3.7. As a quality of a tax or a tax system everyone demands fairness, or equity (the terms will be used interchangeably). But, in tax matters as in law and ethics, it is an ideal exceedingly difficult to define and harder still to measure. It is customary to distinguish the two dimensions of ‘horizontal’ and ‘vertical’ equity: the notions that it is fair that persons in the same situation should be equally treated, and those in different situations differently treated, with those more favourably placed being required to pay more. Both expressions will have to be frequently employed in this report. They reflect the ‘ability to pay’ principle and as such tend to embody the idea that taxation is no more nor less than a sacrifice. As the Committee will record later, this is an idea that needs qualification if it is not to mislead. An alternative principle used in much recent academic discussion is that of ‘benefit’, which relates taxes to the benefits individuals are estimated to receive from government-provided goods and services. Except in a small number of cases where taxes take the form of fees or prices for the direct use of publicly-provided services by particular individuals (e.g. postal facilities), this principle is prohibitively hard to apply. In any case it abstracts altogether from notions of fairness, or implicitly embodies an interpretation of ability to pay that may not be socially acceptable. Hence the Committee argues in this report in terms of ability to pay, though the benefit principle has its place in the discussion of the Australian-origin income of non-residents (Chapter 17) and the taxation of goods and services (Chapter 27).

3.8. When we say that persons in equal situations should pay the same tax we probably say so because we think of the tax as a sacrifice levied upon some kind of private

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‘economic well-being’. But the ‘economic well-being’ is a sequence of barely describable psychological states of a thoroughly immeasurable kind. For purposes of practical discussion and decision-making, both the ‘sacrifice’ by way of tax and the ‘well-being’ upon which the tax is levied have to be measured in money terms. Many of the most difficult questions in tax policy stem from the arbitrariness and convention that must be accepted when making this leap from the immeasurable to the measurable, from levels of ‘well-being’ to the choice and exact definition of the tax base.

3.9. It is usually taken for granted that the best available measure of an individual's ‘well-being’ is his income. The ‘burden of taxation’ is thought of primarily in terms of the proportion of a man's income that goes in paying taxes, whether they be taxes levied formally on that income or indirectly by elements of tax in the price of the goods and services he buys. Horizontal equity is then taken to require that two persons with the same income pay the same taxes (at least in the first place and ‘other things being equal’), while vertical equity would require that, of two individuals with different incomes, the one with the larger should pay more by some correct amount.

3.10. Even when income is so regarded, there remain very great difficulties in finding an exact and workable definition of it for tax purposes, as the length of the Income Tax Assessment Act and its frequent amendment testify. The most important of these difficulties are surveyed in later chapters. There is evidently some discrepancy between the legal approach to this problem, which seeks to extend and refine the everyday meaning of ‘income’, and the more abstract approach adopted by many economists which generates a very much wider meaning.

3.11. A further problem arises over the question of the appropriate unit for tax purposes. Many would argue, for example, that in a family the ‘economic well-being’ of individual members is likely to be measured better either by the average or by the total income of the family members than by their separate incomes. Whether or not this is so is an extremely vexed question and is discussed in Chapter 10.

3.12. Irrespective of whether individual or family income is accepted as the appropriate starting-point, it is recognised that this cannot be the end of the matter. Further argument is required before it can be concluded that two individuals should pay identical taxes simply because their incomes are the same. They will certainly be dissimilar in a great many other respects. Some of these differences would be considered irrelevant for tax purposes by almost everyone (for example, sex, race, religion, and many other personal characteristics), but others (such as health and size of family) are widely felt to be very relevant indeed. But to decide which differences are which, and how much allowance for such things should be given in calculating tax liabilities must involve much nice judgment and many decisions of an arbitrary kind. The main problems are examined in Chapter 12.

