Activity 3(k)

Activity 3k – Government Failure: 

Does Australia’s tax mix lead to an inefficient allocation of resources?

  1. Allocative efficiency is said to occur when society’s wellbeing is maximised through the effective allocation of the nation’s resources. This occurs when no one can be made better off without making someone else worse off. Technical efficiency refers to the use of the scarce resources, whereby output is maximised using the available resources and it is impossible to increase production without increasing inputs. The difference between them can be highlighted by looking at the outcomes. If a society achieved technical efficiency, it would be maximising its output from its available resources. However, this would not guarantee that allocative efficiency would be achieved because the wrong types of goods and services might be produced compared to the needs and wants of society.
  2. Income taxes in Australia are progressive and some economists and businesses argue that they have a negative impact on productivity growth. If a person works harder and increases their productivity, then they may gain some form of performance based pay (a bonus for example). If they lose a high percentage of this in income tax, then the extra effort may not be warranted and the worker might be disincentivised to work harder, therefore technical efficiency might be lower than what it could have been.
  3. High marginal tax rates can distort the after tax rewards from working. This means that high income professionals will be taxed at a higher rate than those who earn less and results in a lower relative after tax wages for higher income earners, which will influence how workers allocate their labour. For example, it might disincentivize some workers from undertaking extensive university study (or other form of training) if they believe that they will not be significantly better off than if they chose to enter the labour force as an unskilled worker. Similarly, if our tax system insufficiently rewards effort, then immigrants may choose to allocate their scarce resources elsewhere (e.g. migrate to countries with more attractive income tax regimes). This would mean that more productive workers could be attracted to Australia if income taxes were lower or more attractive, increasing the ability of firms (who face skills shortages) to meet demand and therefore maximise society’s wellbeing.
  4. Stamp duty is an inequitable tax because it is levied only on those who purchase a new house. This means that a person who moves house will pay more in taxes than someone who stays in the same house for many years. The tax is inefficient because it discourages people from moving. People who may no longer need a large house may therefore make it more difficult for young families to move into the neighbourhood they would like. This reduces allocative efficiency. The tax may also discourage people moving for work. If they factor in the cost of stamp duty when deciding whether to take up a job opportunity in another part of the country, then it is likely to alter their decision. This decreases dynamic efficiency because resources are not being directed to where they are most needed.
  5. Based on the answers to part 2 and 3, one could argue that it could improve technical and allocative efficiency because:
  • It might attract skilled immigrants to the country
  • It could encourage workers to increase their productivity
  • It will reward small business owners who take risks because less of their profits will be lost in tax
  • It reduces the distortion to relative prices
  • It might encourage more marginally attached workers to join the workforce


However, unless the government adjusts other taxes, it will represent a significant reduction in tax revenue. This might mean that the government might have to make cuts to spending programs, which may have a negative impact on allocative efficiency.