Economist Saul Eslake describes Australia's personal tax system as being "like a giant Swiss cheese".
In his words, it is a system "riddled with holes" that allow people to pay less tax on "particular types of income, earned in particular ways". These holes, he notes, are "disproportionately" used by higher income earners.
Are tax deductions on the way out?
Deputy BusinessDay Editor Nassim Khadem explains the proposed changes to taxation that would have Australians no longer claiming deductions.
An attempt to plug these holes is now underway.
Labor will go to the next election with a policy to limit negative gearing to new homes from July 1, 2017, and halve from 50 per cent to 25 per cent the capital gains tax deduction on investment assets including shares.
Treasurer Scott Morrison has asked his department to look into a universal cap on income tax deductions that would apply to work-related expenses, as well as the now-not-so-sacred-cow tax breaks including negative gearing, capital gains tax and superannuation concessions.
The money saved by reducing the ability of millions of taxpayers to offset billions of dollars of deductions against their taxable income could be used to fund personal tax cuts.
This is the very issue a parliamentary inquiry into tax deductibility – which is being led by government MP Craig Laundy – is currently considering.
The theory is that forgoing complex deductions in return for tax cuts will make for a more "simple" and more "fair" tax system.
But the task of convincing Australians that it's not their birth-right to claim work-related expenses or expenses incurred in investments on property against their taxable income is unlikely to be simple – and as they head to the ballot box at some point this year, not everyone will be convinced it is fair.
Aussies' most-loved deductions
'Not everyone has the luxury of having the employer subsidising and providing all the tools for their work,' says CPA Australia's Paul Drum. Photo: Josh Robenstone
Taxpayers have been able to claim deductions against their income for more than 100 years.
It became a feature of Australia's tax laws in 1915 when the first income tax assessment act was enacted.
There is no compelling public policy rationale for any kind of preferential tax treatment.Economist, Saul Eslake
Today, more than 80 per cent of Australia's 12.8 million taxpayers claim deductions when they lodge their tax returns.
In 2012-13, total deductions of $31.3 billion were claimed by personal taxpayers against $704 billion in taxable income, with an average amount claimed of $3025.
The biggest deductions – totalling $19.7 billion – were for work-related expenses. Nine million people claimed an average of $1545 in work-related deductions such as car expenses, office costs, work-related travel and self-education expenses (see graphic).
Next on the list of most-claimed deductions by Aussies were personal superannuation contributions of $2.9 billion, followed by the cost of managing tax affairs and charitable gifts/donations, each comprising about $2.3 billion.
Thanks to record low interest rates, the value of negative gearing tax deductions claimed by nearly 1.3 million landlords fell in 2012-13 to $12 billion (down from $13.8 billion the year before). The average claim per person was still high at almost $6000.
The issue isn't that the deductions exist, but rather that it gives greater benefit to those on higher incomes (taxpayers earning more than $180,000) and opens up the door for tax avoidance.
"Some individuals may attempt to push the boundaries by increasing the value of their deductions," Treasury notes in its submission to the parliamentary inquiry.
Adjunct Professor with the UNSW School of Business, Richard Highfield has been scrutinising Australia's tax system for years. He was previously a senior advisor with the OECD's Centre for Tax Policy and Administration and an Australian Taxation Office second commissioner.
Highfield is convinced that Australia's rules surrounding the deductibility of work-related expenses are too liberal.
He says there is a high incidence of people over-claiming deductions. "Work-related deductions are probably over-claimed, in aggregate, by around 15 per cent," he told the inquiry.
For 2014-15 tax returns, this would represent about $3.5 billion of over-claimed deductions, and about $700 million to $800 million of lost tax revenue.
He points out that more than 3 million wage earners make work-related expense claims for motor vehicle expenses amounting to more than $8 billion, despite the fact that travel expenses to and from an employees' workplace are generally deemed private for tax purposes and are therefore non-deductible.
"While many employees can justifiably point to the legitimate use of their motor vehicles for work purposes, it is extremely difficult to comprehend how this population could extend to anywhere near 30 per cent of employee taxpayers," Highfield says.
There are also equity issues. Parliamentary Budget Office analysis of tax office data found more men than women claim work-related deductions. KPMG tax partner Grant Wardell-Johnson says partly that's due to income inequality. But the other factor may be that "males are more likely to be aggressive in claiming deductions than women are."
Pushing the envelope
Australian Council Of Social Service senior adviser Peter Davidson believes Australians do 'push the envelope' when it comes to tax deductions. Photo: Louise Kennerley
Of course when people overstep the boundaries, the tax man can challenge them.
