Sort out the tax system!

Tomorrow’s federal budget must address two key problems: the work disincentives created by an onerous income tax system, and the dependency culture fostered by a bloated welfare system.

On tax there is now a clear consensus across the ideological spectrum that we must stop penalising people when they try to improve themselves.

Business groups like the ACCI say it is more important to fix the problems in personal taxation than to reduce corporate taxes.

Australian Workers Union leader, Bill Shorten, thinks “our rotten tax system needs root-and-branch reform” in order to improve incentives for the middle class as well as for low income workers.

ACOSS believes the tax system penalises those who seek to move from welfare into work.

Labor’s Lindsay Tanner urges the Government to “give its surplus funds back to Australian taxpayers,” and his colleague Craig Emerson thinks a tax revolt is “just a matter of time.”

At times it has seemed the only people in the country who do not favour radical tax cuts in the coming budget are John Howard and Peter Costello.

As I have argued in the past, there is a strong case for raising the tax-free threshold above the welfare minimum floor so that people do not start to pay tax until they have earned their own subsistence. Had it been indexed to wages, the threshold today would be over $14,000, yet workers begin to pay tax at $6,000. The Australian Democrats have endorsed the idea of raising the threshold, and some Liberal backbenchers also see the logic in this proposal, but the argument is being muddied by misleading government statements.

The Government likes to claim the tax-free threshold is “really” much higher than $6,000 because families with children can claim tax back in the form of the family tax benefit (FTB). In his speech to the Menzies Research Centre on May 3, the Prime Minister claimed: “A family on a single income of $35,000 with two dependent children … pay no tax until their income reaches $41,808. Some dual income families with two children now enjoy the equivalent of a combined tax-free threshold of up to $43,000 a year.” But this is misleading.

FTB is a welfare payment, not a tax reduction. Recipients pay tax and are then given government payments to make up the income they have lost. Ninety per cent of FTB claimants collect this money as fortnightly payments, just like any other welfare transfer. And like other welfare payments, FTB is means tested - its value declines as earnings increase. If it really were the case, as Mr. Howard claimed, that a family with two children on an income of $35,000 “pay no tax until their income reaches $41,808,” then they would obviously pay no tax on the next dollar they earn. In reality, they pay 30 cents income tax on that dollar, as well as losing 20 cents in FTB entitlement. Furthermore, to be eligible for FTB, you have to have children - singles and childless couples get nothing.

The point about an increase in the tax-free threshold is that it is not means tested (so unlike FTB it does not penalise people when they increase their incomes). It also applies to every worker, not just those with children. And it involves leaving people with their own money rather than taking it away in tax and then returning it as a welfare payment (so-called “churning”). When it comes to promoting independence and self-reliance, a dollar earned and retained is worth much more than a dollar handed out by the government.

In addition to raising the tax-free threshold to improve work incentives at the lower end of the income scale, there is also a compelling case for lowering the top marginal rate at the upper end. Australia has one of the highest top marginal rates in the OECD cutting in at one of the lowest income thresholds (just one and one-third average income).

Some academics claim this doesn’t matter - that successful people will not be deterred from working harder (or from coming to or staying in Australia) by punitive taxes like this - but this seems doubtful. CIS will shortly be publishing a paper by Alex Robson which estimates the cost of tax (in terms of output foregone) as at least 120 per cent. In other words, every extra dollar the government takes costs $1.20 in lost output as people are deterred from working harder.

On the fringes of the western world, a movement is growing in favour of flat taxes. Russia and several of the former satellites of the USSR have already adopted a low, flat income tax, and this will soon start to resonate in the richer, high-tax, high-welfare countries of western Europe (France and Germany are already whining about “tax dumping”). Unlike Australia, where the tax take has risen, most western countries have been flattening their tax structures (and lowering their rates), and Alex Robson shows that the biggest tax cutters have been growing their economies three times faster than the rest. The international pressure against high marginal taxes is only going to grow in the future, and the smart thing for Australia to do would be to get in front of the game rather than lag behind it.

Besides, why should people earning $80,000 give up nearly 50 cents in every additional dollar they earn to the government? In his Menzies Centre speech, the Prime Minister boasted of his “defining philosophic commitment” to using the tax system to bring about a redistribution of income, to “tilt the playing field in favour of low and middle income families.” But why (other than pandering to the politics of envy) does he believe in this as an objective of fiscal policy?

