Income tax and welfare payments are very complex in Australia. As testament to this, the government is adding 1000 call centre staff to handle Social Security questions from the public but I fear that the number is not enough. Last year, we had Centrelink’s bungled robodebt recovery system which made tens of thousands of mistakes. Why are these systems so complex?
Income tax is very complex because it is trying to be both a revenue system and an income redistribution system, via:
- Progressive tax scales
- The tax-free threshold
- Medicare levy exemptions
- A variety of rebates and concessions for people in different circumstances.
- Low-income tax offset
Social Security is very complex because:
- Qualification criteria concerning income, assets, age, personal circumstances, spouse’s circumstance, rent paid, dependents etc. interact to produce results that are unpredictable, may shift rapidly, require constant reviews and often lead to over-payments.
- Each benefit has to be withdrawn as income rises and that inevitably leads to high effective marginal tax rates. To avoid situations where rising income actually leads to some people getting less disposable income, additional rules and exemptions are created in the structure of each payment. Again, there is the possibility of over-payments, requiring special measures for recovery.
Effective Marginal Tax Rate (EMTR)
EMTR is the combination of marginal tax rates and the rate of withdrawal of benefits.
The most glaring failure of the existing system is that, unbeknownst to most taxpayers, it is the lower paid workers who often face the highest marginal tax rates. (EMTR can approach 100% of additional income in some income ranges for certain family types.)
There ought to be a way to administer both income tax and welfare in a simpler manner that is still fair, so what principles would underlie this?
- Let the tax department take care of revenue collection
- Let Centrelink take care of redistribution
- The system should be fair, predictable, understandable and its operation transparent.
- The system should not discourage participation in the economy.
Let’s consider some desirable features of such a system.
- Remove the so-called class war that many in Canberra attribute to the other side of politics whenever personal income tax or welfare payments are debated.
- Ensure that effective marginal tax rates are never higher for low-paid workers than those on higher incomes.
- Treat everyone equally when deciding tax rates.
- Remove poverty traps whereby poor people have a disincentive to improve themselves.
- Take account of a person’s assets when deciding how much assistance they receive.
- Consider as many circumstances as possible to determine that assistance.
- Treat everybody equally when deciding assistance.
- Provide people with an incentive to declare their income accurately.
- Ensure no one has an incentive to change their circumstances or rearrange their affairs in order to avoid tax or gain welfare.
- No one gets penalised for failing to rearrange their affairs.
Let’s consider a strategy that can capture the desired results.
- Tax almost everyone at the same marginal rate – a flat proportional tax. That must be fair.
- Pay everyone the same welfare payments based on their circumstances – universal payments. Same rules for everyone.
- Pay the same welfare to all, regardless of income. Changes in one’s income do not affect the amount of welfare.
- Add wealth to the list of circumstances that determine one’s welfare payment. Importantly, we must include the family home in the calculation of wealth. Have an age-based threshold of wealth and only wealth above the threshold affects the payment.
- Include income tax previously paid as a circumstance in order to boost the welfare payment of those that have contributed.
The result would be a very simple income tax system, with just two rates – one for ordinary people and one slightly higher for the very well-remunerated. The vast majority of ordinary people would pay the same basic marginal tax rate on all income and there would no longer be a tax-free threshold.
Factors affecting welfare payment
Social welfare would be simpler too. It would never have to take account of someone’s income, but would take account of some basic demographic information. Here are the major ones:
- Household type: 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.
- Under twenty-five living at home.
- In education.
- Total net wealth – above an age-based threshold.
- Number of children qualifying.
This seems like a long and complex list, but these items are already in many social security calculations. Moreover, it is far simpler not having to account for changes in income. Note that rent payments will not need to be included as a circumstance as this will be implicitly captured by a person’s wealth and employment status has disappeared from the list as it becomes irrelevant.
What would it be like in operation?
The amazing thing, when you apply this method of flat tax and universal asset-tested payments, is that the result is quite similar to the existing complex arrangements in terms of disposable income, but without the complexity, the loopholes and the confusion. Above all it is fair.
Compare three working families
Suppose the flat income tax rate was set at 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 (97% of gross.)
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%)
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. If the combined threshold is $500,000 and family two has assets of $1.5 million they will lose $6,000 from their welfare payment so their net income is $154,000 (77%.)
Family three has $5.0 million in assets above their threshold, so they will lose all of their welfare payment. Their net disposable income drops to $252,000 (63%.)
The changes in peoples’ circumstances, including net wealth, produces an intuitively fair and reasonable change in their overall tax burden and welfare benefits.