Andrew Leigh

My AFR column today is on the psychology of tax reform.

The Psychology of Change, Australian Financial Review, 4 October 2011

In his book The Political Brain, psychologist Drew Westen argues that the marketplace that matters most in politics isn’t the marketplace of ideas, it’s the marketplace of emotions. Drawing on a plethora of anecdotes and research, Westen contends that reformers who trade solely on rational arguments are less likely to succeed.

So with the Tax Forum starting today, it’s worth momentarily stepping out of the enticing world of excess burden, elasticities and economic incidence; to consider how past tax reforms have drawn on emotion as well as economics.

Two of the most powerful emotions – fear and hope – have been on display in many of the tax reform movements of Australian history. The expansion of federal income taxation in the early-1940s was driven partly by fear of a Japanese invasion. Similarly, the stake that was driven through the heart of inheritance taxes in the late-1970s was the result of a fear campaign, made easier by the fact that thresholds were not indexed to keep up with inflation.

Hope has played a part too. In the Eureka Rebellion, miners rose up for the hope of replacing mining licences with a tax on gold production. In the mid-1980s, the Hawke Government painted an optimistic picture of how Australia could prosper with lower income tax rates, but with a tax base expanded to encompass capital gains and fringe benefits. Tackling climate change carries a similar message of optimism: if you want to generate the clean energy jobs of the future, the country with the highest level of CO₂ per capita needs to put a price on carbon pollution.

So the next time you bump into a budding tax reformer, perhaps the first question you should ask her is: ‘Are you peddling hope or fear?’.

Another lesson from psychology is that we feel losses more keenly than gains. So it may be tough to sell a tax reform that provides diffuse benefits to many, but imposes heavy burdens on a few. This is perhaps one reason why cutting border taxes was historically such a vexed issue. When tariffs fell, hardly anyone switched their vote because the import price of school shoes had been halved, but footwear workers who would lose their jobs campaigned against trade liberalisation.

Loss aversion is further magnified in a 24-hour media cycle. Conflict makes great television, so it’s little wonder that the $14 billion pension increase in the 2009-10 budget received less media coverage than the $2 billion flood and cyclone reconstruction levy in the latest budget. To the best of my knowledge, Today Tonight is still yet to run a story on the $3900 that tariff cuts put into the pockets of the typical Australian household.

Particular features of our tax system can be traced to the power of psychology. One reason that Australian company tax rates were historically too high is that voters mistakenly thought that the burden fell only on investors. With a broad recognition that company taxes also impose an economic burden on employees and consumers, rates have steadily fallen. Similarly, the term ‘payroll tax’ sounds like something that’s paid by the boss – yet we know that payroll taxes effectively come out of workers’ pay packets.

Hypothecation is also a tribute to the psychology of tax. In principle, there is no reason to link taxes with particular spending. According to standard economics, revenue should be raised in the most equitable and efficient way, and spent on the most worthy programs. Yet as a Treasury paper by Sam Reinhardt and Lee Steel points out, hypothecated taxes date back to the 1813 promise by colonial NSW to spend customs duties on orphanages and hospitals. In 1945, part of income tax was hypothecated to social services. Since 1984, the Medicare levy has helped pay for universal health care (though it has never paid more than a portion of public health care costs). Hypothecation is rarely efficient, but it persists because it offers a clear promise: if you pay A, you will get B.

Psychologists shouldn’t be asked to design our tax system any more than economists should be deployed as therapists. But that shouldn’t stop those of us who want to improve the tax system from learning a few lessons from political psychology. Emotions, loss aversion and hypothecation are good reminders that it takes more than the left side of the brain to implement enduring tax reform.

Andrew Leigh is the federal member for Fraser. He is one of the government representatives at the Tax Forum.