Published in Menzies House blog on 10 July 2011 under the title “A closer look at the income tax changes“
The government has announced their plans for a new carbon tax, and the related compensation payments and tax cuts. The good news is that the government is increasing the tax-free threshold and winding down the confusing and misleading “low-income tax offset” (LITO). Next year the tax-free threshold will increase to $18,839.
Unfortunately, the government continues to hide the actual marginal tax rates by reporting the LITO and medicare levy separately from the “headline” marginal tax rates. The actual marginal tax rates for 2011, 2012 and 2015 are at the bottom of this post. As you can see, they are as confusing as ever.
Some points to note…
- The government is claiming to increase the tax-free threshold from $6000 to $18,200 and have an effective tax-free threshold of $20,542. This is misleading for a number of reasons. First, the current TFT is actually $16,000 and so the increase is not as large as they say. Second, while normal income tax may not kick in until $20,542 the medicare levy kicks in at 10% for people earning over $18,839. This was a great opportunity for the government to scrap the mis-named medicare levy, or at least get rid of the regressive 10% bracket ($18,839 to $22,163). So the actual change in the TFT is from $16,000 up to $18,839. That’s the first bit of good news.
- In winding down LITO the government has had to adjust some other tax rates. It has been reported that they are increasing the 30% bracket up to 33%, but that isn’t right. In reality (as seen in Table 1 below) the current rate is actually 35.5% for people on $37 – $67k, and that doesn’t change under the new scheme. Also, the current rate is actually 20.5% for people on $30 – $37k, and that doesn’t change under the new scheme. People earning between $30 – $67k will be paying about $300 less tax per year and will not face higher marginal tax rates. That’s the second piece of good news.
- But not everybody is so lucky. People on $20.5 – $22.2k will see their marginal tax rate increase from 25% to 29% and people on $22.2 – $30k will see their marginal tax rate increase from 16.5% up to 20.5% (see bold tax rates in the tables). As can be seen, these rates remain regressive due to the absurdity of the medicare levy 10% bracket. While these low-income earners will actually be paying less tax thanks to the higher TFT, they will be facing a higher marginal tax rate. This is important because it is the marginal tax rate that determines the incentive to work. Somebody on $21k/year will now have an effective marginal tax rate (EMTR) of 72% (up from 70%) once you factor in the 60% withdrawal of welfare. These high EMTRs create a disincentive to work and can lead to a “poverty trap”.
- The other group who face higher marginal tax rates are those earning between $67 – $80k, who will see their marginal tax rates increase from 31.5% up to 34% and then 34.5% in 2015 (see bold tax rates in the tables). It is worth noting that these people will not be paying more tax (indeed, somebody on $80k will be paying $3 less tax per year), but they will be facing a slightly bigger disincentive against work.
- It is worth remembering that income taxes are implicitly increased every year due to bracket creep, where inflation pushes people into higher tax brackets even through their real (inflation-adjusted) income hasn’t improved. As Clinton Mead has shown, when you factor in bracket creep over the next two years, these tax cuts are mostly gone, and anybody earning over $40k will see a tax increase. (Note that Clinton does not include the medicare levy, and so his tax rates can’t be directly compared to the rates I provide below.)
- It is also worth remembering that these tax cuts are supposed to be compensation for a new carbon tax. However, while the carbon tax is designed to increase (from $23/tonne to over $100/tonne if government modeling can be believed) the tax cuts will not continue to increase. There is a tax cut in 2012 and another small cut in 2015, and then no further scheduled tax cuts.
In summary, these tax changes are a bit hit and miss — helping people on about $18k or $50k, but decreasing the work incentive for people on about $25k or $75k. The biggest problem with these tax cuts is that they are far too small. The tax cuts are enough to compensate for 2-3 years of bracket creep, but then after that there is no compensation for the ever-increasing carbon tax or future years of bracket creep. The government has also missed an opportunity to index income tax brackets (ie stop bracket creep) or to entirely phase-out LITO or to remove the absurdities of the medicare levy.
Some people are seeing that the government is churning a lot of money around the economy, and they are accusing the government of simply engaging in wealth redistribution. I think that accusation is missing the point. If the government wanted to redistribute from rich to poor, then they wouldn’t use a carbon tax — which is a regressive tax that hurts poor people more than rich people. The main redistribution from the proposed carbon tax is from people (both poor and rich) to the government.
I have previously said that a carbon tax could be a benign policy if the rate remained low & fixed, and it was matched with real tax reform. The changes proposed today to not meet that requirement. The government is introducing a growth tax and billions of dollars of new spending, and offering token income tax cuts that will soon disappear in bracket creep, while actually making the work incentive worse for many people. I have an open mind to including a carbon tax in tax reform… but the carbon tax proposal we saw today is no good.
UPDATE 11/07: The original version of this article incorrectly stated that EMTRs for people on 21k were now 89%. This was incorrect, and it has now been fixed. Thanks to Prof Peter Whiteford for pointing out the error.
Table 1: Actual marginal tax rates (2011)
| MTR | Tax paid | ||
| $0 | $16,000 | 0.0% | |
| $16,000 | $18,839 | 15.0% | $426 |
| $18,839 | $22,163 | 25.0% | $1,257 |
| $22,163 | $30,000 | 16.5% | $2,550 |
| $30,000 | $37,000 | 20.5% | $3,985 |
| $37,000 | $67,500 | 35.5% | $14,812 |
| $67,500 | $80,000 | 31.5% | $18,750 |
| $80,000 | $180,000 | 38.5% | $57,250 |
| $180,000 | $250,000 | 46.5% | $89,800 |
Table 2: Actual marginal tax rates (2012)
| MTR | Tax paid | Tax cut | ||
| $0 | $18,839 | 0.0% | ||
| $18,839 | $20,542 | 10.0% | $170 | -$256 |
| $20,542 | $22,163 | 29.0% | $640 | -$616 |
| $22,163 | $30,000 | 20.5% | $2,247 | -$303 |
| $30,000 | $37,000 | 20.5% | $3,682 | -$303 |
| $37,000 | $66,667 | 35.5% | $14,214 | -$599 |
| $66,667 | $80,000 | 34.0% | $18,747 | -$3 |
| $80,000 | $180,000 | 38.5% | $57,247 | -$3 |
| $180,000 | $250,000 | 46.5% | $89,797 | -$3 |
Table 3: Actual marginal tax rates (2015)
| MTR | Tax paid | Tax cut (from 2011) | ||
| $0 | $18,839 | 0.0% | ||
| $18,839 | $20,979 | 10.0% | $214 | -$212 |
| $20,979 | $22,163 | 29.0% | $557 | -$699 |
| $22,163 | $30,000 | 20.5% | $2,164 | -$386 |
| $30,000 | $37,000 | 20.5% | $3,599 | -$386 |
| $37,000 | $67,000 | 35.5% | $14,249 | -$564 |
| $67,000 | $80,000 | 34.5% | $18,734 | -$16 |
| $80,000 | $180,000 | 38.5% | $57,234 | -$16 |
| $180,000 | $250,000 | 46.5% | $89,784 | -$16 |
John Humphreys 