Problems of tax/welfare churn

Published in Business Spectator on 8 October 2009 under the title “We’re wasting billions on tax churn”. Written in my capacity as Research Fellow at the Centre for Independent Studies.

The Australian welfare system  including health, education and handouts  costs more than $250 billion per year. Some of this is redistribution from the relatively rich to the relatively poor. However, about half of the welfare is pointless ‘churn,’ where the same person both pays taxes and receives welfare benefits.

Some of this churn is ‘cash churn’ where people both pay tax and receive cash from the government. But the bigger problem is ‘services churn’ where middle- and high-income earners pay tax and receive government-subsidised health and schooling services.

This middle-class welfare comes at a high cost. Billions of dollars are wasted shuffling money from taxpayer to government and then back to the same taxpayer. Billions more are wasted by the government shovelling people into the wrong school or health scheme.

But the economic costs are the least of the worries. By pulling the middle class into the welfare net, the government is crowding out civil society and undermining personal responsibility, self-esteem, and social capital. And ultimately, our current welfare state is simply unsustainable. 

By the middle of this century, the government will need to increase the GST to about 25% to pay for the growing welfare bill, and this doesn’t even include the extra money needed for state government services or for new government programs. 

There is an easy solution. Keep the welfare state for low-income people but end the tax-welfare churn for everybody else.

This would involve a trade-off, where middle- and high-income earners would give up their welfare benefits in exchange for a matching income tax cut. Tax and government spending would decrease by about $80 billion, and yet nobody would be worse off. 

In practice, this would mean that government health subsidies and government school subsidies would be means-tested so that they only applied to low-income earners. People on higher incomes would be required to pay for their own health and schooling needs, and would receive a matching tax cut.

For example, the current government health subsidy is about $3,000 per person per year. Low-income Australians would continue to get this full subsidy and receive free health care so they are no worse off. High-income earners would have to buy their own health care, but they would receive a tax cut of $3,000 per year, so they also are no worse off.

At first this may not seem like a big change. There would still be the same amount of redistribution and universal health care. However, by removing the pointless churn in the system, we could save billions of dollars and encourage greater personal responsibility. And importantly, a welfare state that is targeted only to the poor is sustainable. 

One problem with means-testing a government benefit is that it creates a disincentive to work. For example, when a person on Newstart Allowance earns an extra $10 in income, he loses $6 of his welfare.

However, this problem doesn’t apply to a tax-welfare swap, because the disincentive from the means-test would be matched by improved incentives that come from tax cuts. Introducing a means-test on government benefits is good policy, but only if it is linked to matching tax cuts. 

Removing tax-welfare churn would mean that the income tax-free threshold (TFT) was significantly increased. Currently, a worker does not pay tax on their first $15,000 of income (thanks to the Low-Income Tax Offset). After withdrawing tax-welfare churn, a single person would see their TFT increase to above $30,000 and a person with two children at a government school would have their TFT increased to nearly $120,000 per year. That would be a tax saving of about $33,000 every year, which is enough to pay for health care and school fees.

There are many areas of government policy that involve difficult trade-offs between competing goals. Political debates rage about whether we should sacrifice some freedom for security or whether we should trade some efficiency for greater equality. But removing churn does not involve any difficult trade-off. Removing the tax-welfare churn for middle- and high-income families produces economic, non-economic, and dynamic benefits while leaving no family worse off.

Author: John Humphreys

Chief Economist at The Australian Taxpayers Alliance, Sessional Lecturer at the University of Queensland, and National President of the Liberal Democrats.

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