The Australian Taxation Office recently caught one taxpayer trying to claim more than $5000 in "secretarial services" provided by his 7-year-old son.
Gary Ogden, an IBM salesman, had also claimed $2250 worth of groceries for "business partners" who rarely visited, including 39 packets of Monte Carlos, several packets of Bega Stringers cheese and 1.5 litre bottles of Lipton Iced Tea.
But there are more subtle examples of people overstepping the line, and those are harder for the ATO to detect.
The agency is currently doing detailed work on the cash economy, aiming for a better insight into where people are overstepping the mark.
ATO Deputy Commissioner, Individuals, Alison Lendon says that while the agency's analysis of risks gets "better and more intelligent", the ATO does not have limitless resources.
She suggests that one way to simplify Australia's tax system is through more pre-filling of tax return forms by the ATO – for example, of income from investments – so that people just need to tick off the information and submit it. That would require giving the agency greater access to third-party data.
Australian Council Of Social Service senior adviser Peter Davidson believes Australians – especially those who can afford hot-shot tax advisers – do "push the envelope" when it comes to tax deductions.
Davidson says the fact that people with a rental property investment can claim deductions at their current marginal rate now, when the income stream is off in the future, and taxed at half the rate (due to capital gains tax concessions) leaves "a disconnect between deduction and income."
He says while setting limits on deductions may produce consequences that will need to be considered, "the status quo is inequitable; it allows rent seeking".
"The people who are actually accruing costs in earning their income are not necessarily being rewarded in proportion to those costs," he says.
Caps or stricter definitions?
Treasury's Rob Heferen told the inquiry Britain poses 'an interesting counterbalance' to the New Zealand model. Photo: Supplied
If Australia is to tighten up who can and can't claim deductions, there are several countries it can look to that already have.
New Zealand is the most extreme case. It does not allow any work-related expense deductions for employees. It scrapped them in the late 1980s, to broaden the tax base and to fund a reduction in personal tax rates.
It is unlikely Australian policymakers would go down this path. But there is appetite to make the process simpler by moving to a "standard deduction", as recommended by the Henry review, and bringing in caps and/or thresholds on how much can be claimed.
Treasury's Rob Heferen told the inquiry Britain poses "an interesting counterbalance" to the NZ model.
In Britain, claimable expenses must satisfy a stringent test of being incurred "wholly, exclusively and necessarily in the performance of an employee's duties". And under a new budget measure, landlords in the UK will soon only be able to deduct interest expenses from rental income up to 20 per cent, which is the lowest marginal rate of personal income tax in Britain.
The Australian government's tax discussion paper suggests that "given the high proportion of taxpayers who incur a relatively low total value of legitimate work-related expenses, a 'standard deduction' could provide significant compliance savings".
It suggests that rather than substantiating work-related expense claims with receipts, these taxpayers could instead choose to 'tick a box' to claim a standard deduction at a set amount, for example $500. Of course this, according to the discussion paper, would come at significant cost. "People who do not currently have any work-related deductions could reduce their taxable income by the value of the standard deductions."
As Kevin Rudd discovered with Labor's ill-fated plan for a $500 standard deduction (the proposal was that taxpayers could claim the standard deduction or alternatively they could retain the current system of claiming a full deduction with evidence the costs were legitimate) there would have been a loss of revenue.
"Those claiming less than $500 [would claim] the full standard deduction, in effect giving themselves a free tax cut," HR & Block's Mark Chapman says.
If the Turnbull government now wants to abolish work-related deductions it will need to be combined with other reforms, to compensate for the loss. Chapman says tax cuts alone may not suffice. It may have to look at a "significant cut in the rates of income tax, a substantial increase in the tax-free threshold, an uplift in the various tax brackets or a combination of all of those", he says, to ensure people are not worse off.
He says the better option may be to rewrite the laws for travel, meals and motor vehicle usage, replacing it with one set of rules that require proof.
The Institute of Public Accountants manager of technical policy, Tony Greco, is also against imposing a cap on deductions.
"You should always have the opportunity, under our tax system, to claim legitimate expenses," Greco told the parliamentary inquiry.
"There should be no caps on that, so long as you prove the nexus required. Maybe there could be an exercise of strengthening that nexus to reduce the scope, because the scope seems to be getting wider and wider and you have to ask yourself how wide you want it to be and how complex you want that nexus to be."
But Chartered Accountants Australia and New Zealand believes deductions should go so tax cuts can be delivered. Its tax consultant Matthew Hayes says: "There are no good or bad expenses. For each expense, whether it be child care or self-education, you can justify those deductions; that is not the point. Simplicity wins out."
