Lifting the GST would be win-win for states, Commonwealth

Spare a thought for the Prime Minister and the state premiers this Friday. While you are letting your hair down at the office Christmas party, or finalising plans for your summer holiday, our leaders will be locked in fierce debate on tax policy and federal-state relations at the final Council of Australian Governments meeting for 2015.

They come to the debate from very different starting points.

NSW Premier Mike Baird has proposed an increase in the GST from 10 to 15 per cent, with the revenue going to the states to help fund growing hospital costs. The Victorian and Queensland governments prefer an increase in the Medicare levy – effectively an increase in income taxes. South Australian Premier Jay Weatherill has been particularly bold, suggesting the Commonwealth keep the additional revenue from a 15 per cent GST and abolish all tied grants to the states in return for the states receiving a share of income tax revenues.

The Commonwealth has so far remained tight-lipped but has indicated it will advocate changes to the GST only with the support of the states.

Despite the apparent differences in priorities, there is a sensible deal to be done.

The premiers of NSW and South Australia are right to see GST as the best opportunity for tax reform. Raising more money through increasing the GST, or applying it to more things, is preferable to most other means of raising revenue, including higher income taxes. A broad-based consumption tax drags less on economic growth than most other taxes. And Australia raises less of its revenue through its GST than most OECD countries.

Broadening the GST base to include fresh food, health and education is generally favoured by economists because taxing some categories but not others distorts the decisions people make about what they buy. Removing current exclusions would also make GST simpler to administer and reduce compliance costs for business. But increasing the rate of the GST would be a satisfactory second best if the politics of taxing health, education and food prove too fraught.

Extending the GST to cover many of the categories now exempt could raise $17 billion per year. Increasing the rate to 15 per cent would generate about $27 billion.

But the devil of GST reform is in the detail, and particularly the question of how the extra revenue should be used.

Any credible package must compensate poorer households for the higher cost of living while maintaining incentives to work for low and middle-income workers – the people whose work decisions are most sensitive to tax rates.

And in the era of tight budgets, there will need to be a fiscal pay-off for both Commonwealth and state governments to get them to the negotiating table. The days when governments could afford to "buy" reform are long gone.

Our recent report for the Grattan Institute, A GST Reform Package, sets out a tax-reform proposal that strikes a balance between economic growth, budget repair and fairness.

Spending about 30 per cent of the additional revenue from a 15 per cent GST on increasing welfare payments would lift full-rate pensions and allowances such as Newstart by about 5 per cent. This would leave two-thirds of low-income households better off – a helpful buffer to ease concerns voiced by the welfare lobby that compensation might be eroded over time.

Committing a further 30 per cent of additional revenue to income tax cuts will allow the government to shave 1 to 2.5 percentage points off the bottom two tax rates, improving work incentives and helping households further up the income scale.

Together the proposed welfare increases and tax cuts would fully offset the increase in GST for most low and middle-income households – those earning up to $100,000 a year. Overall the tax and transfer system would become more progressive. But not everyone can be fully compensated. Promising "no losers" is a sure-fire way to erode any revenue benefits from the package.

A potential sticking point will be how the Commonwealth and states split the remaining 40 per cent of additional revenue. About $5 billion a year is probably the minimum price for state co-operation – this would grow over time with revenue collections and would be enough to make a meaningful dent in hospital spending growth. That would leave another $5 billion to reduce the Commonwealth's budget deficit, or to pay for other tax cuts that will promote economic growth.

The other sticking point will be how to rearrange payments from the Commonwealth to the states. Most states will want to keep all the GST revenue. If they agree to the Commonwealth keeping a share, history suggests the Commonwealth will unilaterally decide to take a bigger share at some point in the future.

To make the books balance, the Commonwealth would have to treat the additional GST money as a substitute for the grants now earmarked for hospitals or independent schools. Lobby groups are unlikely to be happy about states having more freedom to change priorities in these areas.

An extended tax debate might not be everyone's idea of a fun way to spend a sunny Friday in December, but it's vital that our leaders resolve the current impasse and find common ground.

We think there is a deal to be done that would support economic growth, make the tax and transfer system more progressive, help improve the budgets for Commonwealth and state governments, and even strengthen our federation.

And that might be the best Christmas tax-reform cheer we can hope for.