Essays on fiscal policy in Australia

Abstract

This thesis comprises three papers that examine the role of income tax policy in Australia within the broader fiscal system. The first paper (Chapter 2) studies trends in the Australian personal income tax system's progressivity after the introduction of "A New Tax System (Goods and Services Tax) Act 1999". It measures tax progressivity based on tax liability distribution across the income distribution using the Suits index. The index shows that Australia experienced a cycle of increasing and decreasing progressivity from 2001-2016. Active tax policy with frequent adjustments to income brackets, marginal rates, and offset levels made the tax system more progressive before 2010, while inactive tax policy made it less progressive after 2010. This decline is due to the income tax code failing to adjust for income distribution changes. The paper finds that while indexing tax brackets to inflation can partially mitigate the decline in progressivity; it is not a full substitute for (annual) frequent discretionary adjustments to the tax code. The second paper (Chapter 3) builds on the empirical findings in Chapter 2 and asks a broader question on the optimal design of the income tax system in Australia. To do so, it builds a dynamic general equilibrium, overlapping generations (OLG) model with skill heterogeneity and uninsurable labor productivity risk, calibrated to match the key features of the Australian economy. The paper applies the model to search for the personal income tax system's optimal progressivity, relying on a utilitarian social welfare criterion. Results indicate that reducing the income tax system's progressivity reduces distortions on incentives to work and save, leading to improvements in aggregate efficiency and welfare. Under the welfare criterion, the optimal tax system is proportional with a tax rate of around 14 percent. The income tax system's optimal progressivity level is closely related to the design of a means-tested pension system. Interestingly, the optimal proportional tax code is robust to alternative means-tested age pension system designs. The third paper (Chapter 4) moves from the welfare implications of income tax design to examining the fiscal limits to which the government could use the income tax system to raise tax revenues. It quantifies the fiscal space (the amount of additional tax revenue that can be potentially generated) by changing the progressivity and average level of taxation (tax level) of the Australian income tax code. Using an OLG model that matches key aggregate and distributional statistics of the Australian economy, it examines the Laffer curves for income tax progressivity and tax level in Australia. The peak of the Laffer curve defines the fiscal limit. The paper finds that tax revenue increases when the tax code's curvature decreases (becomes less progressive). The income tax code's fiscal limit is with a flat income tax code at a tax rate of 95%. The associated fiscal space represents a 208% increase in income tax revenue. However, in general equilibrium, as the income tax rate increases, after-tax incomes decrease, leading to large reductions in consumption and, in turn, consumption tax revenue. As a result, the total tax revenue gain is significantly lower at 126%. The paper also highlights the advantage of Australia being a small open economy when it comes to the revenue maximizing potential of income tax. The adverse incentive effects on household savings due to rising tax rates are mitigated by foreign capital inflows, preventing aggregate capital stock decline. The paper contrasts the small open economy case with the closed economy case that results in a Laffer curve peak at 60% and a smaller fiscal space of 116%.