Treasurer Scott Morrison says there's scope to cut personal tax rates, but has not decided what deductions should go to fund it. Photo: Andrew Meares
Aside from financial consequences, there are also behavioural impacts of a drastic change to the tax system.
"You are dealing with potentially eight or nine million taxpayers and they will vote with behavioural changes," Greco says. "If you are looking at savings, you have to be careful of the shift of some of the expenses to employers."
Parliamentary Budget Office's first assistant parliamentary budget officer, Colin Brown, told the inquiry that predicting the impact on peoples' behaviour was virtually impossible. "That is an area of great uncertainty," he said.
Shifting the cost from the employee to the employer, he says, may mean that the revenue gain is, in fact, fully negated, he says.
Treasury's submission warns that changing the rules for work-related deductions could "provide a greater incentive, where possible, for employees to re-characterise themselves as contractors".
It also cautions that any changes to the arrangements for deductions will need co-ordination with the fringe benefits tax (FBT) regime, which allows certain benefits to be provided from employers to employees.
CPA Australia's Paul Drum says far from creating a simpler system, a standard deduction could increase illegitimate claims, while hurting small business people who genuinely need to spend on equipment for their businesses and who rely on claiming the expenses back.
It creates a situation, he says, where someone who does not have any work-related expenses gets "a free kick" (and a lower overall income tax rate) while the self-employed who require tools in the office or out on the job, get penalised through limits on what deductions they can claim to run their businesses.
"Not everyone has the luxury of having the employer subsidising and providing all the tools for their work," Drum says. "Implementing a standard deduction regime to replace work-related expense claims would be a one-size-fits-all approach that would raise equity concerns."
The Australian Chamber of Commerce and Industry's senior manager, economics and industry policy, Tim Hicks, says any substantial change to deductions will be premature without evidence to suggest that a significant proportion of such deductions are being claimed inappropriately.
There is also a risk that employers will be forced to fill the funding gap left by the removal of deductions, he says. "This may be particularly problematic for small businesses that have less negotiating power."
Tax breaks for the rich
Illustration: Simon Bosch
Other submissions to the inquiry from groups including ACOSS and the Grattan Institute call for the government to scrap or at least restrict tax breaks benefiting those on higher incomes, including superannuation concessions, negative gearing and capital gains tax discounts.
The inquiry has also been asked to examine whether there's scope to cut company tax by going after billions of dollars of deductions claimed by big companies for various business investments. But it's facing much the same challenge as the former Labor treasurer Wayne Swan's Business Tax Working Group faced.
There's fierce opposition with vested interest groups each protecting their own turf. Even Treasury has warned that any changes need to be "carefully considered" given Australia is a net importer of capital. That view was repeated by various business lobby groups giving evidence to the inquiry this month, meaning the committee is unlikely to recommended any change on the business side.
But there could be tweaks on the personal income tax side, where most of the debate is focussed.
Grattan Institute chief executive John Daley says while the ability to deduct expenses incurred in generating income is part of the normal operation of the Australian tax system that stimulates investment, "there is no theoretical basis for allowing losses on investment to be deducted against entirely unrelated income such as wages".
"This is a popular tax minimisation strategy that ultimately comes at a cost to the budget bottom line, Daley says.
He says tax deductions from wage income may also generate "psychic payoff" for some investors – "the pleasure of denying the Tax Office its due".
Despite the claims from the Property Council that lower paid workers – such as nurses, teachers and clerical staff – are the primary beneficiaries of negative gearing, Grattan's analysis of ATO data suggests that a greater proportion of workers in high-wage occupations – doctors and lawyers – negatively gear properties.
Economist Saul Eslake, who has long argued that the government scrap negative gearing, also argues it is effectively a subsidy from people who are working and saving to people who are borrowing and speculating. He thinks Labor's plan to restrict it to new homes is more politically courageous than any he's seen to date, but that "as matter of principle I don't like 'grandfathering' because it amounts to privileging people on the basis of birth order".
But he warns that foreshadowing a future date at which negative gearing will cease will risk triggering a surge of investment prior to that date, July 1, 2017 – "and you can bet that's what property investment spruikers, real estate agents and maybe even some mortgage lenders will do if Labor actually wins the election".
He notes, however, that Labor has at least made an attempt to tackle an inequitable system that allows taxpayers in the top personal income tax bracket to earn much higher income in tax-privileged forms than taxpayers in lower tax brackets.
"There is no compelling public policy rationale for any kind of preferential tax treatment", Eslake says.
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