The amount of tax we pay on any given income depends on two things - tax rates and tax thresholds. Although tax rates have declined in Australia over the last 20 years, most of us are losing a bigger slice of our incomes in tax than ever before. This is because tax thresholds have not kept up with inflation. This has affected taxpayers at all levels of income.
In 1980, you did not start paying the top rate of tax (which was then 60 per cent) until you earned around $35,000 - nearly three times the average income at that time. Today, however, we start to pay the top rate (47 per cent) on earnings just one and one-third times higher than the average. Australia today not only has one of the highest top tax rates in the whole of the OECD - it also levies this top rate at a lower income than almost all other advanced industrial nations. The top rate of tax starts at A$83,000 in France, A$84,000 in the UK, A$98,000 in Germany, A$115,000 in Canada and an astonishing A$549,000 in the USA. In Australia, following John Howard’s latest concessions, it cuts in at just A$70,000.
If “bracket creep” has made things bad at the higher end, its impact on the basic rate of tax has been devastating. In 1980, you did not pay any tax at all until you earned $4,041 per year (one-third of average earnings). Wages have gone up by 350 per cent since then, but the tax-free earnings threshold has only risen by around 50 per cent, to $6,000 (less than one-seventh of today’s average earnings). Every worker now therefore pays tax on a much bigger proportion of their earnings than they used to. Had the 1980 personal threshold of $4,041 kept pace with earnings, it would now be over $14,000.
There is a strong case for restoring the value of the tax-free threshold to its 1980 level, because workers should be allowed to earn and retain at least a subsistence income before any tax is taken away from them. We can define the subsistence level as the minimum amount somebody would receive if they were unemployed and living on welfare benefits. A single person on the lowest level of welfare payments would receive $12,567. It follows that, if we want to allow people to earn and retain their own subsistence income before they start to pay tax, the tax-free threshold should be raised at least beyond $12,567.
Because the value of the personal tax-free threshold has slipped to less than half what a single unemployed person gets in income support and rent assistance, the government now takes money away from us long before we have secured our own basic subsistence. Inevitably, it then has to give much of this money back again in welfare payments so those on lower incomes can maintain themselves and their families. This “churning” makes no sense, and it should be a priority for any tax reform to reduce or if possible eliminate it.
Raising the tax-free threshold above the welfare floor is an essential first step in reducing churning and restoring incentives and the principle of self-reliance to the income tax system. But on its own, it is not enough, for even a tax-free income above $12,500 is insufficient to maintain more than one person. Clearly, where workers are earning a wage or salary which is supporting more than one person - for example a spouse, and or dependent children - a more generous tax-free threshold is required if they and the rest of their family are to achieve self-reliance.
The welfare system recognises this, for the minimum income support payable to a non-employed couple is $20,169, 61 per cent higher than that for a single person. When there are children in the household, this minimum payment rises even higher. But the tax system remains blind to the scale of family needs - individuals are taxed without regard to the number of people expected to live off the income.
To bring the tax system into line with the welfare system, we would need to allow family members who do not earn a wage or salary to transfer some or all of their tax-free entitlements to other family members who do so that they can earn a family subsistence wage before they start to pay tax. The case for doing this was recently compellingly set out in a paper by Terry Dwyer, The Taxation of Shared Family Incomes (pdf file 512kb).
Dwyer points to the contradiction between a welfare system that assesses needs at a family or household level, and a tax system that treats individuals as distinct income units and which takes no account of the number of people who eventually share that income. He says the tax system is both inequitable and inefficient.
It is inequitable because it ignores the question of how many people have to be supported from any one individual’s earnings. The welfare system recognises that, say, a family of two adults and two young children needs a bigger income than a single person household, but the tax system is blind to this. A single earner in a family of four starts to pay tax on earnings beyond $6,000, just as a single earner living on their own does. But the former is sharing his or her income with three other people - his or her other family members are the ultimate recipients of a large chunk of the income, but they are not recognised for tax purposes. The earner therefore carries the cost of supporting four people, but can claim only one tax-free threshold.
Dwyer points out that this situation is also inefficient, because it skews people’s preferences and behaviour. For example, the tax system creates an incentive for both partners in a family to go out to work, even if one would prefer to stay home. This is because it makes more sense for two people each to earn an average income than for one to earn a high income and share it with his/her spouse. Two earners will each receive a tax-free threshold and will only pay a basic rate of tax on the remainder, but a single earner will receive only one threshold and will get taxed at higher marginal rates on the additional income earned.
In recent years, the federal government has tried to counter some of the inequity and inefficiency in the income tax system by giving certain categories of families a welfare top-up. Family Tax Benefit, Part B, for example, is paid to families where there is only one earner to try to compensate them for the disadvantages they suffer through the tax system. The result, however, is a tangle of money transfers in which people get tax taken from them only to have some or all of the cash returned in the form of welfare payments. This is not only costly - it is also wrong in principle. We should not be taxing families until they have secured their own subsistence - and a family’s subsistence level will be higher than it is for single people or couples without dependent children.
In his paper, Dwyer explores the various ways in which the tax system could be reformed to recognise shared family incomes. He comes down in favour of a voluntary system in which family members can choose whether or not to pool part or all of their incomes for tax purposes, and he list various ways in which this might be done in practice.