Let’s consider a couple of propositions.
- What if… we taxed all income, from the first dollar, at the same marginal rate?
Or
- What if… we gave welfare to everyone, regardless of their income?
You can imagine the reaction to each proposition – “You must be mad, that would never work!”
- But, what if we do 1 & 2 at the same time?
Now, that becomes interesting because it turns out we get some very desirable results.
- Surprisingly, for the vast majority of taxpayers and welfare recipients, the final disposable incomes of people under the new system are very similar to the current complex arrangements. How can that be? I did the arithmetic and can assure you that its true. You can do the arithmetic and find it is indeed the case.
- This is because we remove the ‘welfare’ component currently built into tax rates (like tax-free thresholds, low marginal tax rates, Medicare exemptions and low-income rebates) and that’s a good thing because…
- We can target the actual welfare payments better than we can with tax-free thresholds or low marginal tax rates or the low-income rebate.
- We can eliminate poverty traps because now everyone has the same incentive to earn money and enjoy spending it. We eliminate high effective marginal tax rates (EMTR) and we encourage participation in the workforce for everyone.
What else does it do?
- We can remove the phrase, ‘class warfare’ from any discussion of taxation or welfare. How? Everyone will have the same basic entitlements and obligations. No one can complain that any group is not doing its fair share of lifting.
- We also get the opportunity to factor in wealth, via an asset test on the welfare payment, to determine a person’s final disposable income.
- We can remove all the fuss about low Newstart and all the anguish of recovering over-payments from the welfare system when mistakes are made. We can actually reduce Social Security complexity to a minimum and thereby reduce the staff required to manage it. No one has to apply for anything – ‘welfare’ as a concept becomes obsolete.
Anything else?
- We would factor in the family home as part of the asset test, so that we can distinguish a mansion in Vaucluse from a flat in Cabramatta.
- We can give everyone an age-related threshold of wealth, below which it doesn’t affect the welfare payment, as everyone accumulates their own wealth (total net assets) over their lifetimes.
- We need to factor in previous tax paid, so that people have an incentive to declare income and pay tax.
- We can effectively eliminate the need for complex tax and financial planning advice because all assets count and all assets are treated equally.
What would the marginal tax rate need to be?
I estimate that the marginal tax rate would be in the high 30s, say 37% or 38%. This would need to be modelled to determine the best result. There would be another higher rate, say 45% for very high incomes. Why? Didn’t I say they’d all be the same? We would have a higher rate for very high incomes because these people are probably no longer getting the welfare payment and we want to reintroduce progressiveness at that point.
What would the factors affecting the welfare payment be?
- Just existing qualifies a person for a basic payment, after which it is adjusted for…
- Household type and one’s position within the household: single without dependents, single with dependents, couple with dependents, couple without dependents, in foster care etc.
- Age – child, adult and aged.
- Disability – a variety of disabilities with a variety of payments.
- Carer – related to the disability.
- Tax paid in prior period – a formula based on previous tax paid up to a limit.
- Being in education would raise the rate.
- Total net wealth – above an age-based threshold – would lower the rate.
- Number of children qualifying – the welfare payment for additional children diminishes as the number of qualifying children grows.
What would the age-based threshold be?
The threshold would be zero for 0 – 15 years but then grow by $6,000 per annum until the age of 65. A person aged 65 would have a $300,000 threshold. A single over 65 would have their threshold doubled.
Here are some examples, to show how the factors relate.
Consider three similar working families with two adults and two children. The only difference between them is their incomes. Assume that the flat income tax rate is 37%.
Family one has two adults and two children with a combined income of $100,000. They pay $37,000 tax. Each adult gets a welfare payment of $10,000 and the children get welfare payments of $5,000 and $3,000 respectively. Because each adult paid tax in the preceding period they get an additional payment of up to $3,000 each. Ultimately, their net disposable income is $97,000 (i.e. 97% disposable income from gross income.)
Family two with a combined income of $200,000 will pay $74,000 in tax and receive the same welfare payments of $34,000. Their net disposable income is $160,000 (80%.) Family three with $400,000 income has a net disposable income of $286,000 (71.5%) (Refer to column one in the table below.)
As you can see, the proportion of disposable income declines as income rises, which is a progressive system. In each case, high or low income, the families have equal incentive to earn money.
Add wealth into the equation
Now add wealth into the equation. The welfare payment reduces by 0.6% of each family’s wealth over an aged-related threshold. (Let’s assume the combined threshold is $500,000 for each family.)
Family one is under the threshold. Family two has assets of $1.5 million so they lose $6,000 from their welfare payment and their net income is reduced to $154,000 (77%.) Family three has $6.2 million in assets, so they will lose all of their welfare payment. Their net disposable income drops to $252,000 (63%.) (Refer to the diagonal in the table below.)
The changes in peoples’ circumstances, including net wealth, produce an intuitively fair and reasonable change in their overall tax burden and welfare benefits.
Disposable income as a percent of gross income |
Income\wealth over threshold |
$0 |
$1.0 million |
$5.7 million |
$100,000 |
97% |
91% |
63% |
$200,000 |
80% |
77% |
63% |
$400,000 |
71.5% |
70% |
63% |
Summary
A flat tax is fair because it affects everyone in the same proportion and gives everyone the same incentive to earn income. Current low marginal tax rates for low income earners are a lie, as it can be shown that low-income earners actually face the highest effective marginal tax rates and so have the strongest incentives to limit participation in the workforce.
A ‘welfare’ payment can be targetted far more effectively than any distributional features built into the tax system. The current tax-free threshold benefits both wealthy and poor in a blunt and non-specific way. A welfare payment can take account of a multitude of verifiable circumstances, including net assets.
When a flat income tax applies to almost all income earners and a welfare payment is paid to all under the same set of qualifying conditions then we approach an almost ideal combination of fairness and efficiency.