I. Taxes and Inflation Control
6.7. The causes of inflation are complex and incompletely understood. But broadly two schools of thought can be distinguished, commonly labelled demand-pull and cost-push.
6.8. The former school looks to the behaviour of individuals and groups in the face of excess demand for goods and services
over available supply, a rapid expansion in the volume of money, and expectations of changes in prices and earnings. It is
recognised too that inflation may stem in part from international factors, and a number of channels by which rising prices
may be transmitted from country to country have come to be identified: for example, by overseas demand raising exporters’
incomes or a balance of payments surplus causing the domestic money supply to expand. In general, the emergence of excess
demand is considered to be the prime initiating factor, though inflation may continue after excess demand has been
eliminated and perhaps even been replaced by a short-fall in demand accompanied by unemployment—what has come to be known
as stagflation. Inflation persists because the pursuit of income claims in response to price increases that have already
occurred establishes a wage-price spiral which is liable to continue as long as monetary conditions permit, reinforced in
some measure no doubt by wage-fixing practices inside and outside the arbitration system. The spiral tends to be
accompanied by greater strike activity as wage earners exploit their market power to press their income claims.
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To control inflation, according to the demand-pull school, the various sections of the community must be induced to
alter their behaviour, which can be done by manipulating such conventional economic variables as the money supply,
interest rates, the exchange rate, taxes and government spending.
6.9. The second school would acknowledge that the economic factors referred to in the last paragraph may at times be important, but argues that the underlying cause of inflation is more deep-seated and relates to a basic social struggle over the distribution of national income. Unions, firms and other groups use their economic and political power to try to protect or improve their share of national income, inflation of the cost-push variety being the means by which conflicting income claims find expression. The process is self-sustaining because governments have a strong political commitment to full employment and are therefore prepared to let the money supply expand to accommodate the income claims. This school also accepts that, to control inflation, behaviour must be changed, but the emphasis is less on manipulating conventional economic variables as on fundamental institutional and social reorganisation.
6.10. The explanations of both schools are undoubtedly important for an understanding of the inflationary process and it is misleading to polarise them. The first school points to the tendency for expenditure plans to exceed the capacity of the economy to satisfy them and sees rising prices as the inevitable consequence. The second school focuses on the conflict about income shares and sees rising money incomes as the manifestation of this struggle.
6.11. This latter view may help account for the long-term upward movement in the price level in the post-war period, but a more immediate explanation for the upsurge of inflation in Australia since 1970, and particularly after 1972, would seem to lie in the excessive growth in money supply, the pressure of demand on available resources and the build up of inflationary expectations. These tendencies can be traced to both international and domestic sources. The rapid growth of international reserves contributed in no small degree to the 26 per cent increase in money supply during 1972–73, while the steep rise in world commodity prices has obviously had a signficant influence on the growth of Australian prices and incomes. On the domestic front the easy monetary conditions of 1972–73 and early 1973–74 added to the growth of money supply and strengthened the demand for factors of production and final commodities. Budgetary policy was strongly expansionary throughout 1972–73 and only very slightly less so during 1973–74. Under these circumstances expectations of continuing and accelerating inflation led employers and employees to use their market power to maintain or increase their share of national income. The severest wage-price spiral since the wool-boom days of the early 1950s was thereby established.
6.12. It is fairly apparent that a reduction in the rate of inflation is only possible if individuals and groups in society can be induced to modify their behaviour. This is as much a political and social problem as an economic one, requiring common agreement about the extent to which the policy objectives of full employment, appropriate use of resources and a fair distribution of national income should be compromised for the sake of greater price stability. Conflicts inevitably arise in establishing satisfactory compromises, but until they are resolved an underlying inflationary trend seems unavoidable. Moreover, even if consensus about policy objectives can be achieved, there is still likely to be dispute over the means of ensuring that behaviour is consistent with the objectives chosen.