Once we have ensured that those at the bottom have sufficient, why do we think it appropriate to keep taking more from those at the top? A belief in meritocracy - the opportunity for all Australians to compete to achieve the best they can - is a worthy objective for a Liberal leader to espouse, but it is inconsistent with Howard’s apparent commitment to egalitarian redistribution. If you believe in meritocracy, you should be happy to see hard work and talent fully rewarded, rather than trying to claw the rewards back in higher taxes.

Until recently, Messrs Howard and Costello were letting it be known that they had no interest in cutting personal taxation, but the pressures on them are beginning to tell, and on budget night we may well see a tweaking of the rates and fiddling with the thresholds. But much more than fiddling is needed to put our tax system right, and it seems the government has the financial wherewithal to make a start on radical reform.

Some economists claim that an anticipated $10 billion budget surplus cannot be handed back to those to whom it belongs - the taxpayers - because this could stoke up inflation and trigger further interest rate rises. This is thought to be one reason why Costello is keen to funnel the surplus into a new “Future Fund” to be used to cover the unfunded superannuation of Canberra’s public servants. But if the retirement pensions of the Canberra bureaucracy are going into the red, why should private sector taxpayers (who mainly enjoy much less generous pensions) be expected to foot the bill? Any shortfall in Canberra’s super liabilities should be funded by imposing efficiency gains in Canberra, not by penalising taxpayers.

If there is a concern to avoid inflating demand by giving back the whole of the surplus in tax cuts, some of this money could be diverted into cutting the tax levied on superannuation payments. We are the only country in the western world that taxes contributions before they even get into a super fund, as well as taxing profits while the money is in the fund and taxing the money when it is finally withdrawn on retirement.

If you dare to become a higher rate taxpayer, you will also pay a surcharge on top of the contributions tax! If Mr Costello really is worried about how the country will cope with an ageing population, one obvious step he should take would be to encourage rather than penalise retirement saving by slashing taxes on super. This would have virtually no impact on current inflation since the money would go into savings rather than consumption.

Tuesday night’s budget is also expected to have something to say about welfare payments. Here, if the press reports of recent weeks are to be believed, the Government is certainly moving in the right direction.

There is a serious problem with the disability support pension which needs fixing. The pension has evolved into an early retirement scheme, and the expected move to tighten eligibility rules is sensible (although it should be made retrospective if it is to have much of an effect on the overall numbers). There is also no justification for allowing single parents to remain dependent on welfare right up until their youngest child leaves school. I have argued for some time that we should come into line with the Europeans on this and require at least part-time work participation once children start school, and it is to be hoped that the Government does not backtrack on this in the budget announcement.

The only problem I have with the anticipated reforms of income support concerns the way ministers appear to be justifying their proposals. We have heard a lot lately about labour shortages at all skill levels, and welfare-to-work initiatives are being touted largely as a solution to this tight labour market. I find this reasoning unconvincing.

For a start, there are still shortages of jobs for lower-skilled workers in at least some sectors of the economy and in some parts of the country, and many of the people currently on welfare are not the kind most employers are looking to recruit. Moreover, the case for welfare reform does not depend on there being a labour shortage - we should be trying to keep the welfare rolls down even if there were a labour glut.

The real case for welfare reform is twofold. First, it is unfair that low-paid workers have to pay so much tax to support people just like themselves who remain on welfare but who could be working. If people are capable of working and earning a living for themselves, rather than living off the earnings of strangers, then it is better they do so.

Second, it is better for claimants themselves that they should be in work. We now know, for example, that single mothers living on benefits are spending an average of 12 years in the welfare system. In this time, they lose the skills they may once have had, they lose the habit and time-discipline of working, they lose self-esteem and the respect of others, and their children lose out by failing to grow up with a responsible adult role model who goes out to work each day to earn the family income.

These are the compelling, moral arguments for welfare reform. Getting people off welfare and into work (even low-paid, low-skilled, low-prestige jobs) is fairer on working taxpayers, and it is better for claimants themselves. If there is a strong labour market case for welfare reform, that is a bonus - but it is not the key issue.