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Heady election tax pledges can bring on long hangovers

Australian fiscal policymaking highlights danger of politicizing economic decisions

Tax cut pledges are not unusual in election campaigns and Australia is no exception. In his last budget before parliamentary elections are due to be held later this year, Treasurer Josh Frydenberg on April 2 promised personal income tax cuts totaling an eye-catching $158 billion Australian dollars ($112.1 billion).

But this won't come in the current year, or even in the four years covered by the budget plan. It would take a full 10 years for the promised reductions to be implemented -- a long time in both politics and the economy.

 Frydenberg is making a pledge that he is unlikely to be in a position to fully deliver, leaving it to his successors to either implement the tax relief, or leave millions of workers disappointed. It is a familiar problem, including in other countries in the Asia-Pacific region -- a short-term promise made for electoral reasons with long-term fiscal and economic consequences.

The costs and complications are amply illustrated by two earlier Australian tax decisions, which seemed like sensible ideas when they were introduced but which have left the country with a political and fiscal headache.

The first issue centers around dividend tax credits. Australia operates an integrated tax system with recipients receiving a tax credit, known as 'franking,' where dividends are paid out of profits already taxed at the corporate level. In 2001, these franking credits became fully refundable. Where the tax liability is lower than the credit received, shareholders receive a cash refund.

The system is much abused. Investors, especially retirees, structure their affairs to lower tax liability and invest heavily in dividend paying shares to receive the cash refund. Pension funds, taxed at a concessional 15% rate, half the corporate tax rate, adjust their exposure to shares providing dividend tax credits to minimize tax or enhance returns though refunds. Self-managed pension funds, used by higher income taxpayers, are significant beneficiaries of these strategies.

The opposition Australian Labor Party (ALP) proposes removing this concession, with an exemption for old age pension recipients, returning the system to its pre-2001 position. The potential tax savings are estimated at A$11.4 billion in 2018-19 and A$59 billion over the medium term.

The second issue involves housing. Under a practice termed negative gearing, individuals purchase property using high levels of debt, sometimes borrowing 100% of the purchase price. Rent after outgoings is typically less than the interest expense creating a loss which is used to reduce tax payable on other income. Capital profits from asset sales are taxed at 50% of the normal rate, providing the asset is owned for more than one year. Negative gearing and the capital gains discount together cost the budget over A$10 billion annually. The bulk of the lost revenue comes from the capital gains tax discount -- A$8.6 billion in 2018-19.

The ALP proposes to limit negative gearing to new housing and halve the capital gains discount from 50% to 25%. The changes would not be retroactive.

Opposing the proposals, the center-right, Liberal Party and National Party, government has become an unlikely defender of the disadvantaged, especially poorer retirees, who would lose from the loss of the cash refund of dividends.

The emergence of arcane tax matters as election issues highlights several problems.

First, the debate highlights the unintended consequence of complex modern tax legislation -- the Australian tax code runs to many thousands of pages. The dividend tax credit system avoids double taxation but has evolved into a tax planning tool. The ability to deduct investment funding expenses has become an unintentional tax minimization strategy.

Second, it illustrates the increasing use of financial engineering to drive prosperity. In an environment of low-wage growth, modest investment returns and stagnant living standards, ordinary savers seek to build wealth by exploiting tax concessions. This benefits the recipients of the subsidy at the cost of other members of society. By reducing the tax base, it decreases the country's ability to invest in infrastructure and provide social services. It disadvantages workers living on paychecks or lower income groups without equal access to these opportunities.

Third, tax arbitrage affects economic activity, distorting capital allocation. The dividend tax credit biases investment toward high dividend paying stocks. Corporations are rewarded for maintaining payouts even where business investment opportunities dictate otherwise. Companies avoid investments, such as ones outside Australia, which would reduce the ability to provide the sought-after tax credit.

Negative gearing and capital gains tax concessions favor property investments, rather than more productive and wealth creating enterprises. The concessions have not alleviated Australia's housing shortage because much of the investment is directed into existing properties.

Fourth, the debate reveals an insoluble public finance issue, where electors are unwilling to pay taxes sufficient to finance the services and benefits, they demand. Limiting the tax credit concession to pensioners will disadvantage some retirees with modest resources but no policy can be totally non-discriminatory and cater to everybody's situation perfectly.

Finally, changes in policy, which take away any benefit, are politically difficult. Affected groups can mobilize support from the other political side. Irrespective of the economics, political parties will use tax proposals for electoral advantage. In the Australian election, these issues have emerged as a wedge issue, something politically divisive and differential in its impact on specific population groups. Fear campaigns, frequently laced with misinformation, which target voters lacking the ability to analyze complex issues, prevent sensible debate.

Australian tax debates are instructive. Most major policy changes were often introduced by the government of the day by stealth. Australia's goods and services tax (GST) was introduced after decades of dithering. In the 1980s, Paul Keating, then Treasurer, sought to implement the GST but was overruled by Prime Minister Robert Hawke. In the early 1990s, Keating opposed the GST which he had championed, winning an election against opposition leader John Hewson, who campaigned to introduce the tax, and famously struggled to explain its effects on the price of a birthday cake. Finally, in 1999, Prime Minister John Howard introduced the tax after stating earlier that the issue was dead, and his government would not pursue a GST.

The debate illustrates deep-seated problems of decision making. Tax cut promises are easy to make, especially at election time. But changes that hit voters in the pocket are only possible under crisis conditions. Politicians require suicidal electoral courage which few possess. Change by diktat also endangers political legitimacy and social cohesion, creating resentment at the lack of participative decision making.

One solution might be to depoliticize certain decisions by delegating them to technical experts. But specialists, and politicians, may not agree on the parameters. The approach would undermine representative government. However, if such ideas are ruled out, we are perhaps doomed to the sort of fiscal politics that Australia is now seeing.

Satyajit Das is a former banker. His latest book is 'A Banquet of Consequences' (published in North America as The Age of Stagnation). He is also the author of Extreme Money and Traders, Guns & Money.

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