3.13. Yet other problems arise because taxes are, in most cases, calculated and levied on the basis of annual magnitudes. This is of course necessary for the administration of the public sector, but the period of a year is arbitrary from the viewpoint of fairness. Those with incomes that vary from year to year will over several years pay more tax under a progressive system than others earning the same total income in an even stream. This aspect of a very fundamental issue is widely recognised, and opportunities for ‘averaging’ are already provided for some groups for whom fluctuations are especially marked and unavoidable. But the deeper issues that arise here are not often thought about in explicit terms. In the Committee's view most people would agree on reflection that fairness mainly requires that taxation be the same for

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individuals whose total ‘well-beings’ are likely to be the same over their whole lifetimes and that too much importance should not be attached to temporal differences in the way ‘well-being’ is distributed, by choice or necessity, over adult years. Indeed, more than a single lifetime is relevant when the fairness of taxation upon an individual's capacity to do his duty to his heirs is considered. This lifetime perspective is not, of course, a practicable basis for taxation, but it has its implications for the structure of an inevitably annual system.

3.14. The custom of using income as the tax base is not inconsistent with this lifetime view of things. Over any short period, say a year, an individual's consumption undoubtedly reflects his ‘economic well-being’ better than does income. A man can, by consuming out of past savings or by borrowing against future income, achieve levels of ‘economic well-being’ much greater than his current income. For many, over a lifetime, total income and total consumption will be the same. In this sense, lifetime income will be a fairly good measure of an individual's ‘well-being’, whichever base is felt to be the fairer.

3.15. But a tax on income is not at all the same as a tax on consumption, even in lifetime terms. When a tax is levied on income, it falls on savings as well as consumption; and when income is earned from those savings in later years, that income too is taxed. This means that the effective tax rate imposed on consumption which is postponed is greater than the rate imposed on current consumption: income tax falls more heavily than consumption taxes on those who prefer to save a high proportion of their incomes and do more of their consumption later in their lives. But individuals may save for reasons other than to supplement consumption in later years: because they wish to bequeath to their heirs, or because the process of accumulating wealth yields ‘satisfactions’ which contribute to ‘well-being’ directly (and independently of any income wealth may bring in). Such motives for saving will be more significant at the upper end of the income scale; but certainly at the bottom end people will primarily save in order that they may consume more in future years (specifically in their old age). For the latter persons, taxation based on consumption is probably fairer than income taxation because it does not discriminate between individuals according to how they spread their consumption over their lifetimes. Higher up, horizontal equity may well be held to require not only taxation of income but taxation of capital as well, and this quite apart from any desire to make the system fairer in a vertical sense.

3.16. Questions of equity are complicated by inflation, as is so much else. The discussion of equity starts from the idea that taxation is a sacrifice of ‘real’ private satisfactions (however much this may be offset by the satisfactions that public expenditure may simultaneously create). But taxes have to be levied in money terms. In the case of incomes from current effort, the distinction may not much matter since incomes and prices may go up simultaneously and tax rates can be adjusted to maintain the same underlying rate structure. However, a serious difficulty arises with property incomes. The real value and the real return on assets with variable money returns may indeed be maintained by rises in their money capital value and their money returns. But the real return on fixed-interest assets declines and their real capital values fall; until redemption is near, their money capital values also fall. With an income tax this latter fall is inadequately reflected in the tax liability. There is a consequent inequity of a horizontal kind; and since fixed-interest securities are often the main financial assets of lower income groups, there may be vertical inequities too. These inequities do not arise so conspicuously—if at all—under consumption taxation.

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3.17. There are good reasons, therefore, why consumption might be preferred to income as the primary index of ability to pay. Some economists, notably Lord Kaldor, have found the reasons sufficiently compelling to justify abandoning personal income tax altogether and substituting a progressive expenditure tax. The Committee is not prepared to go this far, recognising as it does that an expenditure tax would probably be even more difficult to administer than personal income tax. But the philosophy underlying an expenditure tax has much to recommend it, and the Committee has allowed itself to be influenced by this philosophy in certain of its proposals, including those bearing on the tax treatment of income-protection insurance premiums (Chapter 7), investment income (Chapter 9), and superannuation and life insurance (Chapter 21).

3.18 The issues just mentioned relate primarily to horizontal equity. Problems of an equally intractable kind arise with vertical equity. Indeed, establishing the ‘right’ degree of progressivity by reference to the criterion of equity is so fundamental to tax policy, as regards both the set of taxes to be chosen and their rates, that it will need to be explored at length in the next chapter.