous Tax Ideas Michael Walpole 1. What is the problem? There are features of the existing Goods and Services Tax (GST) in Australia that deliver outcomes that are less than ideal. There are troublesome features such as: the revenue yield is relatively low and there are gaps in the GST base which mean that not every form of consumption is taxed the same; 1 the tax (like most invoice-credit style Value Added Taxes (VATs)) incurs high compliance costs for suppliers; 2 the dividing lines between GST-free and Input Taxed supplies create legislative and regulatory complexity. 3 In light of these features, it may be possible to revisit the consumption tax and design it in a different way that removes or reduces these problems. The Australia s Future Tax System Review (AFTS also known as the Henry Review ) in 2008/9 4 made a few suggestions to reform the consumption tax that we currently have and this paper seeks to explore the options suggested in The AFTS Review. 2. What is the proposal? The AFTS Review 5 was strictly limited in what it could include in its scope. It was made emphatically clear that proposals concerning the GST were not to be discussed. There were several specific exclusions of the GST topic from the AFTS terms of reference. 6 It was pleasing to find that the AFTS review panel ignored this advice and did indeed discuss consumption tax. One of the proposals that it floated was a subtraction method cash flow tax and combined this with a financial services tax. As we come again to a national discussion of tax as result of the Federal Government s discussion paper released on 30 th March 2015 it may be timely to revisit this aspect of GST. 1 The GST taxes only about half of our consumption. See Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia 286. Quoted in Kathryn James The Rise of the Value Added Tax (2015) Cambridge University Press Luca Barbone, Richard M. Bird, Jaime Vazquez Caro, The Costs of VAT: A Review of the Literature, International Center for Public Policy Working Paper April 2012, at See for example M. Walpole, The Miraculous Reduced Input Tax Credit for Financial Supplies in Australia, (2011) 22 (5) International VAT Monitor at 320; Luca Barbone, Richard M. Bird, Jaime Vazquez Caro, The Costs of VAT: A Review of the Literature, International Center for Public Policy Working Paper April 2012, at 5. 4 See Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia. 5 See Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia. 6 These exclusions were to be found at each of at Term of Reference 3, 5 and 16. 1

2 This paper refreshes the proposal to abandon the current invoice credit model of GST and to replace it with a tax on consumption that is much closer to the subtraction model of VAT and which does not rely on individual invoices - but simply imposes a tax on the difference between the business s sales of goods and services and the cost of its inputs. This is passed on to the consumer through pricing. The operation of a tax of this type is illustrated by Grinberg who explains the difference in operation between a subtraction method VAT and an invoice credit method VAT. Credit-invoice method VATs calculate VAT due by multiplying the value of taxable sales by the relevant tax rate and subtracting VAT paid on inputs from the tentative tax due on sales. Subtraction-method VATs subtract the amount paid for inputs from taxable sales and multiply by the relevant tax rate. 7 Grinberg goes on: A subtraction-method VAT does not use credits and that tax due is not calculated by subtracting tax paid from gross tax liability.instead, registered traders subtract the value of their total nonlabor inputs from the total value of their sales and then multiply by the VAT rate to determine their tax liability.as a result, the subtraction method is described as being "accounts-based," rather than "transactions based," and is commonly perceived to be a tax on an entity. 8 Grinberg illustrates the operation of the tax thus: 9 Grape Grower Winemaker Retailer Total Basic Transactions Pretax sales $30 $70 $100 Pretax purchases Value added (sales + purchases) Subtraction-Method VAT VAT liability (20% of line 3) Grinberg s descriptions are useful background to the proposal in the AFTS Report, which was that It would be possible to replace [inefficient state based taxes] with a low-rate broad-based cash flow tax that more effectively utilised the consumption base. Exports would be exempt and imports subject to the tax, to ensure that it taxes consumption in Australia. The tax could be designed so that returns from labour would be taxed, making an additional payroll tax unnecessary. It would be highly efficient, because it would cover most of the consumption tax base. It would also be a 7 Itai Grinberg Where Credit Is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT (2010) 63 Tax L. Rev at Itai Grinberg Where Credit Is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT (2010) 63 Tax L. Rev at Itai Grinberg Where Credit Is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT (2010) 63 Tax L. Rev Example 2 at

