The support for a tax free threshold in New Zealand appears wider than for almost any other policy. The right supports it, the left supports it – then why is it not government policy, and why do I not support it?
A tax free threshold at $9,000 would cost approximately $3.5bn (according to Patrick Nolan’s NZIER tax cut calculator from November 07), and would give everyone earning over $9,000 the same chunk of money (assuming that other tax thresholds remain unchanged).
Lets discuss why the policy may be popular along the political spectrum:
Now the fact that this effectively hands back the same amount of money to everyone earning over $9,000 (depending on tax incidence of course), or 80% of the population over the age of 15, is what excites people on the left. After all, the tax cut is equivalent to a flat benefit payment to this part of the population – implying that it will reduce inequality. In fact, its inequality reduction impact is obvious when we notice that it will reduce the “average tax rate” for those on low incomes by more than it will for those on high incomes – implying that the proportion of the total tax take paid by the wealthy will now be higher.
The reason for the right supporting such a tax change is significantly different. David Farrar succinctly establishes this point in the following statement about Micheal Cullen refusing to introduce such a change:
This is a pity because I think there is a strong case that there should be no tax on your income until you are earning more than the minimum amount you need to live on. The welfare system then tops people up to that minimum standard, but it is significantly wasteful to tax people just to then give them that money back as welfare
Effectively, the right views a tax free threshold as a method that can be integrated with the benefit system in order to reduce “churn” – which is when the government taxes money and gives it back, which in turn has an administration cost. In this case benefits are provided in order to allow people to achieve a certain level of income. A zero tax rate with a percentage reduction in benefits will allow the government to pay benefits to people who are working without this churn.
Given this the question is – is this policy worth $3.5bn?
Where is the problem?
We know that this policy constitutes a $3.5bn shift of the claim on resources from the public to the private sector. We also know that this policy will reduce inequality and that it will reduce the “churn” associated with taxing people who are still earning benefits. However, we don’t know if such a tax cut will actually be the best use of this $3.5bn.
Tax cuts have another essential role on the “supply side” of the economy. Fundamentally, changes in tax rates can change “supply of labour” depending on the marginal tax rate that these individuals face.
This impact is strongest on secondary earners. Now having a zero income tax at low levels will see more secondary earners enter the labour market – however, if we cut taxes further up the income chain we would see a greater increase in labour supply (especially given our high level of labour market participation!).
Why is this? Well the extra “costs” of being in a job increase in the number of hours you work in that job. Part-time and secondary earners are especially responsive to changes in these costs and the benefit associated with working. As these worker types are becoming increasingly prevalent in NZ (especially on the service side of the economy) a cut further up the tax scale will illicit a greater response in terms of the number of hours these workers will work, by increasing the marginal benefit of this type of work in the face of rising marginal costs.
Another issue is savings. The “marginal tax rate” that an individual faces is important for determining their savings decisions, as income taxes are also placed on the interest returns from savings. The further we place the tax cut up the income scale, the greater the savings response will be.
In terms of the “churn” argument I think an important issue has been missed – the administration cost of introducing another tax bracket. Furthermore. the government separates taxes and benefits as much as they can in order to reduce the administration costs associated with having to go through individual income in any great detail. As a result of these issues and the amount of automation in this process in modern times I’m not convinced that churn is a big issue.
Finally, is it fair? People who work only part time are being given the same amount of money as those who work 50-60 hour days. By moving the tax burden further onto those on medium and high incomes are we really achieving our equity goals?
So why am I against it rather than indifferent
Well, the labour supply argument and the savings argument are important issues on the supply side of the economy. As the benefit system is the best way to achieve our equity goals, changes to the tax system should be made with efficiency goals in mind.
As this tax cut delivers little bang for its buck on the supply side of the economy, I have to stand against it. However, I’m happy to be convinced otherwise 🙂