Most of us accept that we should contribute to the cost of public goods and services such as the police. This occurs most obviously through taxation.

There are three basic ways taxes can be allocated among citizens. The first is a head or poll tax. This is a fixed exaction upon individuals of an amount that does not vary with income. The street cleaner and the banker pay the same level of tax.

The second form of taxation is a progressive tax: The rate of taxation increases as the amount of money subject to the tax increases. New Zealand's income tax is a progressive tax. The rate of tax applied to the first dollar of income is 15 percent whereas that applied to each dollar of income over $60,000 is 39 percent. The rate of tax could start at zero and rise to 100 percent, or higher.

The third option is a flat tax. The rate of tax is the same regardless of the amount of income earned. The street cleaner and the banker would pay the same rate of tax, say, 25 percent. The banker would still pay more total tax than the cleaner because he/she earns a higher income.

Head taxes are very unpopular. At first sight they may seem bizarre. Yet we accept a somewhat similar approach every day when we belong to a gym, society or club:  membership generally means flat dues for everybody. Similarly, prices charged by supermarkets do not depend on the income of the shopper.

The head tax, however, runs into serious problems if the tax is more than trivial. If taxpayers earned little income relative to the level of the head tax, they would face severe hardship.

The government might decide to remit the head tax on people who do not earn a minimum level of income, but this would create problems. It would need to raise additional tax from other people to compensate for the revenue forgone. The head tax has gone out the window.

The relevant question then is whether a flat tax or progressive income tax is more desirable.

A flat tax is more robust than a progressive tax. It is relatively easy to set the rate of tax and calculate the amount of tax paid by each taxpayer with a flat tax. It does not matter whether income is earned through a company or superannuation fund, or as a fringe benefit. All income would be taxed at the flat rate. Because every taxpayer pays the same rate of tax, there is less scope for the level of tax payable by different groups to be altered simply for political reasons.

The progressive tax is more complicated. The government must decide which particular progressive tax scale it favours out of the vast number that could be conjured up. This choice is a political question. There is no principle to resolve it objectively. Political debate over the shape of tax scales can be divisive.

Some people claim that an increase in the progressiveness of the tax scale is warranted on fairness grounds. There is no limit to such arguments. A little more progressivity is always said to be fair.

A move to a flatter tax scale is often seen as a sop to the rich. People on high incomes initially benefit more than those on low incomes. But over time higher productivity may make everyone better off. A progressive tax scale discourages productivity and adversely affects living standards more than an equivalent flat tax.

Richard Epstein, a leading legal scholar at the University of Chicago, spoke on the flat tax during a recent visit to New Zealand as a guest of the Business Roundtable. The shape of a progressive tax scale leads to what he called the Goldilocks problem. This is the futile search for a schedule of tax rates that is 'just right'.

If there is little difference between the bottom and top tax rates, what is the point of the additional complexity and costs entailed in implementing a progressive tax? On the other hand, if the tax scale is highly progressive, people who create wealth and jobs are encouraged to engage in wasteful tax avoidance activities and some might migrate to other countries.

As Professor Epstein pointed out, there is great reluctance in the United States to have progressive tax systems at the state level because, "the folks who live in California can happily relocate to Nevada with a lower tax base." Tax competition is a strong restraint on the level of taxes and the progressivity of tax scales. This is a relevant lesson for New Zealand.

A flat tax is generally better than a progressive one. Paying taxes may not be a pleasure for most of us, but it could become somewhat less painful for many New Zealanders if the recommendation of the 2001 Tax Review (which was headed by Business Roundtable chairman, Rob McLeod) that a flatter income tax system be implemented were adopted.

For more information, contact:

Roger Kerr
Executive Director
Ph: 04 499 0790
Email: rkerr@nzbr.org.nz

David Young
Communications Advisor
Ph: 04 499 0790
Email: dyoung@nzbr.org.nz

Web: www.nzbr.org.nz