UNIVERSITY OF NEW SOUTH WALES
SCHOOL OF BUSINESS LAW AND TAXATION
RATCLIFFE MEMORIAL LECTURE 2001

`THE FUTURE OF TAX REFORM IN AUSTRALIA'

MR DICK WARBURTON
CHAIRMAN OF THE BOARD OF TAXATION
WEDNESDAY 17 OCTOBER

Introduction

Thank you Professor Taylor for that warm welcome. May I say that I am honoured to have been invited by Professor Taylor, and by the School of Business Law and Taxation, to give the Ratcliffe Memorial Lecture for 2001.

My intention this evening is to speak fairly broadly on the topic of tax reform. In particular, I would like to explore why the reforms of recent years were required and indeed why further reforms to the tax system are both unavoidable and desirable. And in referring to the 'tax system', I include not only the laws and their administration as they currently stand, but also the processes that exist for the design and implementation of new tax laws. In this context, I will also take this opportunity to speak on the role of the Board of Taxation in the tax system.

The recent round of tax reform

It would be not be an exaggeration to say that, by the mid-1990s (and probably much earlier), the Australian taxation system was in desperate need of reform.

The problems with the tax system and the measures introduced by the Government to address them have been well documented elsewhere, but I think it is useful to briefly recap, if only for the purpose of highlighting the magnitude of reform attempted in the past two years.

Indirect Taxation

To begin with, the basis of the indirect tax system had been the wholesale sales tax (WST).

Introduced in the 1930s, this tax originally applied at a single rate of 2.5 per cent to the wholesale value of goods (but not at all to services) and was a robust and stable source of revenue.

However, the WST had well and truly passed its use-by-date by the 1990s.

The WST base was shrinking, it had become a very complex tax and more than half of WST revenue was raised from goods used as inputs to one type of business or another, raising business costs and hampering international competitiveness.

The commencement of the goods and services tax from 1 July last year in place of sales tax means that Australia now has an indirect tax that is broadly-based, raises more revenue and grows along with the economy.

The introduction of the GST also facilitated significant changes to Commonwealth-State financial relations. The payment by the Commonwealth of GST revenues to the States and Territories has enabled, among other things, the abolition of financial institutions duty and marketable securities duty. There is also the prospect of the removal of such taxes as the bank account debits tax and business stamp duties at a later date.

Personal Taxation/Social Security

Personal tax rates were high by international standards and people on average earnings faced rising marginal and average tax rates.

In the absence of reform, many moderate income earners would soon be paying the top marginal tax rate of 47 cents.

For lower income individuals and families, these effects were made worse by the interaction of the income tax and social security systems.

The personal income tax cuts introduced by the Government, through both reduced income tax rates and higher income tax thresholds, are worth over $12 billion a year. The result of this is that more than 80% of individual taxpayers now face a tope marginal rate of just 30%. In addition, the rate of capital gains tax has effectively been halved for individual taxpayers.

Business Taxation

The business tax system was also beset with problems, at the heart of which has been the inconsistent taxation treatment of different business entities and different types of investments.

The Government established in 1998 the Review of Business Taxation to investigate and consult on reforms to business taxation. The Government's response to the recommendations of the review has been a drawn-out process, reflecting the breadth of the report and the desire of the Government to consult more widely with business on the proposed reforms.

A number of significant reforms have been implemented, including:

• the lowering of the company tax rate from 36 per cent to 34 per cent for 2000-01 and now 30 per cent;

• changes to the capital gains tax regime:

• the simplified tax system for small business;

• the unified capital allowances system; and

• new debt/equity measures and thin capitalisation arrangements.

The Government announced earlier this year a further phasing of the remaining business tax reforms.

Tax Administration

At the same time as introducing these tax reforms, the Government also introduced some major changes to taxation payment arrangements, with the introduction of the Pay As You Go (PAYG) withholding system, to replace the PAYE and Prescribed Payment Systems, and the Business Activity Statement (BAS).

What have we learned from recent tax reform?

The trilogy of indirect, personal and business tax reforms represent a massive undertaking on the part of the Government, business and the broader community. Education, technological change and consultation programs have been undertaken on an unprecedented scale, and business and tax practitioners have faced an enormous implementation task.

The Magnitude of Reform

Clearly, the Government's tax reform agenda was highly ambitious and placed incredible pressure on its own resources and those of the Parliament, the Australian Taxation Office and the community, including taxpayers and taxation advisers.

