Changes to Tax Rates or Thresholds

This post is by PaulL, a regular commentor and occasional contributor. It is the twelfth post in a series on the financial incentives to work and the impacts of our tax and transfer system on household formation, and the fifth post on the “what could we do” subsection. The index to all posts in the series can be found here.

If a tax free threshold isn’t a solution to incentives to work, are there changes to tax rates and thresholds that could improve incentives? The two biggest contributors to the effective marginal tax rate for those coming off a benefit are the benefit abatement itself, and the tax rate that they’re on. Today we look at the tax rates and thresholds.

For our sole parent with two children, their taxable income is in the $18K to $52K range (from 0 hours of work to 40 hours of work). The tax brackets we’d look at are therefore the 17.5% rate and the 30% rate. The thresholds for these are due for inflation indexation, which would change the picture a little.

Let’s again start with our sole parent with two children, their income graph looks like this:

We start by considering a change to eliminate the second tax bracket. Our income tax will be 10.5% up to $48,000, rather than having a 17.5% income tax rate from $14,000.

It’s hard to see on the graph, but this improves the earnings through the lower end of the range. At zero hours of work they are $6 per week better off, and up to 6 hours per week they get around $2 extra in the hand for each hour of work, a reduction in their effective marginal tax rate (EMTR) of around 7 percentage points.  Their EMTR goes down from 18% to 11%.

From 11 hours through to 16 hours their EMTR drops from 75% to 73%, they keep an extra 50c an hour in the hand.  This 50c extra an hour stays the same till around 30 hours of work a week, then increases to $1.50 per hour until 37 hours of work, then they move out of this tax bracket and get no further benefit.

This change offers benefit, but not really game changing benefit. When you previously were keeping around $6 per hour in the hand then getting $6.50 instead is better, but probably not the difference between deciding to work and not. The interaction with early childhood education also still means net disposable income is poor, at around 6% of their additional income available after taking into account costs of childcare.

The cost of this change can be estimated from the Treasury tables. Taking the midpoint of each range as the income for that whole range, I calculate $6 billion in revenue reduction. I feel that we could do better with $6 billion in revenue reduction, and that is because $4 billion of this revenue reduction goes to people earning over $50,000, i.e. people outside those we’re targeting.

Another alternative is to remove the 30% tax rate. We would pay 17.5% up to 70,000, where the 33% rate starts. The graph looks like this:

In this case the difference cuts in at 37 hours of work, when they pass the old $48,000 threshold. Above 37 hours they get an extra $3 in the hand for each extra hour of work. This is a substantial change over that range of hours worked, and could change the incentive to work. The question is how many sole parents would be working 37 hours a week, and whether we are especially keen to get them to move from 37 to 40 hours or beyond. 

The reduction in childcare subsidy rate at 38 hours also means that, although the tax rate gets better, the reduction of that subsidy means the household is net worse off from working extra hours.

If they earned more per hour this might impact at a lower number of hours, but in general it doesn’t feel like a substantial change in outcome for many of those we’re targeting.

This change, calculating on a similar basis to the above change, would reduce revenues (cost government) by around $3.8 billion. 

My conclusion from this post is that the key rate for those moving from a benefit into work is the 17.5% tax rate. The 30% tax rate doesn’t impact people moving off a benefit much, because only a small subset of those people have taxable incomes greater than $48,000. 

I note, for completeness, that their effective household income can be quite a bit higher.  Whilst our sole parent with two children has a taxable income of $16,000 when not working, the household’s effective gross income is $43,000. They receive quite a few non-taxable allowances. At 16 hours of work a week their effective gross income passes $48,000.