While tax cuts are a topical issue, in this article we takea step back and instead look at what a better tax-benefit benefit system couldlook like. Just as with the current system, the size of government could be asbig or as small as society desires, but the debate around tax cuts would bemuch clearer than some of the vacuous comments we hear from politicians and thedubious findings of badly constructed opinion polls.
Take a family with two children, both aged under 13. Onepartner works 37 ½ hours per week and earns $40,000 per year. The other works12 hours per week for an annual income of $10,000. Their household net income(allowing for tax, ACC levies and Working for Families tax credits) is $47,098. If the higher income earner receives a pay increase of $1000, household netincome rises to $47,555, an increase of only $457. The implied tax rate onthat extra $1000 of earnings â€“ known as the Effective Marginal Tax Rate (EMTR)â€“ is a monstrous 54.3%. This is higher than the top marginal income tax rateof 39% which kicks in at $60,000. Is that fair?
This example is not unusual. Punitive EMTRs are widespread inour tax-benefit system. They are the insidious result of a system that is notproperly integrated â€“ a system whose designers pretend to look after the poorermembers of society, but who actually have not thought through the longer runimplications of their system for both economic growth and the welfare of thevery people they are ostensibly concerned about.
High EMTRs come about because of the interplay betweenincome linked benefits, progressive tax rates, and in some cases the taxing ofdifferent types of income at different rates. The very worst EMTRs can beavoided by welfare payments that reduce only slowly as income rises, but thisextends the range of income over which high EMTRs apply. Is there no escape?
There is, but it involves relinquishing two emotive concepts:progressive tax rates and means-tested benefits. A flat rate of personalincome tax combined with a universal Guaranteed Minimum Income (GMI) provides incomesupport but ensures that the EMTR is always the same as the tax rate. Considerthe following purely illustrative example where the rate of income tax is 25% andthe GMI is $10,000.
Tax is paid on every dollar ofmarket income (wages, interest, etc) at a universal rate of 25%. However,because of the minimum income guarantee, one receives more from the governmentthan one pays in taxes until market income reaches $40,000.
The real strength of the system is that all of the majorsocial welfare benefits (Unemployment, Sickness, Invalids, Domestic Purposesand NZ Superannuation) would all be rolled into the GMI. If you lost your jobor became ill, or were too old to work, you would automatically receive the$10,000. No application forms, no means testing. Society guarantees you aminimum income irrespective of your circumstances. Asunder the current system, there is nothing in this system that preventsadditional payments for specific needs such as wheelchair access for thedisabled. The important point is that such additional support is not linked toincome.
Other advantages include:
1. It removes the incentive for people to arrangetheir affairs to lower their tax â€“ income splitting or setting up trusts. (Note that the tax rate on corporate income and trust income should also be25%.)
2. It avoids decisions about partneringand marriage being driven by tax and benefit policy. The GMI is an individualentitlement for all from say age 18.
3. It substantially reduces thegovernment’s administration costs and individuals’ compliance costs, and henceimproves the efficiency of the economy.
4. It creates real incentives for mostpeople to earn income beyond the GMI, leading to increased economic growth andhigher real per capita incomes.
5. If provides a cash income tonon-earning spouses and carers.
6. It increases the transparency of fiscalpolicy â€“ raising the GMI would be difficult without an increase in the flatrate of tax. Tax cuts would be difficult without reducing the GMI. Perhapsthis transparency is why politicians won’t like it.
Clearly the flat tax rate and the GMI should not be so highas to discourage work and effort, but the GMI should be sufficient to providefor basic living costs. There is no gain to society from miserly welfarebenefits that force the poor into crime and raise expenditure on security,police and prisons. Equally, there is no gain to society from high EMTRs thatdestroy the incentive to be productive and lead to huge amounts of resourcesbeing allocated to tax avoidance and tax compliance, and to emigration of thecountry’s most talented.
Philosophical differences between individuals may well leadto different views on where the trade-off lies, but a tax-benefit system shouldnot be designed on the basis of a single criterion. It should have a smallimpact on economic efficiency, be equitable, and have low administration andcompliance costs. The flat tax â€“ GMI system proposed above scores highly onall of these criteria.