Hate Income Tax? You Shouldn’t!
Some taxes are more damaging than others. But when working out which taxes are more damaging than others, you should not judge a tax by its name.
The impacts of income tax and GST can be much the same, because income tax and GST largely tax the same thing.
So a special hatred for the idea of income tax relative to GST is unjustified.
Let me explain with a simplified scenario.
First, imagine a country with five citizens and no government.
One of the citizens, ‘the entrepreneur’, establishes a business by borrowing money from one of the other citizens, ‘the capitalist’. In the first year the entrepreneur pays the capitalist $100,000 in interest.
The business imports 500,000 raw inputs at $1 each, and employs three citizens at a salary of $100,000 each.
The business produces 1,000,000 products and sells half of them to foreigners and the other half to the five citizens of the country, all at $1 each. So the business makes $1,000,000.
The business pays $100,000 of dividends to the entrepreneur.
Australia’s income tax and GST do not have identical impacts on purchasing power and do not have identical discouragement effects.
A scenario with no government
Now imagine instead that this scenario includes a government. The government demands enough money to buy 100,000 products. And for now, let us assume that this taxation does not discourage the citizens from producing as much as they would in the absence of government.
The government could get the money it demands via a 20 per cent income tax on the salaries, interest, and dividend received by the citizens. In year 1 this would leave the five citizens with $400,000 instead of $500,000 in their pockets, and with the capacity to buy only 400,000 rather than 500,000 of the business’s products. The government would have $100,000 and the capacity to buy 100,000 of the business’s products.
A scenario with income tax
Alternatively, the government could get enough money to buy 100,000 products via a 25 per cent GST.
The foreign supplier of 500,000 raw inputs would charge the business $625,000, send $125,000 of GST to the government, and, just like in the scenario without government, would end up with $500,000.
The business would continue to sell half of its products to foreigners for $500,000, at $1 each, given that no GST applies to exports.
The business would sell the other half of its products domestically for $625,000, at $1.25 each. The business would pay $125,000 of GST on these domestic sales, but would claim a $125,000 input tax credit, so overall the business would send nothing to the government.
The government’s overall receipts from both the business and the foreign supplier of raw inputs would be $125,000, enough to buy 100,000 products.
The business would continue to provide $500,000 as salaries, interest, and dividends to the five citizens, but this $500,000 would now only be enough to buy 400,000 products.
The impacts of income tax and GST can be much the same, because income tax and GST largely tax the same thing.
A scenario with GST
Under these income tax and GST scenarios, the dollar outcomes differ but the real outcomes are identical.
In the income tax scenario, each citizen receives $80,000 that enables the purchase of 80,000 products.
Regardless of which tax is imposed, foreigners are unaffected, and the purchasing power of each of the citizens is hurt to the same degree.
The reason for this is as follows. In the GST scenario, the tax base is the difference between the business’s domestic receipts and its outlays on imported raw inputs. Yet this tax base is also the money the business pays to the citizenry as income. So the tax base for GST is also the tax base for income tax.
Because the citizens’ purchasing power is hurt to the same degree under both scenarios, the discouragement effect of tax would be the same in both scenarios. Contrary to popular belief, there is no great difference in the discouragement effect of income tax compared to the discouragement effect of GST.
Now, in the real world, Australia’s income tax and GST do not have identical impacts on purchasing power and do not have identical discouragement effects.
This is partly because of inherently different impacts on savings, that I will discuss in a later article.
But the main reason why our income tax and GST have different impacts is that they each have odd exemptions, and our income tax has various rates unlike the flat-rate GST.
In other words, a broad-based, single rate income tax would have much the same impact as a broad-based, single rate GST.
So the special hatred many feel for the concept of income tax seems unwarranted.
