Beware the tax-free threshold

Judging by the fact that the “tax-free threshold” has reappeared as a policy prescription, I can tell it is election year.

I am against tax-free thresholds.  This has been discussed various times before, but the most detailed exposition of my feelings came out three years ago – during the previous election year.

If I had to summarise I would say:

  • A tax-free threshold implies that, for the same level of government spending, effective marginal tax rates must be higher for anyone earning more than the threshold amount (assuming pro-rata increases) – which implies that there is likely to be a greater efficiency cost for the same level of government spending.  [Think of it in this simplified way:  if we don’t tax the first $5,000 of someones income, but need them to pay the same amount of tax on their income, then we need to charge a higher average amount on all their income about $5,000 – if this tax was flat, this would also imply a higher marginal rate]
  • A tax-free threshold is an indirect form of redistribution – so for that level of “spending” the gains in terms of equity are more than likely to be lower than targeted spending.
  • The benefit of the tax-free threshold is that it avoids “churn” in the tax system (if the tax-free threshold replaces some benefit spending).  BUT, there is a countervailing cost from the greater level of progressivity – namely greater compliance costs and tax avoidance associated with another tax bracket.

In net terms, an increase in the progressivity of the tax system (an efficiency cost) combined with the fact that any redistribution will be poorly targeted (a relative equity cost for the same level of efficiency) appears (to me) to be far more important than the benefit of “reducing churn”.

A clear and transparent flat tax system that raises revenue, combined with benefit spending that targets social goals, is (in my view) the best way to ensure that our society achieves its preferred equity-efficiency trade-off at the lowest cost.  A zero tax threshold moves us away from this – and so just doesn’t feel right to me.

UpdateKiwiblog (David Farrar) is also in favour of a tax-free threshold, because of the “reduction in churn”.

Again, remember that the tax-free threshold isn’t just for those who “receive benefits” – it is for all income earners.  As a result, effective marginal tax rates HAVE to rise to keep revenue constant, reducing labour supply.  This implies that there is a direct efficiency cost – which all parties seem keen to ignore.

Update 2: More points here.  And NZIER also agrees.  Clean sweep of economists are against, yet both people on the left and the right are for it – fascinating … I am going to have to post more on the issue I suspect.

  • http://billbennett.co.nz Bill Bennett

    At the bottom end of the system there are people who pay less tax than the cost of collection. This simply doesn’t make any sense.

    One often overlooked advantage of a tax-free threshold is that it take thousands of people out of the income tax system altogether. This reduces collection costs.

  • Danyl Mclauchlan

    Look at how horribly it’s crippled Australia’s economy, while our flatter, less progressive system powers our impressive growth.

  • http://www.tvhe.co.nz Matt Nolan

    @Bill Bennett

    Ahhh, but it merely zero rates those people – it doesn’t mean that IRD, and the firms hiring them, and the self employed, don’t have to take into account the income earned. The recording and analysing that takes place would still take place whether the rate was zero or some non-zero number – so it is a matter of churn not compliance costs ;)

    @Danyl Mclauchlan

    I don’t like to do cross-country comparisons because of the importance of unobservable differences between countries, but …

    I was under the impression that their actual tax rates were generally lower. A system that is slightly more progressive with lower rates (read smaller government) will be stating that they want more in the efficiency/growth stakes. In fact, for the vast majority of income earners over there EMTR’s are lower than here – which is one of the main factors being discussed above ;)

  • DT

    Matt,

    Does this mean that you no longer support progressive taxation?

  • http://www.tvhe.co.nz Matt Nolan

    @DT

    I support progressivity in the tax-benefit system. And at a stretch I can see situations where a progressive tax system will do the same thing more cheaply when targeting is costly or inefficient.

    However, my preference (by default) is a situation with a flat rate and progressive transfers – I believe I made that switch a wee while ago :D

  • http://offsettingbehaviour.blogspot.com Eric Crampton

    Bryce Edwards, via Twitter, suggested instead eliminating WFF and implementing a $20K tax free threshold. I’d expect that also beats the status quo.

  • http://www.tvhe.co.nz Matt Nolan

    @Eric Crampton

    Unless we truly believe we should be subsidising children in certain types of households.

    I don’t understand why, in politics, they always want to talk about two separate tax changes occurring at once – it is like politicians are trying to obfuscate the issue for some reason ;)

  • Paul

    Include the Medicare Levy, payroll tax plus capital gains and stamp duty on housing, as well as state taxes and municipal rates, and I think you’ll find that the Australians as a whole (and particularly wealthy Australians) pay far more tax than we do by most measurements.

    I remember seeing an Australian accountant from PWC and the Kiwi PWC guy they always get on TV: the Kiwi guy said that taxes in Australia were much lower, while the Aussie guy said that, after saying how Australians pay more tax than us and where,”You might say we [Australians] love paying tax…”

    Lower and middle income earners do pay less tax (and have lower EMTRs) in Australia than in NZ, but that’s due to our relatively flat model and their relatively progressive model.

  • http://www.tvhe.co.nz Matt Nolan

    @Paul

    Hi Paul,

    I thought exactly the same thing until a month ago – when I found an OECD report that took all these different things for a number of countries, and found that the tax burden in Australia was incredibly low relative to other OECD countries.

    http://www.cis.org.au/images/stories/policy-magazine/2010-summer/26-4-10-david-alexander.pdf

    I went through the OECD description, and it includes state taxes, payroll taxes, capital gains tax – everything. And given this measure they pay substantially less – I was genuinely surprised.

    And as I said above – I don’t like inter-country comparisons. Australia has a significant advantage in scale, closeness to market, and a relatively longer and stronger increase in their terms of trade (although New Zealand is having a pretty great time with that now as well).

  • Paul

    Thanks Matt… that is quite a signficant report. It certainly blows my assumptions out of the water.

    It also has a lot to offer people of an egalitarian bent from the left of National to the left of Labour, in terms of arguments around tax and the redistribution of wealth.

    I agree that inter-country comparisons are often spurious, such as the oft cited examples of Singapore and Ireland as possible models for NZ to emulate, but Australia has enough in common with us in terms of culture and political tradition that the comparison has some use. It is mu8ch more useful than comparisons with the US, Britain or Canada, imho.

    Anyway, thanks for the link.

  • DT

    @Matt Nolan
    Okay, good answer.

  • Paul

    Having only skimmed the report I am wondering how it maintains such a political consensus in Australia for high levels of targetting?

    Targetting in other places has led to the breaking down of consensus, as the middle classes feel like they aren’t getting enough help from the government.

    Me thinks it may have to do with them not having a Muldoon to discredit economic intervention… and still having a strong union movement to push wages up.

  • http://www.tvhe.co.nz Matt Nolan

    @Paul

    Targeting in Australia is not really that strong – that is part of the reason why tax revenues as a % of GDP are so low. The progressive nature of the tax system replaces much of the targeting that you would see in the New Zealand context.

    In Australia I’ve noticed that, until recently, most of their regulation has been direct – compared to the price, subsidy, and tax mechanisms NZ favours. I am not really a fan of this, but such actions could satisfy the middle classes in the same way.

    I’m also not sure unions really have anything to do with anything in this context. I think you could point to the unions for showing that inequality is lower – but part of the reason average unemployment is higher over in Aussie is because of the union structure. Again, it is hard to compare the countries directly because even though we share a lot of similarities there are significant differences between NZ and Aussie.

    Comparing us to a specific state (say Tasmania), and trying to control for the flow of government funds from the Aussie mainland, may give us a more appropriate counterfactual – who knows. It is really something I should look into ;)