The attraction of annual tax refunds

One of the many targets of recent tax reform ideas is the deduction for work-related expenses by wage and salary earners.

The abuse of this provision leads to an idea straight out of the tax reform handbook: broaden the tax base and lower tax rates by chopping the deduction and using the money to reduce marginal rates. But taxpayers see it differently.
The amounts at issue are large. In 2013-14 (the latest year for which data are publicly available) taxpayers claimed $21 billion in deductions and saved themselves more than $7 billion in tax.

Strongly in support is the principle that expenses incurred in earning taxable income should be deductible before tax is assessed. Furthermore, the habit of claiming deductions at the end of the year is well entrenched and taxpayers would not give it up lightly. There is some pleasure in getting a refund, even if it means having overpaid tax during the year. It sounds irrational, but no doubt behavioural economics has an explanation.

The problem with the deduction is that it is gamed by taxpayers, difficult to police, and based on fuzzy or arbitrary boundaries between what is allowed and what is not. A principle of tax policy is a fine thing, but it has to be practical to administer.

The Gillard government, following a recommendation of the Henry tax review, proposed a standard deduction for everyone — the default option — but with taxpayers having the choice of claiming a larger amount if they could justify it. However the proposal was canned because of its cost to revenue.

The main goal of tax reform should be to cut marginal rates, and getting rid of deductions for work-related expenses would help make that possible. However, as with many reforms the losers would be more vocal than the winners, and the broader public is sceptical when politicians say they will increase revenue from one source to reduce it from another.

This is another tax reform idea likely to fall off Scott Morrison’s table of options.