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6.13. Tax increases have traditionally been viewed as one of a number of policies for inclusion in a program to combat inflation. Increases in personal income tax reduced disposable incomes, thereby easing the pressure on resources caused by excessive spending in the private sector. Increases in indirect taxes tend to be shifted forward in varying degrees, producing once-and-for-all increases in the price level; but higher prices involve a cut in real spending power and in this sense such taxes are demand-reducing and therefore, in the absence of corresponding wage increases, anti-inflationary. It is conventionally assumed, when tax increases are to be used in a program to combat inflation, that any additional tax revenue is not in fact spent by the government.
6.14. Recent trends of events have called these views into question. It may be unduly optimistic to assume that government spending will be kept in check as taxes increase. Given the political commitment to full employment and pressures on governments to fulfil electoral promises, increases in tax revenue may have the effect, at least indirectly, of boosting government spending with the result that community spending is not in fact reduced. Such commitments and promises, morever, make it unlikely that tight monetary policies will be pursued for any length of time. In these circumstances the conventional assumptions may no longer be appropriate: there now seems to be a distinct possibility that personal income tax will in some degree be shifted too, and once-and-for-all price increases associated with tax shifting in general will become cumulative.
6.15. For a number of reasons personal income tax may be a somewhat weaker anti-inflationary device than used to be thought. To the extent that employees, in formulating their wage claims, anticipate the extra income tax that higher wages will attract, personal income tax may contribute in fairly direct fashion to the wage-price spiral. For if attempts to shift the tax through correspondingly higher wage claims prove successful and employers seek to recover their higher expenses by passing on additional labour costs (including those unavoidable costs accompanying a larger wages bill, such as payroll tax, workers’ compensation insurance premiums, and holiday and long-service leave costs), then commodity prices must rise as long as the money supply is allowed to expand. Workers, in deciding their wage demands, appear increasingly to be recognising the fact that personal income tax not only bites heavily into additional income but, because of the graduated rate schedule, does so with mounting severity the greater the additional income. It is understandable, in these circumstances, that employees should set their wage claims as high as possible, knowing as they do that the real value of their extra pay is going to be eroded not only by the rising prices but also by heavier taxation. Paradoxically, though, the more successful the work force as a whole in securing large wage increases, the more is the real value of extra pay liable to be eaten into by higher marginal tax rates.
6.16. The point is illustrated in Table 6.A. A 25 per cent increase in 1974–75 in the income of the average earner (row 1), if accompanied by similar increases throughout the work force and by a 2.5 per cent growth in national productivity, will mean a rise in consumer prices of the order of 22 per cent. The increase in pre-tax real income will thus be modest (row 2), being confined to growth in productivity. However, because of the considerable expansion in money income, tax payable will rise sharply in the context of an unadjusted rate schedule (rows 3 and 6). Were the 1973–74 schedule still functioning, the real value of the average earner's take-home pay would actually decline (row 5); indeed, had the 1974–75 schedule applied in both years, the decline would be somewhat greater (row 8).
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| 1973–74 | 1974–75 | Change 1973–74 to 1974–75 | ||
| $ | $ | Per cent | ||
| 1. | Average earnings per employed adult male unit | 6,136 | 7,670 | +25.0 |
| 2. | Value of average earnings at 1973–74 prices (a) | 6,136 | 6,289 | +2.5 |
| 1973–74 rate schedule and dependant allowance provisions | ||||
| 3. | Tax payable (b) | 761 | 1,202 | +58.0 |
| 4. | Take-home pay | 5,375 | 6,468 | +20.3 |
| 5. | Value of take-home pay at 1973–74 prices (a) | 5,375 | 5,302 | -1.4 |
| 1974–75 rate schedule and dependant allowance provisions | ||||
| 6. | Tax payable (b) | 455 | 922 | +102.6 |
| 7. | Take-home pay | 5,681 | 6,748 | +18.8 |
| 8. | Value of take-home pay at 1973–74 prices (a) | 5,681 | 5,531 | -2.6 |
| note | ||||
6.17. It is thus all too clear that tailoring wage demands to allow for the additional tax liability that higher incomes involve, if attempted by all employees, must be self-defeating in the absence of adjustments to the rate schedule or of the acceptance of lower profit margins by business. Nevertheless, particular sections of the work force, viewed in isolation, may be perfectly rational in seeking to maximise their wage demands; for if they are only modest in their demands, while other sections are not, they face the prospect of being made even worse off both absolutely and in relation to the rest of the work force. In the outcome, such inflationary pressures as already exist in the economy tend to be reinforced. Resistance to paying heavier taxation merges with the more basic struggle, adverted to in paragraph 6.9, between different groups in society each seeking a larger share of national income and reacting to the claims of others for a larger share.
