Warning: this is a non-technical, but fairly wonky post about tax
Will there be wailing and gnashing of teeth on Sunday? There will if the Coalition’s voluminous prognostications about the carbon price package are correct. There will also be a reduction in the effective tax rates faced by low-income earners, but that doesn’t fit so easily into a glib slogan.
The effect of the carbon price package on effective tax rates at the lower end will be modest but important. I’ve already established that the changes represent the largest real boost to the effective tax-free threshold in at least three decades, and possibly the largest ever. Everyone with a taxable income below $80 000 will receive a personal income tax cut on Sunday (unless they didn’t pay any income tax to begin with).
Another way of looking at this is that the average tax rate, which is just the amount of personal income tax you pay divided by your income, will go down for everyone on less than $80k.
So far, so humdrum. It’s no secret that everyone with an income of less than $80 000 will receive a personal income tax cut on Sunday. What’s less well examined, but no less important, is the effect of Sunday’s changes on the effective tax rates faced by low-income workers. By effective tax rates I mean the amount of income that a person will lose in benefits and increased taxes out of some increase in income. The usual way of looking at these rates is to measure how much a person would lose out of a very small (‘marginal’) increase in their labour income – this gives you the effective marginal tax rate or EMTR.
High EMTRs can mean that people only keep a small amount of any additional income they might earn by working more – at some levels of income, people keep as little as a quarter of an additional dollar that they earn. This can discourage people from working or taking on extra shifts, and can create ‘poverty traps’.
According to my calculations, the changes on Sunday will lop off the most severe EMTRs faced by single, adult, childless Newstart recipients (who I’ll focus on in this post). At the moment, someone with labour earnings between around $10 000 and $13 000 per year faces an EMTR of 75%. From Sunday this will be cut to 60%. Good news! There is a much smaller increase in EMTRs over a smaller range of income for slightly higher earners, from 15% to 19%, but that isn’t much of a concern.
Estimated EMTRs for a single, adult Newstart recipient, before and after 1 July 2012
The problem of high EMTRs is widely acknowledged and understood, at least within the world of policy wonks. The problem with them is that people don’t generally change the amount of work they take on by $1 increments. Instead, workers take on an extra weekly shift, or they go from unemployment or part-time work to full-time work. To measure how much people will gain as a result of those sort of decisions, you need the effective average tax rates or EATR. It’s the EMTR’s less well-known cousin. The EATR uses the same basic calculation as the EMTR – lost benefits plus additional taxes, divided by the change in earned income – but you use a more realistic change in income, like the move from part time to full time work.
The chart below shows the EATR faced by people who change their labour income in various ways, like moving from unemployment (NS) to part time work at the minimum wage (NMW), both before and after the 1 July changes. The good news is that EATRs will be cut for single adults in all the scenarios I’ve examined.
The EATR that people face in going from not working to working is also known as the participation tax rate (PTR). The chart below shows that PTRs will be reduced for a range of incomes – people who go from receiving Newstart to low-paid part-time work will keep more of their extra income than they did under the pre-1 July system.
In all, the income tax cuts are targeted in the right way to boost low-paid workers’ incomes and reduce poverty traps, albeit modestly.
NOTE: All tables and charts in this post are based on my own calculations. They are for single adults with no children. They incorporate tax, the LITO, the BTO, Newstart withdrawal, and the Medicare Levy. If you think I’ve made an error, please let me know.