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Trusts tax will cause economic damage in the name of equality

August 10, 2017

Trusts tax will cause economic damage in the name of equality

Judith Sloan, The Australian, 5 August 2017

First it was fairness, now it’s inequality. Bill Shorten and his Labor colleagues clearly reckon they have stumbled on a winning organising theme to regain office at the next federal election. That so many of their proposed policies are an effective repudiation of the Hawke-Keating legacy doesn’t seem to worry them at all.

Recall that this legacy placed primary importance on growing the economic pie by unshackling the economy of its efficiency-sapping rules and regulations. Think: floating the dollar, removing capital controls, deregulating the financial system, reducing tariffs and other forms of import protection, selling government-owned businesses, retreating from centralised wage fixing and compulsory arbitration, modernising the tax system, and the list goes on.
It’s unimaginable that a Labor government led by Shorten would even contemplate these sorts of reforms, which involved the transformation of the economy to become open, competitive and vibrant. To be sure, there were winners and losers in the process, but the productivity gains were large for the Labor government to sell the program of change.

Australia went from a position of having average per capita income levels that placed us around 20th among developed economies to being in the top five. This was a truly remarkable outcome and the benefits of that suite of policy reforms are still felt today.

The contrast with the policy approach being adopted by the present Labor opposition could not be starker. Rather than prioritise policies that will promote higher rates of economic growth, an obsession has developed in which the main objective is to fleece higher and middle-income earners even more because it is deemed to be fair and will lead to lower inequality.

Of course, opposition Treasury spokesman Chris Bowen should know better. After all, the empirical evidence is clear: the best way to reduce inequality is to ensure that people get jobs. Imposing bigger tax burdens on higher-income earners and businesses inevitably leads to less investment, less risk-taking, reduced work effort and ultimately fewer jobs in total.

Let’s take a look at yet another lurch to the left by Labor: the decision to impose a minimum tax of 30 per cent on trusts. Note that farm, charitable, disability and philanthropic trusts will be exempt. According to confidential costings by the Parliamentary Budget Office, this move will lead to additional revenue of $1 billion a year, which is complete chicken feed given income tax alone will raise more than $185bn this financial year. So why would Labor make this change if the payback is so low and the damage to small business owners, many of whom use trusts to structure their financial affairs, could be substantial?

Let’s be clear on one thing: the change being proposed will not affect the really wealthy. Where the individual trust distributions exceed $137,000 a year, Labor’s policy has no effect. For those trusts with such high distributions, their underlying structures generally will be much more complicated than a mere discretionary trust. They will often involve trustee companies, bucket companies, partnerships and other complicated means of structuring business and family financial affairs.

And while tax minimisation may be one objective of these arrangements, asset protection and estate planning are often more important considerations.
For many modest small businesses, Labor’s trust policy could be punitive indeed. Instead of paying average tax rates of well under 20 per cent, all of sudden trust beneficiaries, many of whom may work directly in the business or contribute indirectly, will be hit with a tax rate of 30 per cent.

In all likelihood, many small business trusts will be terminated and other means of arranging financial affairs will be considered. We should not forget that the PBO costings, modest though they are, will not have taken into account the potential for behavioural changes. Rather than saving a Labor government $1bn a year, in practice, the policy may even deplete revenue.

It is interesting to note here that the comprehensive tax review commissioned by the Rudd Labor government and undertaken by former Treasury secretary Ken Henry did not recommend any change to the taxation of trusts. Henry simply noted that “trusts can be used as an alternative structure for conducting business activities. Trusts are largely taxed on a flow-through basis, with the income of a trust allocated to its beneficiaries based on their ‘present entitlements’. However, losses do not flow through to beneficiaries.”

His only recommendation was the trust rules be updated and rewritten to reduce complexity and uncertainty around their application, particularly in relation to capital gains derived through trusts. Indeed, if there were one dominant theme of the Henry tax review it was that the tax system must be assessed as a whole in terms of efficiency, equity and simplicity. It makes no sense to tweak individual parts without understanding what this does to other parts of the tax system. This is one of many criticisms of Labor’s hotch-potch tax policy package.

Didn’t the Liberal Party also contemplate taxing trusts as companies, commissioning John Ralph to undertake a comprehensive review of business taxation? The key theme of the Ralph review was, in fact, to align the company tax rate with the top marginal income tax rate.

At this stage, the company tax rate is 30 per cent for large companies and 27.5 per cent for smaller ones. These rates compare with a top marginal income tax rate of 45 per cent plus a two percentage point Medicare levy. Under Labor, this rate will go to 49.5 per cent — an extra two percentage points on the marginal income tax rate and an increase of 0.5 percentage points in the Medicare levy.
It is the gap between the company tax rate and top marginal tax rate that drives a lot of the tax minimisation and arbitrage that occurs. And this will get worse under Labor, not better.

Indeed, the chief weakness in our tax system is the design of the income tax schedule and the disincentives it creates for investment, work effort, risk-taking and entrepreneurship. Not only is the top marginal tax rate far too high, it also cuts in at too low a level — $180,000 a year, a figure that has been unchanged for many years. In addition, the tax-free threshold is too high, leading to a steeply rising set of marginal tax rates. Compare this with New Zealand, with a top marginal tax rate of 30 per cent and a company tax rate of 28 per cent, and you can appreciate how out of alignment is our tax system.

It is hardly surprisingly in Australia that there has been a dramatic increase in the number of trusts and other legal entities that seek to deal with the gap between our top marginal income tax rate and the company tax rate.

But what Labor’s policy on the taxation of trusts will do is to hurt honest small business owners that distribute relatively modest sums to beneficiaries while not laying a glove on the very wealthy.

The best outcome will be for Labor to reconsider some of these ill-advised tax policy initiatives — applying the higher Medicare levy only to those earning more than $87,000 a year will lead to the mother of all effective marginal tax rates and there is a major loophole in Labor’s negative gearing policy — lest serious economic damage is done in the name of pretending to reduce inequality.