Amidst the backdrop of a looming funding gap for hospitals and schools, NSW Premier Mike Baird and South Australian Premier Jay Weatherill are taking proposals to increase the GST to 15% to the Council of Australian Governments (COAG) this Friday.

While raising or broadening the GST is acknowledged as one of the least economically damaging ways to boost revenue collections, the regressive impact of a higher or broader GST has been a crucial sticking point.

The Grattan Institute’s new report, A GST Reform Package, outlines how governments can increase revenues through the GST in a way that is fair and does not deter people from working.

Welfare increases can protect those at the bottom

A key objective of the compensation package outlined in our report is to ensure that the poorest households – those in the bottom 20% of the income distribution – do not go backwards. This group has low taxable incomes, and so tax cuts can’t help them much. The only effective way to target this group is through higher welfare payments.

If the GST were increased, the poorest 20% of households by (gross) income would account for 8% of the additional revenue collections. In a perfect world, giving back 8% of the revenue in the form of higher welfare payments would be enough to compensate them.

But this isn’t a perfect world, and the economics of reform are not that simple. First, welfare payments are not just made to the poorest 20% of households. Less than one in every three welfare dollars reach the bottom fifth of households. This “leakage” occurs despite the fact the Australian welfare system is the most targeted in the world.

Consequently, governments will need to spend more than 8% of additional revenue to ensure the poorest are no worse-off on average.

Source: Grattan Institute

Second, the considerable variation in spending amongst low-income households also makes it hard to ensure no one goes backwards. The Australian Bureau of Statistic’s (ABS) 2009-10 Housing Expenditure Survey (HES) – a somewhat out-of-date source, but the best publicly available – shows a very wide variation in the amount of GST paid by poorer households. In 2009-10, 680 000 households in the bottom quintile paid 50% more GST than the average for that quintile.

Our analysis shows that spending around 30% of the additional revenue from a 15% GST, or $8 billion a year, would increase full rate pensions and allowances such as Newstart by about 5%. Such increases will ensure that two thirds of poorer households are better off as a result of the changes. More than half would receive back more than 125% of their additional cost of living increase.

Source: Grattan Institute

Income tax cuts improve efficiency and help compensate the middle

Income tax cuts should also be part of any GST reform package. A reduction in income taxes will improve work incentives and provide some compensation for higher costs further up the income distribution. To provide the biggest economic pay-off, tax cuts should be focused on the low and middle brackets. Low and middle-income earners are the most responsive to effective tax rates in deciding how many hours to work.

Committing 30% of the additional revenue from a 15% GST to income tax cuts would allow governments to shave 2.5 percentage points off the bottom ($18,200-$37,000) tax bracket and 2 percentage points off the $37,000-$80,000 bracket.

As well as providing an economic dividend from increased work incentives, tax cuts of this magnitude help compensate for cost of living increases for working low and middle-income households. Taken together, our proposed package of tax cuts and higher welfare payments fully offset the increase in the GST for most households earning up to $100,000 a year – while also providing some benefit for those further up the income distribution.

Source: Grattan Institute

But not everyone can be a winner

Not everyone can be fully compensated for the GST increase. The Commonwealth budget is in deficit and state governments need more money to help them finance growing hospital spending. Trying to guarantee there would be “no losers” would be so expensive it would actually defeat the purpose of the reform.

Some proponents of an increased GST have painted an idyllic vision in which no individual household earning less than $100,000 is worse off. Unfortunately, given variations in spending and imperfect targeting, the cost of realising this vision is prohibitive.

Even a more modest objective – such as ensuring no more than 20% of these households are worse off – would still be extremely expensive. With our $8 billion welfare package, tax cuts to ensure that 80% of low and middle income households are better off would cost over $23 billion a year. Welfare and tax cuts would cost the budget more than the additional GST raised. It is simply not possible to compensate every household this far up the income distribution without increasing budget deficits.

Instead governments will have to settle for a far more modest aim: that on average, households with incomes under $100,000 will be better off. Tax changes inevitably have both winners and losers.

How to share the spoils

Our proposed package of welfare payments and tax cuts would absorb 60% of the additional revenue from a higher GST.

That leaves 40% – roughly $11 billion a year – for Commonwealth and state governments to work with. This may be less than state and Commonwealth treasurers hoped. But it could still potentially improve budget bottom lines.

The Commonwealth and states will have to agree on how to split this additional revenue. Around $5 billion a year is probably the minimum price for state cooperation – 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 or so to reduce the Commonwealth’s budget deficit, or to pay for other tax cuts – such as further cuts to income taxes or company taxes – that will promote economic growth.

The GST is not a magic pudding: it cannot satisfy everyone’s tax reform whims and at the same time protect all Australians from paying a cent more. But we are confident that a well-designed GST package can support economic growth, make the tax and transfer system more progressive and still offer the Commonwealth and state governments some budgetary relief. Now that’s a vision worth discussing.

John Daley, Chief Executive Officer , Grattan Institute; Danielle Wood, Fellow, Australian Perspectives, Grattan Institute, and Hugh Parsonage, Associate, Grattan Institute

This article was originally published on The Conversation. Read the original article.