What if GST and payroll tax are unconstitutional?

In my second-round submission to the Henry tax review, I argued that the collection mechanisms for GST and personal income tax violate s.82 of the Constitution, which says in part: "The costs, charges, and expenses incident to the collection, management, and receipt of the Consolidated Revenue Fund shall form the first charge thereon ..."

At face value, those words would make it unconstitutional to require businesses, at their own expense, to collect income tax payable by employees or GST payable by customers. Tax-deductibility of the expense is insufficient because it still leaves an after-tax component that is not charged to Consolidated Revenue.

In the case of the GST, sellers explicitly collect the tax from buyers by issuing tax invoices. So the obvious way to make the GST comply with s.82 is to eliminate tax invoices and make the tax payable on sales instead of purchases. But that raises another problem: how do we handle input credits, for which tax invoices serve as proof of payment?

One solution is to remove restrictions on credit for GST paid on business inputs. In general, whether GST has been paid on inputs depends on the nature of the inputs. But whatever their nature, the GST is presently reclaimable only for inputs purchased from GST-registered suppliers, i.e. suppliers who presently issue tax invoices. The GST paid by "input-taxed" suppliers and passed on in their prices isn't reclaimable even by GST-registered customers; it's called "sticky" GST, and leads to tax on tax. If one could claim input credits for both classes of suppliers, one wouldn't need tax invoices to distinguish between them.

This solution would slightly reduce the GST base, but would substantially cut compliance costs for traders whose turnover is low enough to qualify for input-taxed status, but who are forced to register for GST just because prospective customers want to claim input credits. (The number of affected micro-enterprises is reportedly in the hundreds of thousands.)

A better solution, yielding a far greater reduction in compliance costs with no contraction of the GST base, is to do away with input credits by making the GST a retail tax instead of a VAT.

Conventional "wisdom" holds that a VAT is harder to evade, because sellers who fail to declare sales may be exposed through their customers' input credits. That's complete nonsense because any purchase that qualifies for an input credit will also qualify for an income tax deduction, which is more valuable and therefore more likely to make customers keep records of their purchases.

And what if you're a retailer, so that your usual customers don't claim input credits? In South Korea they solve that problem by offering tax incentives to retail customers who use credit/debit cards, which create electronic records of purchases. This would work just as well for a retail tax as for a VAT. If the "incentives" were rebates rather than deductions, they would work even in the absence of an income tax.

Conventional "wisdom" further argues that a VAT encourages traders to declare sales so that they can claim the corresponding input credits - conveniently forgetting that income tax has the same feature, and that it is more lucrative to hide both sales and purchases than to declare both. The only merit in this argument is that traders will pay VAT on any undeclared inputs - provided of course that the non-declaration has not been suborned by suppliers who also evade VAT!

But the clincher is that a VAT opens a second front for evasion: bogus input credits. Under a VAT, traders who overstate their inputs get income tax deductions plus VAT credits, whereas under a retail tax they only get income tax deductions.

In truth, the one thing a VAT does better than a retail tax is to generate compliance costs, which give larger businesses an advantage over smaller ones and deter start-ups that might compete with established players. As politicians are beholden to big business for campaign funds, the best hope for small business may be a constitutional challenge to the GST as presently implemented.

Either of the above remedies - relaxing restrictions on input credits or switching to a retail tax - would be within the Henry review's terms of reference, which rule out raising the GST rate or broadening the base but say nothing about narrowing the base or changing the implementation.