This is, in part, a consequence of the Government's courage in implementing tax reform on the scale in question. It is also a consequence of one major political issue - namely a ridiculously short three year parliamentary term, which almost forces the government of the day to try and get all legislation through in that short term. However, some commentators feel (and I must admit that I have some sympathy with this view) that the tax reform "pie" was simply too large to digest within the timeframes originally planned by the Government. The deferral of some business tax reform measures indicates that the Government came to share this view.

There is no doubt that the scale of reforms undertaken in a relatively short period has had some unfortunate consequences. And they raise some important questions about how we should look to develop our tax laws in Australia.

First, there is the question of the extent to which some of the transitional costs, and high degree of angst among taxpayers and tax professionals, could have been avoided if there was more time for genuine and effective consultation with the community on some of the reforms. Here the Business Activity Statement is a case in point.

Second, many in the community (especially business and practitioners) feel that the "Big Bang" approach to tax reform has resulted in an unbalanced implementation of reform measures. The perception is that the measures given priority by the Government have focused on anti-avoidance, while eagerly anticipated reforms, such as the review of Australia's international taxation system, simplified imputation arrangements, and the introduction of the company consolidation regime have been afforded a lower priority. The question of balance in the implementation of reform is arguable, but there is no doubt that some of the unfinished areas of tax reform are very important to the business community.

Another consequence of the "Big Bang" approach to tax reform has been the emergence of a large tax legislation backlog. The most unsatisfactory aspect of this situation is where changes to the operation of the tax system having been announced and are notionally in force, without legislation having been passed by or introduced into Parliament, or even drafted by the Government.

Finally, to balance some of these critical observations, it is probably fair to say that had the Government only intended to achieve what it has to date implemented, then it is likely that less would have been achieved.

Has it been worth it?

With the New Tax System having operated for just over a year, some significant teething problems only recently having been addressed and key elements of business tax reform still to commence, some could understandably be hesitant to hail the reforms as a success at such an early stage.

Tax reform, by definition, involves changes to the status quo. Accordingly, it is inevitable that transitional costs will arise as a result of this process and the recent tax reforms have been no exception to this. Moreover, the costs are often more immediately evident than the potential benefits, which can accrue over a much longer time frame. However, I believe we have laid the foundation for a more robust, fairer and flexible taxation system going forward. The issue is whether these achievements warrant the grueling transition that we are still going through.

Speaking from a business perspective, we supported tax reform with an eye firmly on the need to secure the long term national benefits, but we also knew it was not going to be easy. And I think we have been proved right on both counts.

When one considers the alternative, which was persisting with the tax system as it stood two to three years ago, my belief is that the gains to the economy and the nation generally over the longer run will significantly outweigh the costs that have been faced in this transitional period. My main concern, though, relates to the extent to which many of the transitional costs might have been avoided or reduced as a result of better processes, in particular, better consultation during the development and implementation of the legislative reforms.

The case for ongoing reform

The question now is whether the Government should let the tax system rest for a good while, to help overcome what could be described as 'tax reform fatigue' out there in the community. For example, a recent survey of businesses by the Australian Chamber of Commerce and Industry (ACCI), with more than 2,300 responses, found that the frequency and complexity of changes to tax laws were the most important concerns. ACCI has suggested that the incoming government should leave major tax initiatives alone and concentrate instead on improving the efficiency and clarity of measures that are now in place.

I have a good deal of sympathy for this view. A 'pause' in reform would give taxpayers and tax advisers a much-needed breather. It would provide time for the significant changes of the past two years to be properly bedded down before a new round of reform is undertaken. It would also provide time for the authorities to 'catch up' with more minor changes to the law that are required, including measures that have long been announced but are still waiting to be legislated.

However, for a number of related reasons, I do not believe that we can afford to stand still for too long.

Unfinished Business

First, there is still what might be called 'unfinished business' from the recent round of reforms, particularly in the realm of business taxation. Some of the deferred key business tax reform measures, such as the proposed company consolidation regime, the review of foreign source income rules and the regime for the taxation of financial arrangements, hold much promise in terms of improving the operation of the tax system, from the point of view of both taxpayers and administrators.

International Competitiveness of the Tax System

The second point I'd make is that we cannot afford to stand still for the simple reason that other countries are not. Indeed, while the reforms of recent years have been significant, it could be suggested that we have simply caught up to the position that most other industrialised countries reached some time ago.