6.18. This view of the contribution of personal income tax to the wage-price spiral has intuitive appeal and is beginning to gain many adherents. Empirical studies have yet to establish conclusively that there is a close relationship between changes in income tax, changes in wages, and changes in the general price level: investigations in the United Kingdom and Canada point to a relationship, but the research there is in its early stages and the findings are necessarily tentative. However, the wide publicity now being given to theories of inflation that attach importance to the passing on of personal income tax may in time serve to confirm such theories by bringing home more forcibly to income earners just how significant a bearing high and progressive rates of income tax have on the real value of take-home pay.
6.19. Doubts of other kinds have also been expressed about the efficacy of personal income tax as an anti-inflation device. Exactly how far work effort is inhibited by personal income tax is a matter of conjecture, but to the extent that it is it may tend to accentuate inflation by curbing the supply of goods at a time when demand is rising strongly. The issue is particularly important in relation to overtime work: it was concern on this account that led New Zealand, in 1974, to introduce a special rebate of tax on overtime earnings.
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6.20. There is the further point that if unions are now increasingly bargaining in net of tax terms, high and graduated rates of personal income tax may mean greater industrial unrest and strike action as workers attempt to achieve their wage demands, which again will be reflected in the supply of goods coming on the market as well as in the cost of producing them. Strong claims have been made, on the basis of United Kingdom data, for the existence of a relationship between strike activity and taxes.
6.21. Finally, the demand-reducing effects of personal income tax may be weaker than often thought. An increase in personal income tax expected to be only short-lived may do little to restrain personal consumption spending. To the extent that personal consumption depends upon ‘permanent’ rather than current income, the effect of a temporary increase in rates of personal income tax will be to reduce saving rather than consumption. A counter-cyclical increase in personal income tax may thus be ineffective in restricting demand precisely because it is seen to be a temporary stabilising measure. Moreover, in so far as personal income tax reduces the reward for saving and acts as an inducement to consume now rather than later, its efficacy in curbing demand may be further weakened.
6.22. In the conventional view, company tax reduces demand, and hence inflationary pressure, by diminishing company savings and the income of shareholders and thus reducing the rate of spending in both corporate and household sectors. To the extent that tax is shifted forward to consumers, the spending of companies and their shareholders will be less affected, but purchasers of the company's output will find their disposable incomes reduced in real terms. In the latter case, however, raising company tax is likely to exacerbate the wage-price spiral unless the offsetting demand-reducing effects are substantial.
6.23. It has been customary to argue that increases in rates of indirect tax are passed on as once-and-for-all increases in prices and constitute a deflationary measure because of the accompanying decline in the real spending power of consumers. However, the deflationary impact on the demand side may prove weaker than the initial effect on the general price level; furthermore, the price level effect may become embodied in expectations and hence in income claims. In these circumstances the tax increase will lead to cumulative shifting—forward to consumers through firms raising their prices and backward to firms through employees raising their income claims. Like other taxes, therefore, it is by no means certain that an increase in indirect taxation will be effective in reducing inflation; indeed, it could make things worse in some situations. Payroll tax is particularly open to criticism on this account, directly tied as the levy is to the size of an employer's wages bill.
6.24. Understandably, therefore, the view is now being widely canvassed that stabilisation policy in a period of severe inflation should feature tax cuts rather than tax increases, and the Committee can see some merit in this. Tax cuts, if accompanied by appropriate action in such other areas of policy as government spending, money supply, the exchange rate, tariffs and surveillance of prices and incomes, may have at least three attractions:
- (a) Once inflation becomes at all rapid, the appropriate setting of monetary and exchange rate policies and
levels of government spending is likely to be associated with long delays before the effects are seen in a
reduction of inflation. Tax cuts may fulfil the useful function of breaking into the wage-price
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spiral and thus of shortening the time-lag involved in applying other more conventional policies. - (b) Tax cuts in effect represent a reduction in the income claims of the government sector, which is one of the major groups involved in the struggle over income shares.
