Tax cuts – the right kind

If someone told me they were going to forego some money cutting tax and asked me for some tips these are some tips I would have given them.

  1. Cut the bottom marginal rate or lift the threshold at which the second marginal rate cuts in.
  2. If you’re cutting tax to the battlers consider providing tax cuts via income tax credits – that way you can claw back the benefits to those higher up the scale.
  3. If you want to cut taxes to those higher up, do it by lifting thresholds rather than lowering rates.
  4. The largest efficiency gain you can make is not a ‘big ticket’ item.  It is simplifying people’s tax. Get the ATO to ‘pre-populate’ citizens’ tax returns with all the information it collects – on PAYG tax, interest and dividends received – and then get them to make any additional amendments they want to make. And do it all on line.

The budget does all those things.  Lateral Economics argued the first three propositions here and I argued the case for copying other countries and simplifying tax returns here.  Andrew Leigh has also advocated this for some time.  I’ve not checked the details yet, but having set this up it makes sense to spend some money on it by providing taxpayers with increasinly large automatic deductions.  That way we don’t have to go running round keeping all our receipts.  We all get some credit for business deductions each year and paperwork is cut further.

Anyway it’s nice to see good politics and good policy can sometimes make for such a good fit.

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Backroom Girl
Backroom Girl
14 years ago

I agree with you on the tax cuts, Nicholas. I think they are just about perfect. Andrew Leigh should be happy with them – due to the increase in the Low Income Tax Offset they are actually progressive. And while I haven’t been able to crunch the numbers yet, I think they will do a lot to fix the remaining areas where effective marginal tax rates are over 90 per cent.

Sharan Burrow had a hard time trying to find something good to say about them though – she was reduced to comparing the tax cuts that low income earners get now with the ones that very high income earners will get next year.

vee
vee
14 years ago

I knew I had read the fourth option somewhere.
I don’t understand how the second option works though

Backroom Girl
Backroom Girl
14 years ago

Vee

Nicholas’ second point was about the Low Income Tax Offset (affectionately known as the LITO). This essentially provides a targeted increase in the tax threshold. Because low income earners get the first $750 of their tax back as a rebate, it means that for they effectively don’t pay tax until they earn $11,000 a year, compared with $6,000 for middle and high income earners. At the cost of adding a little complexity (and an effective tax rate of 34 cents in the dollar between $30,000 and $48,750), it costs quite a lot less than putting the tax threshold up to $11,000 for everyone.

derrida derider
derrida derider
14 years ago

But Nicholas (2) is incompatible with (3)! A targeted tax credit like the LITO raises the rates where it is being clawed back. I can understand the attraction of this hidden rate raise for pollies (Costello’s boast last night that “80% of Australian workers will have a tax rate 30% or less” is just untrue BTW), but not for economists. I can’t see the obvious attraction of a tax scale which has a higher marginal rate on incomes between $30 and $48K than between $48k and $80k.

Further, a sizeable such credit has serious administration problems. If you put it into the PAYG withholding scales then there is a likelihood of widespread end-of-year tax debts amongst lower middle income earners. If you don’t then the incentive effect of it is lost because it is not reflected in immediate returns to work (not to mention the loss of political impact when people don’t get a rise in their after-tax pay on July 1). We’ve only avoided these problems to date because the LITO has been small, but if it keeps growing in size like this each Budget then they will start to cause real trouble.

Sinclair Davidson
Sinclair Davidson
14 years ago

80% of Australian workers will have a tax rate 30% or less is just untrue BTW

How is this untrue? The co-called EMTR may be higher than 30%, but that is not a tax problem. That is a targeted welfare problem. There is a big difference between paying tax and receiving welfare.

Backroom Girl
Backroom Girl
14 years ago

DD – don’t forget the power of the tax refund. I agree that having to wait a year to get your LITO may blunt the work incentive effects somewhat, but people do love lump sum payments all the same.

If it was just an increase in the LITO I would be more worried, but don’t forget that the lift in the 30% tax bracket will be felt straight away. (For people earning over $30,000 more than two thirds of the total tax cut comes from that cut in the marginal rate.)

When the two measures are put together, I think the 4 percentage point increase in EMTRs between $40,000 and $48,750 may be a reasonable price to pay for the 15 percentage point reduction in EMTRs between $25 and $30,000. So overall I would hope the work incentive effects will be positive.

I also note that there was a sizeable increase in the Dependent Spouse Tax Offset (snuck that one through under the radar, didn’t they)- I’m not so happy about that but some people will be I guess. Do you think they are trying to restore the old relativity between the DSTO and FTBB?

Backroom Girl
Backroom Girl
14 years ago

No Sinclair – in this case the 34% effective tax rate is entirely a taxation issue. It is the 30 per cent tax rate plus the 4 cents in the dollar withdrawal of a target tax measure (the LITO). There are other instances of this, of course, such as the phasing in of the Medicare levy which increases EMTRs temporarily by 20 percentage points, but clearly those things are best ignored when trying to communicate the larger political message.