But it is essential for our economy that we have an internationally competitive taxation regime. While we have taken some large strides recently in this regard, we must continue to recognise and respond to the implications for our tax system of emerging global trends.

Time does not permit me to explore these trends in any detail, but they include such factors as:

• the integration of national economies and increasing mobility of capital and labour;

• the increasing importance to Australian companies of both foreign shareholders and foreign source income;

• aging populations in Western countries; and

• the increasing awareness of the need to address the environmental consequences of economic activity.

Complexity

Third, it is arguable that the recent round of reforms has done little to address the complexity of Australian tax legislation. In the past, Australia's tax system has been described as second only to the United States in terms of complexity and I suspect this has not changed.

Australia's income tax law was first enacted in 1915 and contained only 24 pages. The law has been growing continually since then because of 85 years of patching and filling, but the growth has accelerated dramatically since 1985. Over 650 different tax policy changes have been announced and nearly 3,000 pages of legislation have been added in the last 16 years.

Rules have been added to the law for a number of reasons but a key one has been the desire to develop and protect the tax base, for example in the areas of capital gains, fringe benefits and foreign source income. This has been important to ensuring the integrity of the tax system.

The length of the tax acts is not so much the issue. It is more a symptom of the main issue, which is the way changes have been made over the years. That is, through ad hoc additions to the law without a coherent and all-embracing framework, which have led to the large volume of law and systemic complexity. For instance, instead of stating a concept once, we find that the law has many variations on each concept. This is the fundamental nature of the problem - that there are different regimes trying to do essentially the same thing - to assess gains and provide relief for losses. Each of these regimes has its own pattern and set of rules and together they form a complex web.

The inevitable 'boundary' issues that result have meant that further rules had to be added to cover gaps, to deal with overlaps, to counter arbitrage opportunities and other exploitable defects and to extend policy concessions granted in one area into other areas.

The complexity in our tax laws is by no means solely an unintended consequence of changes to the tax system over the years. Modern commercial transactions are highly complex and therefore the tax rules that deal with them need to reflect that. More generally, it is often the Government's deliberate intention to give greater weight to other objectives, such as

• achieving equity in the tax system;

• pursuing specific policy objectives for taxpayers in various circumstances, such as in different industries or carrying out particular activities (such as research and development); or

• delivering non-tax related policies through the tax system, such as in the areas of family benefit payments and health.

Irrespective of the merits of these objectives, pursuing them through the tax system necessarily implies greater complexity in our tax laws and rules.

I believe we have reached a point where we need to question whether such a path will continue to be sustainable. A high level of complexity and the degree of uncertainty that it implies imposes high compliance costs, distorts decision making and increases the incentive and opportunity for tax avoidance and minimisation. This has led to the frustration of both tax practitioners, with the never-ending stream of patches that have been applied (particularly in relation to the taxation of business income), and tax administrators, with what has been interpreted as a lack of respect for, and voluntary compliance with, the tax system.

The Way Forward

So how can we do better?

In my view, much of the answer lies in developing better processes for tax law development in this country. Processes that, in particular, would foster a closer "partnership" between Government and its tax advisers, on the one hand, and those in business and the broader community who are most directly affected by the taxing outcomes, on the other.

That is not to suggest, however, that governments should be consulting on every issue of tax policy. Nobody enjoys paying taxes. So it is quintessentially a government role to determine who does pay and how much they should pay, although governments obviously need to be aware of the economic, social and political consequences of their policy decisions.

Rather, I am suggesting that there is much to be gained from facilitating more fulsome community input to tax law development and implementation processes once a broad policy intention has been established.

In today's complex world, it is simply impossible for governments and their advisers independently to fully comprehend the likely consequences of their decisions. So it is vitally important, I think, that input from those directly impacted is provided for at the earliest possible phase.

Not only is it important that we get right the detail of tax legislation and associated administrative arrangements, but also that the right options for approach for implementing a policy proposal are pursued in the first place.

We have already seen some movement in this general direction with the Ralph Review and subsequent business tax reform implementation processes. These have taken community consultation and involvement in tax law development to a new level, through such mechanisms as the more frequent release of exposure drafts and the convening of focus groups of interested stakeholders.

But I think we need to go further.