- (c) Tax cuts can be made to serve as a quid pro quo for trade union agreement to moderate wage claims. Employing taxes as part of a ‘social compact’ of this kind inevitably merges with the broader issue, now also attracting much attention, of using the tax system to implement some form of income and prices policy. This warrants closer examination.
6.25. Incomes and prices policies have found favour with many overseas countries, at one time or another, as a means of coping with inflation, though the results have been disappointing especially in the longer-term context. These policies usually involve the setting of guidelines for the growth of national and individual prices and incomes, and the adoption of devices to induce employers and employees to behave in a manner consistent with those guidelines. The inducement devices vary considerably, from moral suasion at the one extreme to legal compulsion at the other. In most countries the central government has had the power to pass legislation to regulate prices and incomes directly, but this is not the case in Australia and perhaps goes some way to explaining why, at least in peacetime, such policies have never been tried here. Lately, however, a number of proposals have been put forward for using the Australian tax system to induce employers and employees to formulate their income claims in conformity with certain national guidelines. This is not the place to debate the merits and shortcomings of incomes and prices policies generally; but it is not inappropriate to comment on particular tax arrangements designed to put pressure on management and labour to behave in certain ways.
6.26. Most of the suggestions in this area involve employing company tax to stiffen the back of the corporate sector in wage negotiations with employees. They include raising the basic company tax rate to, say, 60 per cent and then providing a rebate of perhaps 20 per cent for all companies holding wage increases within prescribed limits; leaving the basic rate unaltered but providing tax relief to firms that keep their wage increases down; and the denial of wage payments, in excess of some norm, as a tax deduction. More sophisticated proposals involve tapering the tax rebates or penalties. An excess profits tax has been canvassed too. Outside the company tax field there has been some support for a penalty rate of personal income tax on all increases in income in excess of a prescribed figure. One suggestion goes so far as setting the penalty rate at 100 per cent.
6.27. There may be constitutional obstacles to tax-penalty schemes of these kinds. Under section 51(ii) of the Constitution, the Commonwealth Parliament has power to make laws ‘with respect to taxation’. It is open to argument that a law purporting to impose differential rates of tax on employers according to their policy on wages or seeking to confiscate wage rises above a certain norm by imposing a marginal tax rate of 100 per cent would not be a law ‘with respect to taxation’ but one imposing wage control.
6.28. As well as constitutional problems, substantial tax shifting might occur, which would defeat the whole purpose of
such measures. Indeed, unless the tax penalties were carefully designed, and effective price controls to apply, price
might rise even faster than otherwise in circumstances where firms were readily able to shift taxes forward because of the
buoyant state of the market and were anxious to avoid becoming
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embroiled in protracted industrial disputes. The
ability to shift tax penalties is likely to vary markedly in different parts of the economy depending, for example, on the
degree of competition from overseas suppliers or from domestic producers not subject to the penalty provisions. Such
penalties might therefore prove highly inequitable, even as between firms exposed to penalties.
6.29. The use of the company tax system to restrain wage increases has further shortcomings. It might encourage some companies to assume partnership or trust status to avoid penalties. It might encourage others to change their method of operation, relying more heavily on sub-contractors instead of on their own employees. It could undermine many soundly-based production bonus schemes. It would make it extremely difficult for firms to estimate the effects of the coming into operation of major items of new equipment or the launching of additional products. There would be formidable administrative problems for employers and endless and unproductive argument on the exercise of the many discretions the Commissioner would need to be given to ensure that the scheme will function with some semblance of equity for all taxpayers.
6.30. It is extremely doubtful whether an excess profits tax aimed at inhibiting firms from pushing up their prices would achieve its purpose; it might simply weaken their resolve to hold down costs. Moreover, the problems to be faced in designing a scheme that would be both equitable and administratively feasible are daunting indeed. They were examined in some detail by the Spooner Committee which, in 1950, was asked to look at methods of giving effect to the government's decision, subsequently abandoned, to impose an excess profits tax as an anti-inflation measure.
