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.