(You can consider the LITO and the Medicare thresholds as welfare measures of course, but nevertheless they are part and parcel of the tax system.)

Sinclair Davidson
Sinclair Davidson
14 years ago

LITO is welfare. I’m happy to quibble about the Medicare Levy, but then we need consistentcy. Is the top rate 45% or 46.5%? Costello would say 45%.

Backroom Girl
Backroom Girl
14 years ago

Is the top rate 45% or 46.5%? Costello would say 45%.

I dare say he would. While I believe there may be a small group of people who don’t have to pay the medicare levy (armed forces?), the medicare levy is an unavoidable part of the tax system for most of us.

And you would have to acknowledge that Costello likes to have it both ways. I heard him say that due to the LITO the real tax threshold is now $11,000 pa and the Budget site has a big table showing what the ‘real’ tax threshold is for all kinds of different family situations (counting FTB as a tax measure, not the welfare measure most people think it is). So I don’t think our friend Derrida Derider was too far off the mark pointing out that he was gilding the lily somewhat.

spog
spog
14 years ago

Hi Sinclair. Would this tax scale be welfare?

0 – 11,000 0%
11,001 – 30,000 15%
30,001 – 48,450 34%
48,451 – 75,000 30%
75,001 – 150,000 40%
150,001 + 45%

It is effectively the scale we will have for 2007-08, except that some of it only comes via a tax refund. Does getting it as a refund change its complexion from tax to welfare in your eyes?

It’s done this way because it’s cheaper than raising the threshold generally. It could be done as a tax scale (as above) but then it would be obvious that it’s not progressive. Does a government ruse to hide what it’s really done make it welfare?

spog
spog
14 years ago

Oops, my fat fingers and the nearness of the 4 and 7 on the keypad have meant that 48,750 has come out as 48,450.

My apologies.

Patrick
Patrick
14 years ago

That scale is beautiful, it proves the point really, because it is inaccurate and it is inaccurate because of course this is welfare, and so the thresholds are relative. Your threshold is only $11k if you are eligible for it (ie earn less than $30k). Once you earn more than $30k your first bracket basically starts sinking back down towards $6k.

Sinclair Davidson
Sinclair Davidson
14 years ago

BRG, Never mind, DD – I’m happy to have a go at Costello for gilding the lily. But I think we need to keep clear in our minds what is tax and what is welfare. I understand that some want to blur the distinction, and that Costello blurs and unblurs the distinction to suit his need.

Spog, I’m not sure I’m following your point. Refunds occur when you over-pay tax, so getting that money back isn’t welfare. I do understand the point about EMTRs and I agree they create perverse incentives etc. etc. Where I disagree is calling them a tax problem (see previous para).

Backroom Girl
Backroom Girl
14 years ago

But most of the people who claim the LITO (not that you need to, it is calculated automatically from your tax return) are people who don’t have anything to do with the welfare system – Patrick and Sinclair are you saying that because they get a small refund of tax at the end of the year they are recipients of welfare? That seems to me to be a relatively odd concept of welfare versus tax – logical if you think of them as one integrated system, but not if you think of them as beasts of two entirely different kinds.

Backroom Girl
Backroom Girl
14 years ago

Patrick, I agree that Spog’s alternative tax schedule really does prove some point – which for me is how much is in the eye of the beholder. It seems to me you can take your pick – your version (that you have a tax threshold that varies as your income rises because we’re all welfarists at heart) or his (that we have a fairly respectable tax threshold of $11,000 pa with a rate schedule that is progressive except for a bit of a hiccup halfway along). Not sure I care, really.

Sinclair Davidson
Sinclair Davidson
14 years ago

It is a payment (or a mechanism to reduce tax) targeted at individuals because they have low income. It is a welfare measure. As individuals low income increases they are not entitled to it and so it phases out. (Perhaps we need to bring back the distinction between earned income and unearned income – unearned income is some payment from government for some reason that may reduce as your earned income rises.)

Backroom Girl
Backroom Girl
14 years ago

So is it the motivation behind something that makes it a tax measure or a welfare measure then? Or whether it is means-tested or not? Would a classical kind of Negative Income Tax scheme be a tax measure or a welfare measure? Just trying to get my head around this new way of thinking.

I still wonder how you would think about this if indeed we had the alternative tax schedule as outlined by spog, which gives you exactly the same result in terms of tax liability but just doesn’t look like a classic progressive income tax schedule.

Sinclair Davidson
Sinclair Davidson
14 years ago

I’m not a fan of the negative income tax. I also see no reason why government should give back money to reduce a tax on income. So if the government doesn’t want the money, don’t collect it in the first place. I am a fan of Adam Smith’s maxim (actually all his tax maxims) “Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the publick treasury of the state” (bold added). We get ourselves into these problems because the graduated progressive tax system is a silly idea. A flat rate tax with a high tax threashold would eliminate these sorts of problems.

