Listener: 23 January, 1988 (Edited for length)

Keywords: Distributional Economics; Regulation & Taxation;

What is a flat tax on incomes?

Income taxes are imposed on different categories of incomes at different rates. For instance, under the regime introduced in October 1986, at the same time the Goods and Services Tax (GST) was introduced, the first $9500 of annual taxable income (say $180 per week) was taxed at 15 percent (or 15 cents in each dollar). The amount between $9500, and $30,000 ($180 to $580 per week) was taxed at 30 percent and the balance above $30,000 was taxed at 48 percent.

This meant that as one’s income increased, the share paid in tax to the government increased. Ignoring exemptions, a person on $10,000 a year pays just under 16 percent of their income in tax, a person on $100,000 a year pays just over 41 percent of their income in tax. This is called a progressive income tax.

Under a flat tax the three steps would be replaced with a single tax on all income. Suppose the rate was 25 percent. Then a person with an income of $10,000 or $100,000 a year would pay the same share – 25 percent – of their income in taxation. The rich would still pay more tax, but they would not pay proportionally more tax. The progressivity of the income tax scale is lost.

What are the advantages of a flat tax if we lose this progressivity?

The advantages of a flat tax are said to be easier administration and less effect on market incentives.

Obviously a flat tax involves simpler calculations for employers, taxpayers, and the Department of Inland Revenue. It also eliminates some of the opportunities for tax avoidance and evasion (such as dummy persons and income-splitting). But some of these gains will be balanced out by additional administration by the Department of Social Welfare, and there will still be tax avoidance. Someone on $200,000 a year paying $50,000 tax will still want to avoid paying the tax.

The incentive argument focuses on the lowering of the ‘marginal tax rate’, which is the amount the taxpayer pays on the last dollar of income. About three-quarters of all taxpayers effectively face marginal tax rates of 30 percent or higher. It is argued that in facing these higher tax rates individuals do not have an incentive to go out and earn an extra dollar because the taxation reduces the value of the effort.

Despite the vehemence with which this claim is made, there is remarkably little evidence that high marginal tax rates act as a disincentive (with one exception reported below).

More generally, claims for ‘supply-side’ effects from tax reform tend to be overrated. Where are the major gains that were claimed for the October 1986 GST and income tax reform package? Even more enthusiastic claims were made for the American tax reforms under Reagan. They did not happen either.

There are efficiency improvements from a flat tax but they are much smaller than often claimed, and sometimes barely measurable.

How high is the flat rate tax going to be?

The Government did not announce a figure, waiting for the 1988 budget sums but it is generally supposed that the rate will be about 23 percent.

Interpreting any figure requires care because of inflation and other changes in the tax regime, including a higher rate of GST. A 23 percent flat income tax rate with a 12 percent GST is about the same as a 25 percent flat income tax with a 10 percent GST.

Taking a 25 percent flat rate, and not adjusting for the GST change, how are taxpayers going to be affected?

Compared to the present regime and a 25 percent flat-tax regime, and ignoring deductibility of things like life insurance and superannuation payments (which are to be deleted), and family support. virtually everyone with taxable income less than $30,000 a year (or $580 a week) will be worse off under a flat tax of 25 percent. Only about 10 percent of taxpayers have annual incomes of $30,000 plus.

The reason for this is that in order to give large tax cuts to the rich, those on lower and middle incomes have to pay more tax. Douglas acknowledges this possibility, for he is reported as having said that some people ‘may be worse off on day one of the regime’.

However the actual number of those worse off will not be as large as the above numbers suggest, because the Government has also promised to increase its guaranteed family minimum income level. But it would appear that unless there are special transition provisions, the childless on incomes below $30,000 a year are likely to be worse off on ‘day one’.

How does the Guaranteed Minimum Family Income (GMFI) fit in?

We do not know the details. Roger Douglas has said that the ‘grossed-up’ income for the full-time family will be in the region of $23,000 to $26,000 a year. (Grossed up means before tax is deducted.) The after-tax weekly rate is likely to be between $340 and $375 a week, compared with the figure of $270 a week announced in the 1987 budget. Thus the Government’s intention appears to be to give a real boost to low-income families with children.

What we do not know is how they will treat families with more than one child, how the tax credit will be financed, whether the family benefit will be maintained and to what extent family support will be reduced or ‘abated’ out.

Wait a moment. If family support is to be abated out, does that not mean that many families will face higher marginal taxation than the flat rate?

Yes. We can illustrate this by assuming that the abatement rate stays at its present 18 percent. That means once family support begins to be abated, the family which earns an extra dollar will pay 25 cents in tax, and have their family support reduced by 18 cents. So of their initial dollar they will have only 57 cents (i.e. 100 minus 25 minus 18 cents) in the hand. We call this 43 percent the ‘effective marginal tax rate’.

This is confusing. First I am told it is a good thing to have a lower marginal tax rate. and the flat tax will ensure this, then you tell me that many families are likely to face higher effective marginal tax rates than the rich.

True. And so will national superannuitants (since it is not planned to abolish that surcharge), probably many social security beneficiaries. So a lot of people are likely to face higher effective marginal tax rates than the rate paid by top taxpayers.

Interestingly, the one group for which there is convincing evidence for significant disincentive effects from higher tax rates are those who are part-time workers or thinking of entering the labour force. A lot of people mentioned in the previous paragraph are in this group.

Could we not get out of the bind of these higher marginal tax rates by not abating family support?

Yes, but that would be very expensive. Not abating family support at its current level would raise the cost from $400m a year to $1000m a year. Funding the extra $600m (plus whatever is required for the higher GMFI) would require a higher flat rate tax. .

If there was no abatement of family support, national superannuation, and low abatement on social security and any transitional rebates, the flat rate would be nearer 30 percent.

But even with abatement, how is the Government planning to raise the revenue it needs for its package?

Some of the income tax costs will be paid by others paying higher income taxes. The Government has also announced extra revenue hiking GST to 12.5 percent on October 1, 1988. It is also closing various tax loopholes, but it is always doing that. The elimination of the tax concessions on life insurance and superannuation will reduce the flat rate, although not the actual tax people pay, since the flat rate will be spread over more of their income.

There may also have to be cuts in social spending, or perhaps the Government will run a larger government deficit before sales of assets. But the sums have not been done yet. That is why the Government has not announced the details of the proposals such as the flat tax rate and the rates of abasement.

So is the new tax and benefit package progressive?

What we know is that the Government has promised to transfer income from the childless on low and middle incomes to poor families. That is a progressive redistribution.

We also know that there will be a transfer from those on low and middle incomes to the rich. That is an anti-progressive or ‘regressive’ redistribution of income.

So the package has both progressive and regressive features. The rich and some poor families will be markedly better off, the rest will not.

Is that fair?

The Government established a Royal Commission on Social Policy, at the centre of whose terms of reference was to investigate the fairness of our society and economy.

A central question which it must have been pondering is what is a fair contribution from the rich to the funding of the welfare state? Should they contribute in proportion to their income, as under a flat tax? Or should they contribute proportionally more than those on lower incomes, as under the present tax regime?

The Government appears to have preempted the Royal Commission’s decision by choosing the flat-tax decision. It is rather like the Government commencing legislation while a court is still considering it, which is a reason why the commissioners threatened to resign.

Whether the commissioners will establish principles which will justify the new tax and benefit system, or whether they will conclude it is fair that the rich pay proportionally more tax remains to be seen. Perhaps they will decide that any pronouncement of theirs will be so compromised by the decisions the Government has already taken, that the Royal Commission will avoid the issue. Which would be a pity, because fairness in the tax system is one of the most important issues which faces the community.