Monday, January 17, 2005

poverty and tax: effective marginal tax rates.

Effective marginal tax rates as a potential disincentive to work are certainly a problem, and have long been recognised as such, by both sides of the game. The problem is, as Gavin Wood points out, the question of the effects of tax arrangements on poverty (and housing) are frequently put in the too hard basket in the political arena. I feel that part of this problem is that people are only thinking about the initial effects of the tax system, and are not considering the interaction between the tax system and welfare regimes. This is where effective marginal tax rates come into play.

Gillian Beer defined effective marginal tax rates as “the percentage of [a] one dollar increase in private income that is lost to income tax and income tests on government cash benefits”. So, as someone on the dole earns more and more money, the benefits they are receiving decrease, as shown by the red line in the picture below.

This also affects the rate at which their total income (welfare payments plus earned income, shown by the blue line) increases. So when a Newstart recipient’s fortnightly earned income goes over $142, they only pocket 30 cents in every dollar they earn — an effective marginal tax rate of 70 per cent.

Here, the red line shows the relationship between welfare payments (w) and earned income (Y) — as earned income increases, payments can be seen to decrease. The blue line shows the relationship between earned income and total income (earned income plus payments).

Other payments (such as Family Tax Benefits and Rent Assistance which would increase the initial level of payments above $394.50) can lead to other reductions in welfare benefits.

Now, if you are in this position, then are you really going to go out and bust your ass, in a job that you find particularly uninspiring, that has little prospect of further development, when you are only going to pocket 30 cents for every dollar you earn? That, my friends, is called a poverty trap — there is very little incentive to go out and get off the dole. People in the situation are facing an effective marginal tax rate that is far greater than those in the upper brackets.

The main reasons for getting into this were that (i) these lads (whose blogs I enjoy reading) were arguing about the proposed LDP income tax system; (ii) I felt like working out what was happening here (I am bored) and (iii) I thought I should write something today, although I just have to hurry up and get this done, now.

The LDP propose some reforms to try and deal with problem of high effective marginal tax rates. This scheme is not radical — the idea has been around for ages in one form or another.

But it would be tough to get it to work, and there are a number of problems with the proposed system. Notably, there are no equivalence measures (ie. different payments for different family structures) that are described. They also provide no description of the rate at which they would withdraw benefits and the rate at which they would tax. The impression I get is that it is a linear (flat rate) which would lead to something looking like this:

In this figure, p represents the welfare payments received, and where the blue intersects with the horizontal (income) axis is the point where you receive no payments and pay no tax. The LDP set this at A$ 30 000.

I like the smooth transition from receipt of welfare to income payments (ie. negative welfare receipt), which does make for more acceptable effective marginal tax rates. However, this basic model is not progressive — it taxes everyone at the same amount.

I would prefer a model that looks a bit more like this:

Here the effective marginal tax rate is low for welfare recipients and steadily increasing as it progresses into negative welfare benefits (income tax). I have put two lines in there because you need to adjust the point at which the curve intersects the horizontal axis according to family structure (ie. move it to the right as the size of the family increases).

Anyway, I need to get on with stuff. This article looks as though it would be useful to read about effective marginal tax rates in Australia, if you want to know more (although it is a bit dated).


At 11:02 PM, Anonymous Anonymous said...

There are no equivalence measure in our tax plan.

Each individual is treated separately (and has a tax-free threshold of 30,000) whether married, defacto, single, living in a harem or whatever.

There's no reason why husband + wives should get tax breaks that flatmates do not.


At 9:34 AM, Blogger gringo said...

There are implicit equivalence measures, such as the Family Tax Benefit (A and B). Not forgetting your $3 000 bonus courtesy of Costello, if you pop out a pup!

Fair enough, I agree that husbands and wives should not get tax concessions that flatmates don't. However, I do think that you need some sort of measure to deal with the added costs of raising a child. That's where I would like to see the scale shift to the right. Also - I have no conflict of interest in arguing this. I have no kids. Although I could do with the 3 G's...

At 9:38 AM, Blogger gringo said...

What I meant to say was that there are equivalence measures in the current system, and I think that they are justified, to some extent.


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