Adding complexity, taxes the issue of equity – Part 1

More sensible than the Government’s Stage 3 tax cuts would be the approach put forward by the Henry Tax Review of an explicit and high tax threshold and no means-tested ‘tax offsets’.

The Morrison Government may be extreme in its short-term ‘transactional’ approach to policy decision-making, but it is by no means alone in ignoring the need for simplicity and coherence in the tax and transfers system.

As governments have made the tax and transfers system increasingly complicated, it is getting more difficult to provide an overview of the distributional impact and the rationale of either the system as a whole or of incremental change proposals.

Equally, too many commentators are blinkered by their  political agendas, looking only at particular parts of the system, or only at marginal winners and losers, not the overall impact.

A system-wide assessment suggests the budget measures are nowhere near as bad as some commentators suggest, but also nowhere near as good as they might have been.

Traditionally, three attributes were regarded as essential for a coherent tax system; these equally apply to the whole tax and transfers system:

  • Equity: to protect those in need and to tax according to capacity to pay;
  • Efficiency, particularly economic efficiency: to ensure there are appropriate rewards for working and saving by avoiding excessively high marginal tax rates (administrative efficiency was also important); and
  • Simplicity: ensuring people can understand the system and can make rational, informed decisions including over work, consumption and saving.

Using these desirable attributes of the system as a whole, the following explores three elements of the system that are the subject of debate over the 2020-21 Budget: personal income tax, JobSeeker unemployment payments, and family assistance and child care. Personal income tax will be addressed below, while Jobseeker and family assistance and child care in Parts 2 and 3.

Personal income tax: The Government’s three-stage plan

I highlighted last year how Stages 1 and 2 of the Government’s tax changes broadly compensated for bracket creep over the period to 2022-23. That conclusion was consistent with the analysis by the ANU Centre for Social Research and Methods.

But Stage 1 was unnecessarily complex, relying on the Low Income Tax Offset (LITO) and a new Low and Middle Income Tax Offset (LMITO), each with its own ‘means test’ rules often imposing higher effective marginal tax rates than the tax scale suggested. Those offsets are a complicated way of increasing the tax threshold (and the following tax point) but apparently have a political advantage by highlighting specific tax cuts at specific income levels.

Stage 2 demonstrated the possibility of simplifying the system by replacing the LMITO with appropriate adjustments to the tax scale, but it simultaneously increased the LITO and made its ‘means test’ more complicated.

Budget measures add  complexity to the tax system

The budget measures involve bringing forward Stage 2 while retaining the LMITO for 2021 only. Representing this as a single composite tax scale as I did previously for Stages 1 and 2 would reveal an even more complex arrangement. Very broadly, it involves a one-off increase in the tax threshold this year (from $21,884 to about $23,226) and a whole array of marginal tax rates between $37,000 and $126,000, as low as 16.5% over some income ranges and as high as 40% over other income ranges.

Bearing in mind low (if any) wage increases and the bring-forward of Stage 2, this now represents tax cuts beyond compensation for bracket creep at nearly all income levels.

Looking at Stages 1 and 2 together (which I believe is appropriate), the 2020-21 arrangement does not unduly favour high income groups, and does provide reasonable tax cuts at low incomes, but at the expense of unnecessary complexity and some relatively high marginal tax rates for many low and middle income earners. (Whether any tax cut is preferable to increasing welfare payments in the current economic context is a separate question.)

Low- and middle-income groups face tax hikes next year

Apart from its complexity, the main weakness is that the effective increase in the tax threshold will be reversed in 2021-22, increasing tax for those on low incomes next year (and for many middle income groups with the withdrawal of LMITO).

Moreover, the Stage 3 reductions legislated to take effect from 2024-25 do not increase the threshold either, and provide by far the biggest gains at high incomes (with the 32.5% rate from $45,000 dropping to 30% and applying up to $200,000, not Stage 2’s $120,000 with 37% thereafter).

A more sensible approach would be a high tax-free threshold and no tax offsets

More sensible than the Government’s Stage 3 would be the Henry Tax Review approach of an explicit and high tax threshold and no means tested ‘tax offsets’ at all.

This approach could avoid the relatively high marginal tax rates at low and middle incomes caused by the LITO means test, as well as reducing the number of tax steps (as the Government desires) with the vast majority of taxpayers facing a standard marginal rate no higher than 35%.

Equity would be achieved by a further substantial (and transparent) increase in the tax threshold, as Henry recommended. A threshold of around the level of the age pension would increase coherence across the tax and transfers system, setting an income level below which personal tax was not payable broadly similar to that used for poverty alleviation in the social security system.

A step towards such a Stage 3 could be implemented in 2021-22 by making permanent the effective increase in the tax threshold to occur in 2020-21.

This article was first published by the Tax and Transparency Policy Institute

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Andrew Stuart Podger, AO is a retired Australian senior public servant. He is currently Professor of Public Policy at the Australian National University.

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