Thursday, September 12, 2013

Why the Henry Review wanted to scrap the GST

Ken Henry ponders our tax and transfer future.

While barrels of ink have been spilt analysing and reporting on the Henry Review, there remains one key undiscovered gem - its conclusion that the GST should be scrapped.

At face value the Henry Review should have very little to say about the GST. The terms of reference explicitly excluded it from the review stating that “The review will reflect the government's policy not to increase the rate or broaden the base of the goods and services tax (GST).” But if you read between the lines, the review actually says a lot about the GST – namely that it should be abolished and replaced with something entirely new:  a business cash flow tax.

This is, it’s fair to say, a somewhat unorthodox view.  The consensus amongst economists is that the GST should, if anything, be expanded, not scrapped. But I think there is quite a bit of evidence that that the Henry Review was not a fan of the GST and wanted to substitute it with something else:

  • First, the only mention of the GST in the review covers how costly, complex and burdensome it is – especially for small businesses stating that “a large number of very small businesses bear the compliance costs of the GST while contributing very little to overall revenue collection”.
  • It then proposes the introduction of a cash flow tax as alternative method of taxing consumption, with recommendation 55 stating that “Over time, a broad-based cash flow tax could be used to finance the abolition of other taxes...” The two diagrams from the Henry Review below compare the cash flow tax with the GST (note the similarities!) – I suspect the Henry Review wanted to introduce the cash flow tax to replace the GST.

  • GST

    Cash Flow Tax

    •  Finally, what I think is the most telling piece of evidence, Heather Ridout a member of review spelt out their intentions on an episode of ‘Q and A’ late last year (which coincidentally I was in the audience for!):

      “ of the conclusions [of the Henry Review] was [that] the GST is a very old fashioned tax. You issue millions and millions of invoices and you collect tax off a few of them and there was a recommendation there called a business cash flow tax, which actually is a more modern version and that, I suspect, will get more attention in the years ahead.”

      I think this is pretty clear cut. The Henry Review considered the GST to be an inefficient tax and wanted to replace it with a cash flow tax – but couldn’t because of the strict terms of reference with respect to the GST (essentially “No Touching!”).
    So what is a cash flow tax? A cash flow tax, similar to the GST, is a broad based consumption tax. But instead of taxing businesses individual sales and expenses (the "millions of invoices" Ridout referred to) , it only taxes the aggregate ‘cash flow’: the total sum of incoming money (from sales) minus outgoing costs (wages, inputs etc).1

    Thus the main difference between the cash flow tax and the GST is in the way the two taxes are collected and implemented. The GST relies on a complex system on invoices whereby every business needs to report every single purchase it makes as a business expense and in turn provide receipts for their own customers. A cash flow tax in comparison only needs to measure the cash flow of each business which is much simpler to measure. The current GST system (where by every firm needs to collect every receipt and issue invoices) is quite burdensome - especially for small businesses. For example, under the GST a local butcher needs to submit invoices for all of the inputs it uses (meat, knives, utilities, fridges, packaging etc). With the cash flow tax it would only need to report the total cost – a single number.

    So the differences aren’t massive: the cash flow tax is essentially easier to implement and is somewhat more efficient method of taxing consumption.

    A more interesting question is the direction future of reform. The Coalition (and now government of Australia) has promised not to increase or broaden the GST – while at the same including the GST as a part of their post-election review of the tax system. One way to square this circle, would be to crib off the Henry Review and take the next step in abolishing the GST and replacing it with a more efficient tax. This would, economically speaking, have the same impact as broadening the GST. However it would allow the Coalition to reform the way we tax consumption, whilst keeping their election promises in letter if not in spirit.

    Will this happen? Who knows. It would undoubtedly require some political courage from a party that has taken the populist position on virtually every issue so far, and I suspect Abbott has little ideological love for efficiency in the tax system. But as Ian Harper mentioned at the Economics Q and A earlier this week good policy, not matter how unlikely it seems, eventually gets its time in the sun. Perhaps the time has come for the business cash flow tax.

    1 There are several other nice features of the cash flow tax, notably the way it treats investment and depreciation, and more interestingly how it features as a part of a progressive consumption tax – but that discussion is for a post another day. 


    1. This is a surprise. Henry was told to keep his paws of GST but he could not help himself. This is an important blog because it gives the political classes a way to reform the GST in a way that will seem nicer. Who'd have thought it?

    2. One problem I could see with a cash flow tax is how to quarantine food, or anything else that the government deems necessary to remain free from tax.

      1. Yes but i think most economists and the ATO would see that as a feature, not a bug. It wouldn't be possible for a grocer selling GST exempt and GST applicable foods to distinguish relevant items, so all food would have to be taxed.

        (I don't have a problem with this)

      2. Exactly, without duplicating the complexity of the GST the cash flow tax would cover all consumption. In order to offset its regressive effects you would probably ramp up the more progressive parts of the tax and transfer system.

    3. Does the cash flow system operate anywhere in the world? Did the Henry Review mention this?

      1. As far as I know it hasn't been implemented, but the Henry Review references several proposals and commissions that have outlined the tax in the US.

    4. I think you are overstating the difference between a broad based GST and a cash flow tax. Surely, businesses would still be required to keep records of transactions for a cash flow tax. The paper work burden would be reduced by having to differentiate between taxable and tax exempt items.

      I thought referring to a cash flow tax in the review report was just a clever way of advocating for broadening the GST base with out breaching the terms of reference.

      1. The idea behind the cash flow tax, is that *all* consumption is taxed. There are no tax exempt items, so you don't need to track them.

        I suspect you're right, the cash flow tax was a bit of a back door for advocating GST reform (namely broadening the base).