3 relatively simple tax if it could be added to the existing tax reporting obligations of businesses. 10 I have discussed aspects of the proposal elsewhere. 11 Significant features include that it would tax the value added by labour which GST does not as it does not apply to salary and wages - and that it seemingly would operate in parallel to the income tax on businesses. There were perceived advantages in the possible use of a cash flow tax that would include financial services in the form of the Real plus Financial or RF based cash flow tax. This would be the broadest possible consumption tax. Such a tax would include financial services and thus would identify financial transactions and tax them as part of the cash flow. The operation of the broad based consumption tax in this way would avoid giving any price advantage to...products that rely more on the value add from financial services. 12 However, there were also disadvantages associated with this model the principal one being the transition because it would affect those assets that had already been financed by debt. The result of the imposition of the new tax would be that lenders would not be able to offset their receipts of interest and repayments by deduction of the initial loans and associated input costs. Instead, the AFTS Report recommended leaving financial services out of the broader based consumption tax and subjecting them to a discrete financial services tax. The need to maintain a financial services tax was seen to arise from the need to ensure taxation of domestic consumption of financial services. Financial services are currently under taxed to domestic consumers at an amount calculated in the AFTS Report that seems staggering. As I have mentioned elsewhere the AFTS Report explained that businesses in Australia are over taxed on their consumption of financial services and that consumers are massively undertaxed. The relevant quantum was expressed as business having been over taxed on its domestic consumption of financial supplies to the tune of $760 million in and taxation of domestic consumption of financial services by households in the same period was $3.9 billion under what it should have been. 13 With regard to the financial services dimension of this discussion I am left with the impression from the AFTS Report, if these figures are correct, that reforming the consumption tax so as to more comprehensively tax financial services would result in increased revenue and should be attractive to financial service providers as they should no longer be overtaxed. Domestic consumers of financial supplies might however bear a higher cost than they currently do. I am also of the opinion that the transition to a RF based cash flow tax ought to be possible without significantly disadvantaging lenders part way through loan arrangements. But the precise operation of these transitional rules would need to be carefully worked out. 10 Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia at See M. Walpole The New Option 2? "The New 'Option 2'? The Henry Review's Broad Based Cash Flow Tax" [2012] JlATax 6; (2012) 14(1) Journal of Australian Taxation Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia at See M. Walpole Re-basing the GST. The case for a tax on financial services in Australia. Presentation to the ATAX Annual GST Conference April 2015, Brisbane at 3. 3

4 The overall attractiveness of a straightforward and simple cash flow tax is powerful indeed. Compliance would align with business processes that calculate cash flow and it would simply follow the accounts. 14 The processes would be easy for small business to follow and could be semi-automated. 15 The tracking of individual invoices would be unnecessary Why is it a good idea? There are several reasons why taxing consumption by means of a cash flow tax would be a good idea. Such a tax would no longer be dependent on the maintenance and tracking of invoices. It would also be unnecessary (and difficult) to distinguish between different types of supply. The only simple way of establishing exemptions from the tax would be by way of exemptions applicable to the entity/ies involved it would not really be possible to exempt different categories of supplies. The consumption tax would no longer be an indirect tax. 14 Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia at Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia at Australia s Future Tax System Report to the Treasurer December 2009 (2010) Commonwealth of Australia at

5 This would address the efficiency criterion in tax it would not be possible to differentiate between different types of supplies having a further desirable impact on revenue as there would be no leakage through tax breaks and less lobbying for differential treatment of different types of supply. (There is a risk that there would be increased lobbying for differential treatment of different types of supplier.) In addition, in relation to this point concerning the political acceptability of the change as the tax would not be dependent on invoices it would not be readily discernible to consumers and this may take some of the political sting out of the tax once in place and out of changes to the tax. Consumers would not necessarily be aware of the tax. Such a tax also addresses the issue of cascading of taxes which creates economic inefficiency because it removes the problem of taxes being imposed later in a sequence of transactions, on taxes previously imposed on transactions earlier in the sequence. This is advantageous to exporters who tax policy suggests should not have to bear tax on exports, and is advantageous to downstream consumers of supplies that hitherto included an upstream input taxed supply. 4. Is it outrageous? The proposed form of consumption tax is outrageous for several reasons as follows: 1. It completely changes the manner in which so-called exemptions are dealt with. In its purest form the tax will apply at a single rate across the entire economy so that there are no input taxed supplies and no zero-rated supplies. There may be some room for special treatment of certain entities if necessary for example charities so that there is some shelter for the provision of certain public goods. However, this should be avoided if possible. 2. It is likely to be highly regressive so that those with lowest incomes pay out a disproportionately high portion of their income on tax. Thus there would need to be a compensation package either in the form of income tax reductions or social security benefits so as to compensate for the regressivity. 3. The extension of the tax base may be so encompassing that it results in a reduction of tax rate- this would make the change more palatable to the community. 4. The tax would also tax the value added by labour and would replace payroll tax. 5. The tax would tax financial suppliers in a manner that is indistinguishable from other supplies. 6. Some taxpayers like start-ups and exporters would enjoy substantial refunds. 7. Australia would be implementing a tax in a form that to date only Japan has adopted. 8. The tax would operate in parallel with the existing income tax. It would be reserved to the states in terms of the revenue derived. This would give rise to perceptions and accusations of double taxation. 5. What next? (Turning the idea into practice...) The first step necessary to assess this proposal is to determine whether, by careful drafting existing arrangements involving financial transactions can be quarantined so that they are not affected by the move to an all-encompassing tax that is based on cash flow. The principal area of concern would be the returns on loans already made. The drafting might be designed 5

6 to allocate a deemed expenditure to those receiving cash flows into their business arising from such loans, or it might be drafted to simply carve all standing arrangements out of the new regime. Once it has been determined whether financial transactions may be quarantined in this way, it will be necessary to undertake modelling to determine the revenue likely to be raised from the proposed tax at various rates and the extent to which particular entities might be sheltered from the tax in order to adopt measures to offset regressivity. In particular, consideration should be given to how low a rate might be applied as a low rate across a broad base may make it politically easier to sell. Related to the above modelling detailed analysis should also be undertaken of what existing state taxes (especially inefficient ones) might be abandoned upon adoption of the broad based consumption tax and the revenue it would generate. 6

THE NEW OPTION 2? THE HENRY REVIEW S BROAD BASED CASH FLOW TAX

THE NEW OPTION 2? THE HENRY REVIEW S BROAD BASED CASH FLOW TAX By Michael Walpole 1 This article critiques the cash flow tax proposed in the Australia s Future Tax System Review (the Henry Review)(the