Tony Abbott and Michael Stutchbury have called on the Government to adopt the Henry Review’s recommendation for a nearly-flat personal income tax system. The Review recommended abolishing all our current offsets and levies, including the Low Income Tax Offset and the Medicare Levy, and folding them into a simple structure with a high tax free threshold and a marginal tax rate of 35% for 97% of taxpayers. In case you’ve forgotten, here’s what the recommended income tax structure looks like:

The Henry Review’s income tax recommendation

It’s entirely predictable that the Right would favour the recommendation, as it involves massive tax cuts for high income earners. By my calculations, anyone earning between $35600 and $94100 would pay more tax under this system, while anyone earning above that amount would get a tax cut.

You won’t catch Stutchbury or Abbott directly arguing for the massive handouts to high income earners that would result from implementing the Henry recommendation. Instead, the argument is cloaked in the language of boosting workforce participation by reducing effective marginal tax rates for low income earners, which Henry’s recommendation does do to some degree.

However, the case has not been made as to why the improvements at the very bottom need to be accompanied by massive tax cuts at the top end. There is no reason why the two aspects of the recommendation need to go together, save for the fact that one gives political cover for the other. This is a cynical ploy to make the tax system less progressive under the guise of assisting low income earners.

The problem of high effective marginal tax rates (EMTRs) for low income earners (mostly part time workers who receive some income support payments) is a big one. These high EMTRs occur when a person starts to earn some money on top of their income support payment. The payment then begins to be withdrawn, often at the rate of 50c or 60c per additional dollar earned. On top of that, they pay tax on the additional dollar. So, when you combine the two, you get the effective marginal tax rate, that is, the proportion of an extra dollar earned that someone will lose in taxes and withdrawn income support.

The Henry Review’s solution for dealing with this longstanding problem is increasing the tax free threshold from $16000 (which is our current effective threshold when you take the Low Income Tax Offset into account) to $25000. Instead of integrating the welfare and tax systems, as some had suggested, the Henry Review recommended keeping them as far apart as possible, so that people don’t start paying tax until they’re earning enough to be clear of the income support system.

The big idea here is that by reducing EMTRs for low income earners, we’ll encourage people to work more hours, or to join the workforce in the first place. All the evidence suggests that sole parents and secondary earners are the most sensitive to changes to their after tax income as a result of working. If they’re only going to keep 30 cents out of an extra dollar they earn, it’s probably not going to be worthwhile earning that extra dollar. So, by reducing these EMTRs at the bottom end, we can help people (by enabling them to keep more of what they earn) and help the economy (by encouraging income support recipients to work more). A fine idea, and one that refreshingly relies on ‘carrots’ rather than the sadly more common ‘sticks’ in encouraging people to work.

The Henry recommendation, though, is not the panacea for low income earners that it’s made out to be. I’ve analysed the recommendation and compared it to the current system. It looks to me as if the Henry system would actually increase EMTRs on a lot of low income earners.

EMTRs for  a single adult Newstart recipient

The part of the graph where the blue line (the current EMTR) is higher than the red line (the Henry EMTR) shows the area where people would see their EMTRs reduced under the Henry system. This covers the span of incomes from $6000 to $25 000. Where the red line exceeds the blue line, people would face higher EMTRs under the Henry system. This covers the span of incomes from $25 000 to $37 000.

According to my calculations (and this is not a definitive estimate by any means), the Henry system lowers EMTRs by between 7.5 and 10 percentage points for people earning up to $25 000. However, above that, it raises them by between 14.5 and 18.5 percentage points. To put these numbers in perspective, someone would earn $25 000 a year by working 24 hours a week (three full time days) at $20/hour. These are the very people who we’re supposed to be focused on in the effort to reduce EMTRs.

At the moment, someone who is on Newstart and not working at all who takes a job earning the National Minimum Wage will end up with a disposable income 2.22 times the Newstart rate. If we moved to the Henry system, their income would be 2.29 times the Newstart rate. This is not an earth-shattering improvement.

My point is this: while the Henry system would indeed deliver gains for some at the low end of the income distribution, it’s not the silver bullet that Stutchbury suggests. My real qualm with this system is that it unnecessarily pairs these gains at the bottom end with gains at the top end.

High income earners have already received massive tax cuts over the past decade. The level at which the top marginal rate kicks in has risen from around 1.5 times average earnings in the late 1990s to around 3.5 times average earnings today. The second-highest marginal rate has been cut repeatedly, with the result that our tax system has already become much flatter. High income earners are not suffering under a punitive personal income tax system.

High EMTRs for low income people need to be addressed. The modest tax bills of the well-off do not. There is no need for one to accompany the other.