A better personal income tax and benefit system
While tax cuts are a topical issue, in this article we take a step back and instead look at what a better tax-benefit benefit system could look like. Just as with the current system, the size of government could be as big or as small as society desires, but the debate around tax cuts would be much clearer than some of the vacuous comments we hear from politicians and the dubious findings of badly constructed opinion polls.
Take a family with two children, both aged under 13. One partner works 37 ½ hours per week and earns $40,000 per year. The other works 12 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 net income rises to $47,555, an increase of only $457. The implied tax rate on that extra $1000 of earnings – known as the Effective Marginal Tax Rate (EMTR) – is a monstrous 54.3%. This is higher than the top marginal income tax rate of 39% which kicks in at $60,000. Is that fair?
This example is not unusual. Punitive EMTRs are widespread in our tax-benefit system. They are the insidious result of a system that is not properly integrated – a system whose designers pretend to look after the poorer members of society, but who actually have not thought through the longer run implications of their system for both economic growth and the welfare of the very people they are ostensibly concerned about.
High EMTRs come about because of the interplay between income linked benefits, progressive tax rates, and in some cases the taxing of different types of income at different rates. The very worst EMTRs can be avoided by welfare payments that reduce only slowly as income rises, but this extends 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 personal income tax combined with a universal Guaranteed Minimum Income (GMI) provides income support but ensures that the EMTR is always the same as the tax rate. Consider the following purely illustrative example where the rate of income tax is 25% and the GMI is $10,000.
Tax is paid on every dollar of market income (wages, interest, etc) at a universal rate of 25%. However, because of the minimum income guarantee, one receives more from the government than one pays in taxes until market income reaches $40,000.
The real strength of the system is that all of the major social welfare benefits (Unemployment, Sickness, Invalids, Domestic Purposes and NZ Superannuation) would all be rolled into the GMI. If you lost your job or became ill, or were too old to work, you would automatically receive the $10,000. No application forms, no means testing. Society guarantees you a minimum income irrespective of your circumstances. Asunder the current system, there is nothing in this system that prevents additional payments for specific needs such as wheelchair access for the disabled. The important point is that such additional support is not linked to income.
Other advantages include:
1. It removes the incentive for people to arrange their affairs to lower their tax – income splitting or setting up trusts. (Note that the tax rate on corporate income and trust income should also be 25%.)
2. It avoids decisions about partnering and marriage being driven by tax and benefit policy. The GMI is an individual entitlement for all from say age 18.
3. It substantially reduces the government’s administration costs and individuals’ compliance costs, and hence improves the efficiency of the economy.
4. It creates real incentives for most people to earn income beyond the GMI, leading to increased economic growth and higher real per capita incomes.
5. If provides a cash income to non-earning spouses and carers.
6. It increases the transparency of fiscal policy raising the GMI would be difficult without an increase in the flat rate of tax. Tax cuts would be difficult without reducing the GMI. Perhaps this transparency is why politicians won’t like it.
Clearly the flat tax rate and the GMI should not be so high as to discourage work and effort, but the GMI should be sufficient to provide for basic living costs. There is no gain to society from miserly welfare benefits that force the poor into crime and raise expenditure on security, police and prisons. Equally, there is no gain to society from high EMTRs that destroy the incentive to be productive and lead to huge amounts of resources being allocated to tax avoidance and tax compliance, and to emigration of the country’s most talented.
Philosophical differences between individuals may well lead to different views on where the trade-off lies, but a tax-benefit system should not be designed on the basis of a single criterion. It should have a small impact on economic efficiency, be equitable, and have low administration and compliance costs. The flat tax – GMI system proposed above scores highly on all of these criteria.