Time for the states to have income tax?


Stephen King


July 1st, 2014

Professor Stephen King explains why state income taxes is an idea whose ‘time has come’.

Taxation is something all economists know about. As undergraduates, we learn about the costs created by taxation when it distorts incentives. In first year the cost is represented by a deadweight loss triangle. In later years we learn more about the costs of taxation. We see how taxation can have macroeconomic effects by distorting the mix of consumption and savings; how businesses can restructure to avoid tax through loopholes such as transfer pricing (think Google and Ireland); and how some taxes are worse than others.

Given we know so much about taxes, why is Australia’s taxation system so bad?

The 2009 Henry tax review (formally “Australia’s future tax system: Report to the Treasurer, December 2009) recommended that Australia concentrate on four “robust and efficient tax bases”: personal income, business income, private consumption, and economic rents (e.g. from natural resources and land).

It also noted that Australia has a range of high-distortion taxes that should be removed including payroll tax and stamp duties. The cost of these taxes can be large. For example, the Review estimates that the marginal efficiency cost of state payroll tax is about 40 cents per additional dollar raised.

The Henry review is not alone in noting the problems of our taxation system. But if the problems are well known, why don’t we solve them?

In part the problems reflect the design of the particular taxes. Many taxes have exemptions that reflect political expediency and lobbying power rather than good economics.

For example, according to the Australian Taxation Office (ATO) website, the Goods and Services Tax (GST) exempts “most basic foods, some education courses, … some childcare, [and] some religious services and charitable activities”. It provides the example of ‘Lou’ who sells “bread and bread rolls without icing or filling” GST free (with filling he would have to pay GST). He also sells GST free “fruit juice containing at least 90% by volume of juice and bottled water”. But he does not sell “soft drinks and flavoured milk” that do incur GST.

Exemptions create three problems. First they raise the cost of complying with the tax. ‘Lou’ provides a good example of the complexity faced by a small business.

Second, they provide opportunities for parties to distort behaviour to avoid the tax. If a business that supplies a taxed good or service can reorganise its structure to avoid the GST then it will be tempted to do so. It will weigh up the cost of reorganisation with the benefit in saved tax. A business will be willing to spend up to 99 cents to save one dollar in tax. But the dollar tax is a transfer to the government. The 99 cents is a real resource cost to our economy. So when a business spends 99 cents to avoid one dollar of tax, Australia loses 99 cents.

Third, exemptions create vested interests and open the door to rent seekers. Vested interests include those who get benefits from the current exemptions, and the advisors who are paid large sums to find tax loopholes. Vested interests will spend resources to maintain the existing taxation system. In contrast, rent seekers gain from taxation changes. If a business can get its tax removed while its competitive rivals remain taxed, then its profits will rise. Rent seekers spend resources lobbying to change the tax system in a way that benefits their own interests.

The resources used by both vested interests and rent seekers in lobbying are social losses.

Another key problem with the design of the Australian tax system is the federal-state separation. The federal government controls income taxation. It also operates the GST on behalf of the states. GST revenue is passed back to the states albeit not on a dollar-for-dollar basis. Some states receive more than their residents pay, while others receive less.

The states are left with a relatively small base for tax collections such as land tax, stamp duties (for example on the sale of a property), payroll tax, and taxes on gambling. These are a mixed bag. A broad based land tax can be efficient, but in practice, states do not apply the tax to the ‘family home’. So there is a simple (and distortionary) exemption. Don’t buy a second property, upgrade the family home and avoid the tax.

Stamp duties can be highly inefficient. They apply to one-off transactions like property sales. Want to avoid the tax? Then don’t transact! Put up with your present house rather than moving to a preferred property.

To improve the efficiency of the Australian taxation system we need to move the states from narrow-based taxes to broad-based taxes. The GST appears to be an obvious starting point. And, indeed, the quid pro quo for the federal government collecting the GST on behalf of the states was that the states would eliminate a range of the most inefficient taxes. Some inefficient state taxes were removed, but by no means all of them.

To replace inefficient state taxes with GST revenues means raising the GST. But this can only be done with the agreement of all the states. This makes the GST inflexible. It is possible that the states would agree to raise the GST, but this means shoe-horning all states into a one-size-fits-all taxation solution.

A simple, flexible alternative is to allow the states to raise income tax revenue.

This is simple because it would be administered through the existing income tax system. When businesses and individuals pay their federal income tax each year they would also be required to pay their state income tax. It could be administered through the ATO with relevant revenue passed back to the states.

It would also be easy for states to set different income tax rates. States that need more income would be able to set higher income taxation rates than ‘leaner’ states.

Of course, differential rates can lead to tax avoidance. Want to pay lower taxes? Then move to a low tax state.

But doing this also means losing the benefits of the government spending funded by the tax. If state governments waste their income tax revenue or spend it badly then they will face an avoidance problem as businesses and families move interstate over time. But if a state government spends the tax revenue on things the community values such as high quality schooling, excellent hospitals, improved public transport and the like, then they are likely to face an influx, not an exodus. In this sense, a state income tax allows interstate competition where the winners are not the low tax states but the states with the best mix of tax and services.

The National Commission of Audit (2014) recently supported a move to state income taxes (see recommendation 8). As state governments find it harder to ‘make ends meet’ on their restricted tax base, a move to state income tax could both reduce the economic costs of taxation and establish real interstate competition in service delivery. Put simply, it is an idea whose ‘time has come’.



The Henry tax review is available at:

The Report of the National Commission of Audit is available at:

For other articles by Stephen (and other economists) see the CoRE Economics Blog at and Stephen’s column at the Conversation,

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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