6.31. There are also likely to be thorny problems in employing a penalty rate of personal income tax to curb wage claims. Persons working overtime or taking on second jobs or securing promotions would have to be accorded special treatment if the system was to be fair and work effort not to be unduly discouraged. Special consideration would also have to be given to persons with fluctuating incomes and to those entering the work force for the first time. There would be a strong inducement to understate income or attribute it to someone else, making the administration of the scheme even more burdensome for the Commissioner. Industrial unrest might intensify.
6.32. In the Committee's view tax penalties of the kinds outlined above are not a feasible proposition. Constitutional difficulties aside, effectively administering such penalties poses many awkward problems and there is no reasonable prospect that the rate of inflation would be held in check.
6.33. As already indicated, however, the Committee is not unsympathetic, in certain circumstances, to employing the opposite technique of tax cuts as part of a properly integrated program to halt inflation. It is particularly relevant in this regard to note the possible introduction soon of a scheme of wage indexation, intended to eliminate the insecurity and uncertainty employees feel about levels of real income and to establish an orderly basis for wage negotiations focusing on changes in productivity. A similar scheme, involving quarterly adjustments of wages by reference to changes in a price index, operated for many years in this country; it was abandoned in 1953 because it was thought to be inflationary.
6.34. The Committee is not in a position to judge the likely impact that the reintroduction of wage indexation would have
on the pace of inflation: much would obviously depend on whether incomes were indexed on a percentage basis or in flat
terms and on whatever other concurrent measures were taken. But if nothing were done to
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counteract price
increases already in the pipeline or to moderate wage claims currently under negotiation, wage indexation would almost
certainly make inflation worse. This is where tax cuts could perhaps play one useful role. They might serve to reduce the
impact on the consumer price index of wage and price increases already in the pipeline, especially if concentrated on
excise duties, sales tax and payroll tax which have a fairly immediate impact on the consumer price index. However, any
moderating effect that tax cuts might have on the consumer price index, and hence on those wage increases directly tied to
consumer prices, would count for little in the longer run if wage indexation failed to exert some downward pressure on
wage claims in excess of increases in the cost of living and improvements in productivity. Hence a second function of tax
cuts might be to foster a climate more conducive to wage restraint. Thus in so far as employees are increasingly seeking
to protect the real value of their take-home pay from the eroding effects of a progressive income tax by bargaining in
net-of-tax terms, one might hope that cuts in personal income tax rates would cause employees to moderate their wage
demands. But it would be asking too much of the tax system to shore up a wage indexation scheme that was poorly conceived
and badly timed.
6.35. In Section II of this chapter, and later in Chapter 14, attention is drawn to the need in times of inflation to adjust tax rates frequently when, in such cases as personal income tax and death duties, rate schedules are progressive. While the case for doing this, at least as far as personal income tax is concerned, may in some measure be to curb wage demands and thus assist in restraining inflation, the main object is to counteract the arbitrary and inequitable restructuring of tax schedules that inflation inevitably produces. In this main object the adjustment may be seen as an attempt not so much to control inflation as to make it more comfortable to live with. In Section II and later chapters attention is also drawn to the way inflation upsets the measurement of the base upon which a tax is levied, and suggestions are put forward for overcoming this problem. These suggestions, too, may be seen as measures to make inflation more comfortable to live with. They are partial expressions of a policy which, in its widest operation, would extend far beyond the tax system and include linking the number of dollars to be delivered on a contract—whether a wage contract, a sale or loan contract, or a pension entitlement—to changes in some specified price index. The Committee is not competent to determine the feasibility of comprehensive indexing along these lines. It would, however, reject the inference sometimes drawn that if a wide enough range of measures is taken to accommodate personal and business circumstances to rising prices, inflation no longer presents problems. Many problems would in fact remain—not least the prospect that inflation may be allowed to accelerate. The community's top priority, in the view of the Committee, must be to reduce inflation.