And here too I think some of the seeds have been sown, including with the establishment of the Board of Taxation.

The Role of the Board of Taxation in Tax Reform

There has been considerable discussion recently in the media as to the Board's place in the tax system and the role it could or should play in the process of tax reform. I would like to turn to this now, in doing so highlighting the ways in which I think the Board can play a role in helping to overcome some of the concerns and issues I have raised to this point.

First, a little background information on the Board.

The Board's creation was a recommendation of the Ralph Review of Business Taxation. There was a perception among business and their advisers that their views on the development of tax laws and the operation of the tax system were not being effectively heard by the Government. There was a strong feeling that improved outcomes could be achieved through better communication with, and input from, the community.

In broadly adopting the Ralph recommendation, the Government determined that the Board should have a broader, whole-of-tax system view rather than just a business tax focus. It was also decided that the Board would be an advisory body rather than a statutory body.

The Board was officially established in August of last year and its members have been appointed with a view to their abilities personally to contribute a broad range of relevant business, practitioner and broader community knowledge and experience to the development of the tax system.

The Board's Mission and Functions

The Board's mission, as stated in its Charter, is to:

"...contribute a business and broader community perspective to improving the design of taxation laws and their operation."

Ultimately, the Board is here to contribute, in the broadest possible terms, to better tax system outcomes, by facilitating more effective community input into the development and implementation of tax laws.

In pursuing this mission, the Board is required by its Charter to have regard to the fact that the Government is responsible for determining taxation policy and that the Commissioner of Taxation has statutory responsibilities for administering Australia's tax laws. The Board is purely an advisory body to the Treasurer.

Within those strictures, nevertheless, the Board still has a potentially very wide ambit in terms of issues it can address.

The first of its key functions, as set out in its Charter, is to advise the Treasurer on:

"the quality and effectiveness of tax legislation and the processes for its development, including the processes of community consultation and other aspects of tax design."

The objective here is to achieve better legislative and implementation outcomes. The Board's main purpose is to provide advice to the Government on processes needed to facilitate the full and effective input of all legitimate community interests in an issue. That said, the Board itself will on occasion engage directly in consulting relevant interest groups, such as in the case of the possible development of the Tax Value Method (as requested by the Treasurer) and consistent with its role of advising on the quality and effectiveness of tax legislation.

The second key function of the Board is to advise the Treasurer on:

"improvements to the general integrity and functioning of the taxation system."

In this regard, the critical issue for the Board is ensuring that it is effectively and continually apprised of the community's views on the operation of the tax system.

It will then be a matter for the Board, of course, to determine which issues it may wish to pursue. Where the Board decides to take up an issue, the process generally will require that it be referred to the Treasurer in the first instance. It would then be for the Treasurer to decide whether or not it is a matter that should be considered further, and whether the Board should have any role in that process. The overriding criterion, nevertheless, is whether, in its view, the Board is in a position to "add value" to the consideration of an issue. In essence, this requires a judgement as to whether the Board can provide or facilitate better insights or emphasis to an issue than what would already be available to the Government.

Where can the Board make a Difference?

As I have already discussed, significant issues for taxpayers, tax advisers and tax administrators include the complexity of our taxation laws, the frequency of changes to them and the problems encountered with the implementation of new laws.

Nevertheless, there is scope to get better outcomes, including by looking at the structure of the tax act and by looking at the arrangements for the development of tax laws.

All interested players in the tax system, both in the public sector (the Government's tax advisers and administrators) and in the private sector have a role to play, but the Board is perhaps uniquely placed to act as a potential catalyst for change.

Review of Consultation Arrangements

The Board in its initial 12 months of operation has been focussing heavily on discerning possible best practice arrangements for gaining more effective community input to the processes of tax law design, which could be recommended to the Government. There have been gains made in areas such as business tax reform as I mentioned earlier, but consultation on the development of tax laws remains very much an ad hoc process.

As a key input to its consideration of this issue, the Board commissioned a report from KPMG Consulting. KPMG was asked to draw together ideas gleaned from, inter alia, a community survey of views about current consultative arrangements and suggestions for the future, analysis of processes employed in other comparable countries and from processes employed in developing other areas of law.

The Board will shortly be considering KPMG's report. Ultimately, we will be seeking to make recommendations to the Government on processes that result in tax legislation that:

• reflects the Government's policy intent.