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[…] Here’s my column for the ABC website on the budget which focuses on what’s good about the tax cuts – already foreshadowed in my previous post. […]

Peter Whiteford
Peter Whiteford
14 years ago

Sinclair

As Spog points out in comment 11 (corrected a bit in 12), you could abolish the LITO and have the tax scale he describes. Most people would think this was on odd scale since the marginal rate drops after 48,750, but nevertheless it would be the income tax scale and have nothing to do with any welfare payments or withdrawal of family payments.

Now if you want to argue that a targeted tax credit is a welfare measure, then it seems to me that any progressive tax scale would then qualify as welfare on this definition. The tax threshold gives a zero rate to low income earners and even if it is not explicitly targeted it produces lower marginal rates for low income earners. The only “non-welfare” system that didn’t reduce taxes on low income earners would be a flat rate without a threshold.

Peter Whiteford
Peter Whiteford
14 years ago

That should be that any tax threshold produces a lower (zeo) rate for the low earners below that threshold and lower average rates for everione else

Sinclair Davidson
Sinclair Davidson
14 years ago

Peter, I understand. We could abolish the LITO and have Spog’s schedule. Or we could devise any number of alternate schedules. But we haven’t – partly because it looks strange, and people would say so. My point is this, giving people money on the basis they are poor (or low-income) is welfare (or charity if the donor is private). I understand that you (and BRG) have a very specific, and different, definition of ‘welfare’ in mind. Collecting income from people and then giving it back because they are poor (or low-income) is not only welfare but inefficient.

The only non-welfare system that didnt reduce taxes on low income earners would be a flat rate without a threshold.

I agree. I have reluctantly come to the view that a threshold is necessary, not on principle, on pragmatic grounds.

derrida derider
derrida derider
14 years ago

Well, I agree with you, Sinclair, that a flat tax system would solve a lot of problems. Unlike you though I would most certainly accompany it with a Basic Income (and I’d also have some wealth taxes, especially land taxes, to square things up a bit). I do concede though, that this argument is far more about the nature of the society we want rather than technical tax design questions, and that my notions of the good society (like your somewhat different ones) are probably destined to remain minority ones.

But all that’s a bit irrelevant – the argument here is that, given the revealed preference of the bulk of the electorate for progressivity, what is the best way to implement it. It seems to me that if you were designing a coherent system to do this you wouldn’t include a LITO – which is the point I was making to Nicholas, who seems to think otherwise.

On the tax/welfare distinction I think you are very confused, but then we have had a lot of pollies over the years who have found it very convenient to blur that distinction in people’s minds for short-term presentational gains.

Sinclair Davidson
Sinclair Davidson
14 years ago

DD, we agree on so much. I don’t know that the electorate has a preference for a graduated progressive income tax. To the best of my knowledge that precise question has not been the topic of an election or referendum. On the tax/welfare distiction I’m happy to agree that we have very different definitions of welfare in mind (and the good society, for that matter). I’m sure we agree that the other is wrong. :)

spog
spog
14 years ago

I think I agree with Sinclair. It seems to me it is doubtful there is a revealed preference for progressivity. Instead I think there is a revealed ignorance about the whole issue. Many is the time I’ve seen people resent/protest higher tax cuts going to people on higher incomes, and yet that is inherent in a progressive tax system. If you keep making the tax cuts the same across all incomes, then in real terms the system gets gradually flatter over time. This suggests a revealed preference for flat tax.

On the other hand, there is also a fairly continual clamour for higher income people to pay more in a progressive system kind of way.

I suspect all this reveals is a desire to have someone else pick up the tab.

spog
spog
14 years ago

Picking up a little on Sinclair’s point about inefficient design (in 24), not only is the LITO concept inefficient in a churning sense, but I’m always dubious about it’s supposed incentive effects.

Today’s papers have a plethora of tables showing how much per week people will be better off with the tax cuts, presumably sourced from Treasury. Despite what they say, no-one with an income under $25,000 will see any tax cut at all until the second half of 2008. The LITO does not deliver tax cuts in the form of reduced pay-as-you-go deductions, but only as somewhat larger tax refunds. Delaying it this way must surely rely for any incentive effects on people actually understanding what is going on.

If people don’t understand the tax system (and LITO in particular) where does the incentive boost come from? Not the hip-pocket. A taxation placebo effect? That may be a new and cheap way to boost incentives to increase work – constantly announce tax cuts you never deliver. Some would argue that already happens.

Backroom Girl
Backroom Girl
14 years ago

Spog

I agree that it is somewhat misleading to present tax cuts as weekly amounts when a fair chunk of them comes as an end of year refund. However, I am reasonably sanguine about the incentive effects, as I said earlier in my response to DD. Don’t forget that the wonderful US earned income tax credit has apparently made all the difference to work incentives there even though for most people it is all delivered at the end of the financial year. Doesn’t make intuitive sense I know, but there it is.

One thing I’m glad about is that I haven’t seen anyone complaining yet that these tax cuts are regressive because people earning below $25,000 only got $150 a year. Perhaps that’s still to come.

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[…] Soon is excellent on the difference between pork and useful stuff, while Nick Gruen looks at ‘the right kind‘ of tax cuts. Taking a different tack, Bryan at OzPolitics points up the difference between […]