I don’t like the idea of a “zero tax” threshold at the bottom of the tax system. I see it was suggested today by Mark Keating, so I thought I should explain why I feel this way (ht Kiwiblog). I’ll put down three reasons, in reality the third reason is by far the most important:
- I don’t believe the cost of “churn” is very substantial – implying that any benefit from setting a zero tax will be negligible compared to taking the tax and sending it back.
- The effort required to set a zero tax and enforce payment of tax when moving out of the bracket requires effort as well – as a result I don’t think it is self-evident that setting a new bracket would reduce administration costs (it might even increase them).
- If we set a zero tax bracket this also acts as a tax cut for EVERYONE earning more than that amount. This has to be paid for by INCREASING other tax rates (substantially as well, since the loss of the bottom bracket will cost more than an equivalent cut anywhere else). As a result, effective marginal tax rates will be higher than if we taxed and paid benefits (for the same average tax rate in other words). This reduces labour supply incentives for higher income earners. As these earners tend to be more responsive to tax there would be a SIGNIFICANT efficiency cost.
Yes, the zero tax rate at the bottom will increase labour supply incentives for those on very low incomes. But this will only lead to efficiency gains if we believe it will get the more elastic secondary earners into the labour market. If we are doing it to promote equity it doesn’t make sense – as those that are actually poor are likely to provide very inelastic labour supply. Overall, it is likely that the negative impact of higher EMTR’s on middle and high income earners will outweigh any positive impact through a increase in, our already enormous, part time labour force.
The purpose of the zero tax bracket is to make sure that people get a minimum living standard. The better way to do this is to ensure that society pays everyone a living wage at whatever level it believes is fair. Leave redistribution to the welfare system (where our social value judgments are transparent), tax needs to be applied on the basis of efficiency in order to be effective.