• is more compatible with commercial realities and the circumstances of individuals;

• minimises complexities and resulting compliance costs; and

• avoids unintended consequences.

Improving the processes of consultation with tax system stakeholders is an area where I see the Board of Taxation making a potentially significant contribution to the process of the development of taxation legislation.

Tax Value Method

A further area of major focus by the Board has been on developing and evaluating the so-called "Tax Value Method" (TVM) for calculating taxable incomes. This task was assigned to the Board by the Treasurer at the time of its establishment in August last year and arises from a recommendation of the Ralph Review of Business Taxation.

The TVM offers the prospect of addressing many of the complexities and inconsistencies in the income tax law that I alluded to earlier, and that have arisen as a result of the ad hoc additions and amendments to the law over time.

The current law uses many different sets of rules and concepts to describe the income tax base (ordinary income and general deductions, statutory income, CGT, trading stock, traditional securities, capital allowances). Special rules are required to address the overlaps and gaps that this approach has caused.

The TVM would introduce something currently missing from the income tax law - a coherent and generic framework of standardised core concepts or rules to support the calculation of taxable income. In doing so, it has the potential to underwrite the development of a stable, less ambiguous and more understandable income tax system. It could also result in a system that is more robust and conducive to accommodating changes into the future.

The Board's strategy for progressing this exercise is to develop a body of draft legislation and associated products sufficient to comprehensively demonstrate, test and evaluate the idea. A unique feature of this strategy is its transparency and the degree to which it allows for open input from key stakeholders and the community more generally.

As such, and aside from whatever the ultimate judgement might be about the TVM's relative merits, the Board's strategy represents something of a fresh approach to a more open and inclusive tax design process. The work being done is also likely to yield improvements to the design of tax laws irrespective of whether the TVM per se is adopted in its entirety.

An extremely good example of the positive outcome we seek has been demonstrated in a startling manner following the drafting of the core rules and resulting draft legislation on key capital gains tax issues. That work has reduced the size of the CGT rules so far redrafted from 126 pages to 28 pages (a 78% reduction). 39 CGT events have at this stage been reduced to 3 (with only 5 other events needing further consideration).

Hence, simplicity is clearly demonstrated and so is certainty and robustness by the use of core principles which apply to all aspects of income tax under the proposed TVM laws.

A Strategic Tax Reform Agenda

More generally, I believe the Board can, through its interaction with the community, assist the Government to prioritise the issues on the tax reform agenda.

I mentioned earlier the large backlog of tax legislation that has arisen due to the magnitude of the reform program that has been pursued by the Government. I think there would be significant benefits if we could replace the propensity for very major tax reform exercises every 5-10 years with a different process. That is, a process that embodies ongoing review of the tax system, highlights a small number of high priority issues to be addressed at any one time and deals with them accordingly.

The Board has already spent a lot of time consulting extensively with community stakeholders, including through meeting with representatives of business, the tax professions and charitable organisations as part of its regular monthly meetings. The aim has been to discern views about the current operation of the tax system and the Government's reforms, and to further refine the Board's modes of operation and processes needed to meet the requirements of its Charter.

In continuously harnessing the community's views on tax matters, the Board should be well-placed to advise the Treasurer of community concerns and priorities in respect of the ongoing operation and development of the tax system.

Conclusion - The future of tax reform

The Ralph Review recommended the adoption of the following three objectives as a focus for design of the business tax system:

1. Optimising economic growth;

2. Promoting equity; and

3. Promoting simplicity and certainty.

These objectives are of course relevant to the design of the tax system generally.

It is important that we understand that "tax reform" is not an end in itself; rather, it is a process designed to help improve the living standards of all Australians. Australia needs and deserves a tax system that is capable of dealing with a changing world environment, changing technology and changing lifestyles.

Tax reform should also take account of the need for governments to raise revenue in an equitable and efficient manner. Australia needs a tax system that provides enough revenue to ensure that the Government can deliver essential services to all Australians. This is of particular importance given increasing community expectations and in particular Australia's aging population, which brings with it the potential for increased health and social security costs to be borne by a smaller proportion of the population.

The world is becoming increasingly globalised. From an economic perspective, this means that activity and trade can flow to more efficient locations around the world more readily than in the past. With such increasing mobility of labour and capital, continuous tax reform is needed in this country to ensure that we can be competitive and thereby ensure that our standard of living will continue to improve.