Taxman needs a better handle on how we behave
If the Henry tax inquiry is to achieve Ken Henry's ambition of providing a blueprint for tax reform over the next decade or two - if it's to stay relevant, that is - it will need to take full account of the findings of behavioural economics.
Likewise, if it's to achieve Henry's longstanding goal of reducing the tax system's complexity and riskiness, it will need to learn from behavioural economics.
And if its reforms, when implemented, are to involve fewer of the legendary ''unintended consequences'' that bedevil policy changes, it will need the much better handle on how taxpayers actually behave that behavioural economics provides.
Fortunately, it seems Henry understands all this because last week the review released a commissioned study on Behavioural Economics and Complex Decision-Making, by Andrew Reeson and Simon Dunstall of the CSIRO.
Their study offers an excellent summary of the findings of behavioural economics, and I commend it to anyone seeking a crash course on what this newish branch of economics is on about. It can be found on the review's website taxreview. treasury.gov.au.
Behavioural economics is the study of the many ways in which that unfamiliar creature Homo sapiens differs from the much more predictable (but non-existent) inhabitant of economic models, Homo economicus. It draws on economic experiments and psychology to bring a deeper understanding of human behaviour into economic theory and policy.
The Henry review, like all tax inquiries, will wrestle with the three great objectives of tax design: efficiency (in the allocation of scarce resources), equity (fairness) and simplicity (low costs of administration and compliance).
The reason the task of tax reform is never-ending is that there's huge potential for conflict between those three objectives. Much of the time, the greatest conflict is between equity and efficiency: what's efficient tends not to be fair and what's fair tends not to be efficient.
So, as with many problems in economics, the game is about finding the best available trade-off between those two equally desirable but conflicting objectives.
All too often, however, this two-way trade-off has come at the expense of the third goal: simplicity. This, combined with the breakdown in ''voluntary compliance'' with the tax laws - the eternal search for loopholes - has made those laws ever more voluminous, complex and risky for the badly advised.
So Henry will have his work cut out if he wants to make significant progress in reducing complexity without going backwards on efficiency or equity. But behavioural economics has light to shed on all three objectives, and some of it points towards better trade-offs.
On efficiency, the main message is that if you're relying on a defective model of human behaviour you'll end up with a lot less efficiency and a lot more unintended consequences than you expected.
On equity, the main message is that humans care deeply about perceived fairness, are willing to sacrifice some efficiency for greater fairness, and are just as concerned about ''procedural fairness'' (the way things are done) as about fair outcomes (the way things end up).
Fortunately, Henry believes he's found the sweet spot in the trade-off, where certain reforms will improve both efficiency and equity. I guess that's easier to do when you use behavioural economics's wider definition of fairness.
In such cases, he's wisely concluded that emphasising a particular reform's advantage in terms of greater fairness is likely to be more persuasive with the electorate than emphasising its advantage in terms of greater efficiency.
(Conventional economists are convinced that, in asserting the primacy of economic growth above almost all else, they're merely reflecting the public's top preference for an ever-higher material standard of living. I have doubts about that but, in any case, there's precious little sign of the public being keen to accept the efficiency improvements that lead to faster economic growth.)
On simplicity, behavioural economics reinforces the point that complexity actually adds to unfairness. Tricky decisions are ''likely to impose a relatively greater burden on those with less experience and education'', the study says.
''Young people, people with limited education or cognitive capacity and people with limited social networks are likely to be the least well equipped to deal with complexity. By contrast, those who know more, and have access to professional advice, are in a far better position to take full advantage of the system.''
This is ironic because many of the complexities in the system are intended to reduce inequity.
Delivering welfare through a complex tax system, as opposed to through direct payments - a favourite trick of John Howard's - may therefore be self-defeating because many of the people at whom the welfare is targeted are the least well equipped to deal with complexity.
Perhaps the greatest case of complexity imposing a burden on ordinary taxpayers is the requirement to submit annual tax returns. It seems people take one look at the TaxPack and freak out. Three-quarters of taxpayers employ a tax agent to prepare their returns.
It's worth noting that the Hawke-Keating government's decision to move to ''self-assessment'' shifted the risk of inaccuracy in a return from the taxman to the punter. Claim something you shouldn't and the taxman will let it through, but then may come after you with bills and fines.
Clearly, anything that could be done to reduce the need for so many people with simple returns to pay for the services of a tax agent - say by using the taxman's electronic data collection from employers, banks and so forth to send taxpayers pre-filled returns which they could simply sign or amend before signing - would strike a huge blow for simplicity.
This, at least, is one good thing safe to emerge from Henry's review.
Ross Gittins is the Herald's Economics Editor.