Comments to the Davis Tax Committee (DTC)
DTC’s First Interim Report on Macro Analysis
The FMF is grateful for the opportunity to submit these comments on the DTC’s Macro Analysis Framework First Interim Report Discussion Document dated June 2015 entitled “The Tax System and Inclusive Growth in South Africa: Towards an Analytical Framework for the Davis Tax Committee”. We make reference below the Full Report, and also to its well-considered Executive Summary.
The First Interim Report is merely a discussion document for developing a framework for analysis. However, we are compelled to disagree with the assumptions throughout the Report that a progressive income-tax system entails increasing tax brackets, that reducing inequality necessitates progressive tax rates and that fairness and equity depend on increasing tax brackets.
We stress that the Hall/Rabushka system flat tax system maintains tax equity and provides for progressive taxation by means of the initial exemption threshold. It is lamentable that the Report’s references to a flat-tax system are reduced to footnotes.
We hail the Committee’s flexible approach in recognising there is no conventional framework for designing a system to grow the economy and allow the increased prosperity to be enjoyed by all.
We support the principle in the Report that overall a tax system must support economic growth.
We respectfully submit that a flat tax system with an exemption for the first part of income, as proposed by the FMF, would best achieve the overarching principles for inclusive growth articulated in the Report.
Minimise distortion, broaden tax base, a low tax rate
We support the principle in the Report that a tax system should minimise distortion in the allocation of resources, and the recognition that in general there is least distortion when a tax is applied to broad bases with low rates.
We concur with the Report’s observation that a broader tax base would foster and create incentives for greater government accountability and responsiveness to citizens, since government depends on them for revenue. The Report asks how the tax system can be altered in order to encourage the formalisation of the informal sector.
We submit that the Hall/Rabushka system flat tax system with a low tax rate would broaden the tax base and make tax evasion more difficult and less lucrative. Low flat taxes minimise the economic distortions caused by taxes. Distortions lead to lost output and high costs pursuing tax-beneficial investments.
As Hall and Rabushka observe, graduated tax rates create different tax rates among taxpayers, with attendant opportunities for leakage. High-income taxpayers have the biggest incentive and best opportunity to exploit tax-rate differentials. Applying the same tax rate to these taxpayers for all their income in all years is an important goal of flat-rate taxation.
Under systems such as America's, or those operating in most of western Europe, the incentives for the rich to avoid tax (legally or otherwise) are enormous; and the opportunities to do so, which arise from the very complexity of the codes, are commensurately large. So it is unsurprising to discover, as experience suggests, that the rich usually pay about as much tax under a flat-tax regime as they do under an orthodox code.
The Report does not rule out a flat tax system. It remarks on the evidence that flattening the personal income tax schedule could be beneficial for stimulating GDP per capita by favouring entrepreneurship, and the evidence about the economic effects of flat taxes from the experiments in certain countries.
Tax equity, fairness and progressivity
As the Report states, income tax can be a progressive form of raising revenue: the level of income determines the amount of the tax, and the poorest are not taxed. Overall, according to the National Development Plan, the personal income tax is a progressive form of raising revenue as the level of income determines the amount of the tax, so that the poorest are not taxed
We reiterate that tax equity is maintained in the Hall/Rabushka system by exempting the poor, indeed everyone, from income tax on the first part of income. Progressive taxation does not require a number of different tax rates. The progression is created by providing the initial exemption threshold. Such a flat rate system is progressive, counter-intuitive as it may appear to some.
Messrs Hall and Rabushka stress that it is not necessary for a progressive tax system to have rising marginal rates. The key is to provide each taxpayer with a personal allowance and to tax all income above that allowance at the one rate. The allowance constitutes a threshold of taxation: taxes are imposed on income above the threshold and exempted below the threshold.
Hall and Rabushka explain that exempting the poor from taxes does not require graduated tax rates rising to high levels for upper-income taxpayers. A flat rate applied to all taxpayers above a generous personal allowance provides progressivity without having to create differences in tax rates.
By way of illustration, take a tax system with a 10% flat rate on all income over R10,000 a year, the first R10,000 being tax free. If a person makes R10,000, his tax rate is 0%. If he makes R20,000 then his tax bill is R1,000 (R20k – R10k x 10%) or 5%, and if he makes R100,000 then his tax bill is R9,000 (R100k – R10k x 10%) or 9%. These are rising average tax rates without needing to have a rising marginal one. This flat tax with an allowance is enough to meet the condition of its being a progressive tax system.
(We accordingly respectfully disagree with the assumptions in the Report that a progressive income-tax system entails different and increasing tax brackets:
(We disagree with the implicit assumption behind the Report’s statement that reducing inequality necessitates progressive “tax rates” for high incomes.
(We would also differ with the Report’s assertion that fairness and progressivity is dependent not only on the tax-free threshold but also on how quickly “income tax brackets increase” as taxable income rises.
(We also disagree that flattening the personal income tax schedule of rates implies a trade-off between growth and equity.)
Redistribution on the expenditure side
The DTC observes that, while progressivity in the overall tax system is an important consideration, a great deal of redistribution happens on the expenditure side of the budget. While the Report says tax-reform initiatives should be guided by the general principle that, among other things, the overall tax system should remain progressive, it remarks that redistribution is often more effective through appropriate government expenditure programmes.
The Report, in evaluating the current South African tax system against the principles of a good system, observes that the personal-income-tax reforms over the last two decades have not really resulted in an improvement of income distribution. It also notes some consensus that personal income taxation is not a very suitable instrument for redistribution purposes in developing countries.
Companies should be taxed at the same low flat rate as individuals
The Report states that relying less on corporate income taxes relative to personal income taxes could increase efficiency. It says however that lowering the corporate tax rate substantially below the top personal income tax rate could jeopardise the integrity of the tax system, as high-income individuals would attempt to shelter their savings within corporations, trusts and other legal entities.
We submit that the government should consider simplifying the tax dispensation by having a zero rate for individuals below a certain threshold and a low flat tax rate of perhaps 15 per cent for everyone else including companies.
The system would tax all income as an integrated system, applying the same low flat rate to businesses and individuals, thereby removing the incentive for individuals to utilise companies and other legal entities to reduce tax.
Forty jurisdictions, large and small, developing and developed, administer a flat-tax system.
The Hall-Rabushka flat tax is in effect a consumption tax. It treats the total amount of investment as an expense in the year it is made. Every act of investment in the economy ultimately traces back to an act of saving. A tax on income with an exemption for saving is in effect a tax on consumption, for consumption is the difference between income and saving.
Consultant to FMF
Comments on Submission on Macro Analysis to Davis Tax Committee