This is quite possibly my wonkiest post ever. If your eyes glaze over at the mere mention of the tax system, you might want to look away now.
In my view, the PM can rightly assert that the carbon price package will promote workforce participation in a modest but important way.
One of the most longstanding policy problems in Australia is the disincentive to work that can arise as a result of the interaction of the tax and social security systems. For example, someone on Newstart Allowance who takes up a part time job will lose some of their wage via a reduction in their social security payments, and might also pay some tax on their additional income. These effects can combine to mean that a person might lose up to 75 cents of an additional dollar that they earn, so it’s hard to get ahead and the incentive to work a few more hours is dulled.
These effects are often expressed as an effective marginal tax rate (EMTR). An EMTR is the amount that a person would lose through increased tax and reduced benefits if they earned a small amount, like an extra dollar.
In some ways, high EMTRs are an inevitable by-product of our targeted social security system. Believe it or not, we have the least middle- and upper-class welfare of any OECD country. [fn1] Payments are ‘withdrawn’ over a relatively brief range of income, so that payments aren’t made to people who are earning enough to support themselves. This withdrawal of the benefit (like Newstart) adds to the EMTR.
In recent years, though, there has been an effort to reduce the work disincentives that are built into the tax and transfer systems. This has happened on the tax side by increasing the effective tax-free threshold and on the social security side by reducing the withdrawal rates for some payments.The household assistance component of the carbon price package builds on this work by increasing the tax free threshold to $18 200. This will mean that fewer people need to file tax returns.
The effective tax free threshold had already been significantly increased in Wayne Swan’s first couple of budgets, from the $11 000 that Labor inherited from the Coalition to $16 000 today. The ‘effective’ tax free threshold that I’m referring to here takes into account not only the statutory threshold, which has been fixed at $6000 since the late 90s, but also the low-income tax offset (LITO). In 2012-13, the effective threshold will be $20 543, an increase of nearly $10 000 on its 2007 level.
So what do the tax changes mean for work incentives? The easiest way to compare the two systems is just to look at the marginal tax rate schedules, including the LITO. [fn2]
The new package will cut EMTRs at the very bottom by a lot (from 15% to 0), raise them slightly in the $20 000s (from 15% to 19%) and leave them unchanged over middle incomes.
Just looking at the graph above doesn’t really give you a true sense of what the change is likely to mean, as it doesn’t include any social security payments for low-income earners. The graph below gives a more complete picture: it shows my estimate of the EMTRs for a single adult Newstart recipient with no children, before and after the carbon price package. Note that the x-axis in this chart is ‘earned income’, or ‘private income’, the person’s income from work.
You can see that the carbon price package lops off the highest peak in EMTRs, so that the highest rate is now around 67% rather than 75%. EMTRs over most spans of income are unchanged. Even this convoluted-looking graph doesn’t really tell you the full story about what will happen to work incentives.
That’s because EMTRs measure the amount a person loses from earning a small additional amount, like a dollar (my charts are based on $100/year intervals, but the principle is the same). Real people tend not to make their decisions like that, calculating the amount they stand to lose or gain from earning an extra dollar. Instead, people ask things like: should I take that job? How much better off would I be if I did? Should I take that extra shift each week that my boss is offering me?
To figure out the effect of the tax system on decisions like this, we need to average the tax and benefit changes over a larger span of income. This is often expressed as a ‘participation tax rate’ (PTR), as below. [fn3] The PTR is pretty much the same concept as the EMTR, but rather than measuring the amount a person loses in tax and lost benefits as a result of earning a small amount, like a dollar, it measures the amount they lose out of their gross income as a result of moving from non-work to work. My estimate of the PTRs for a single adult Newstart recipient under the current system and the post-carbon price system are shown below.
For someone moving from Newstart to full time work at the minimum wage (about $30 600 per year), the PTRs are about the same under both systems. A person moving from full Newstart (and no wage income) to the full time minimum wage would lose Newstart and pay tax equivalent to about 46% of his or her income.
Over lower ranges of income though, there is a cut in the PTR. For someone who moves from full Newstart to 25 hours per week of work at the minimum wage, the PTR is cut from about 57% to about 54%.
Given the inherent difficulty of cutting work disincentives in this complex system, where each change affects something else, the carbon price package quite skilfully manages to reduce the barriers to work without just shifting them up or down the income scale to any great extent. As I said at the start, this is a modest but important improvement in the incentive to participate in the workforce.
[fn1] This ‘middle/upper class welfare’ definition doesn’t take into account tax expenditures.
[fn2] In this analysis I have included the Beneficiary Tax Offset and the Low Income Tax Offset (where appropriate), but not the Medicare Levy. This is because I can’t find details about the low-income thresholds for the levy after the carbon price package takes effect, so I’ve left it out of all my calculations.
[fn3] There is evidence that the PTR more accurately measures the disincentive effects of the tax/transfer system.