EMTR 2: Sole parent, 2 kids, impact of additional hourly wage

This post is by PaulL, a regular commentor and occasional contributor.   It is the fourth post in a series on the financial incentives to work and the impacts of our tax and transfer system on household formation.  The index to all posts in the series can be found here.

This post extends the previous example, if you haven’t read that then you can find it here.  I won’t repeat information from that post.  In this scenario, that same household has the sole parent working 20 hours per week.  The question is whether that person should pursue a pay rise from their boss – what difference would it make to their income?

Getting a pay rise usually means that you would have additional duties or work harder.  You might also need to undertake some training (perhaps in your own time), or work harder or smarter to improve your productivity. 

The graph is similar to that from the previous post, but this time we’re graphing the change in the person’s hourly pay rate, and the resulting impact on their household income.

Since this household is only working 20 hours per week, there is no child care subsidy needed nor provided.

If this person invests in increasing their productivity and pay approximately 83% of their increased income is captured by the government, up till around $47 per hour. 

At $47 per hour their benefit is fully abated, and only family tax credits and accommodation supplement are abating.  However, because the benefit is fully abated, the in work tax credit kicks in, and gives a bump in income.

From $47 to $70 per hour, the government takes 82% of their increased income.  

The return to doubling their hourly rate from $21 to $42 is to move from $976 a week income to $1,046 a week income.  $420 of extra earning turns into only $70 per week extra in the hand, with the government pocketing the other $350.  

The reality for this part time worker is that it makes little difference to this household what their hourly pay is.  Their household income is only very slightly related to their hourly pay rate.  In that situation, what incentive does this employee have to improve their productivity if that requires them to undertake training (in their own time), or take on a more senior job with more stress?

This chart also provides insight into what happens for this household when the minimum wage is increased. For this household 83% of the increase in the minimum wage actually flows to the government in taxes and clawbacks. This household is a perfect example of the type of household we’d typically talk about when increasing the minimum wage – a single wage earner with two dependents. And yet, that minimum wage increase costs business a lot of money, most of that money flows to government. When we increase costs on an employer with most of the money flowing to the government, we’d typically call that a tax.

For completeness, I’ve provided the same graph for a person working 40 hours per week. I consider it unlikely that a sole parent household with a child under 5 would work 40 hours a week. If they did, the analysis is as below.

At 40 hours per week, this household is entitled to childcare subsidy. Again the abatement rates are high, but this time there are also steps in the childcare subsidy abatement that mean net income drops as those thresholds are reached.

Beyond $39 per hour the benefit and supplement abatement finishes, and then normal tax rates of 33% apply. Interestingly this family never faces the 30% tax rate, as they are still receiving benefits and allowances (and facing abatement rates) until beyond the threshold for the 33% tax rate.

For a full time worker, it makes little difference what their hourly rate is from minimum wage up to roughly double the minimum wage ($40 per hour). Beyond that point, investing in productivity starts to make sense, you face only the normal tax rate.

Again, we can see that the tax and transfer system has very substantially reduced the incentive to increase hourly pay (within normal ranges).  Pay rate is what employers often use to indicate to people that they are becoming more productive – senior staff are paid more than junior staff, staff who are promoted would expect to receive higher pay.  If these price signals are broken, what lever are employers using to encourage their staff to become more productive?

The productivity of a country as a whole is really just the sum of the productivity of the people in that country. If significant chunks of our population have no incentive to invest in improving their productivity, because it makes no difference to their income, does that impact our national productivity and wealth?