Wednesday, October 6, 2010

Effective marginal tax rates and Australia’s welfare trap

Australia’s complicated social security system often leaves me baffled. There are so many forms of assistance for families, with rates of benefit and qualifying incomes changing annually, your entitlement (if any) is sometimes a lucky draw.

What I have noticed is the rate at which these benefits decline as the family income increases. So much so that I instinctively feel that earning a few extra dollars is generally not worth the trouble - unless of course my income was already high enough to be out of the qualifying range for family welfare benefits.

So I took the time to examine situation for Australian families, and it is quite revealing.

This recent paper, for example, shows that the effective marginal tax rate (EMTR), which estimates the change in take home income after tax and after accounting for reduced welfare payments, actually declines at higher income levels for almost every family type (see table below). High income families receive a greater percentage of an extra dollar earned than low income families, with middle income families suffering very high EMTRs.

For example, an extra dollar earned by a parent in a family with two dependent children and an income in the middle tax bracket will leave them with an extra 28c in the pocket, while for a high income family, they keep 67c out of any extra dollar.

There are even situations in Australia where the EMTR is greater than 100%! Low income families with dependents on youth allowance have an EMTR of around 110% - for every extra dollar earned, they get 10c less in their pockets.

Unfortunately, I fall into the group with the highest EMTR – families with dependents – where 15% of the group have EMTRs above 70%.

...families with children are more likely to face an EMTR of 50 to 70 per cent than other types of households, due to the accumulation of withdrawal rates for family related payments on top of income support withdrawal and income tax. This is observed even without including the withdrawal of childcare subsidies. On average, the EMTR is highest for couples with dependent children. (here)

After a quick bit of research, it appears that if I earn another dollar we lose 20c from family tax benefits, about 18c in the dollar from child care benefits, and 30c in tax – a 68% EMTR. If my wife earns an extra dollar we lose 40c in Family tax benefits (Part A and B combined), 18c of child care subsidies, and 15c in tax – a 73% EMTR.

In light of this outrageous situation, cutting down to part-time work (4 days/week) provides an extra 48days of leisure per year at a minimal cost to the family.

Also, if we factor in the extra expenses incurred due to extra work hours and time pressure – takeaway meals, remaining child care costs, driving instead of cycling, and splurging on treats because you deserve a reward at the end of a busy day, you quickly see the rational for staying in the welfare trap.

All this makes me wonder just how many families are trapped in high EMTR bands – all earning different incomes, but taking home much the same income ‘in the hand’.


  1. Cameron, I've long argued that we need to completely revolutionize the transfer/welfare/income tax system to ameliorate the very high ETR for lower and middle income workers. The amount of waste in the ATO, Centrelink and inefficiencies built into the system show up in the massive underemployment figures for this country, not only the massive lack of education and skilled base of low-middle income workers.
    A replacement system would be easy to understand, and would probably cost more in the first few years (a policy hurdle to get over, for sure) but would have long running benefits.
    My idea would be to simply eliminate all welfare, all tax offsets and rebates (FTA, FTB, LITO etc) and introduce a "Citizens Dividend" equivalent to about $15,000 to $20,000 for every person. This is paid to everyone, regardless of income, in a weekly payment to their bank account. No questions, no means test, just an EFT.
    However, you then introduce a flat tax of around 30%. This applies from every dollar you earn. Your employer simply deducts 30% from each dollar you earn and sends that to the ATO.
    This effectively creates a "zero" tax payable level of $50,000; i.e you receive $15,000 from government and are taxed $15,000 from your employer. However, neither side needs to worry about paperwork, informing Centrelink of income changes etc. Very efficient (even though it remains a transfer system). Banks would do the same for your interest payments, as would companies paying dividends. Franking credits gone.
    For high income workers, the flat rate continues to apply above $50,000 (you effectively run out of credits)- although you could add another step at say $150,000 or $200,000 (maybe up to 40% - although I think instead of punishing higher incomes we need to punish increased consumption via an increase in the GST).
    A further simplification is to eliminate all deductions allowable, except education which should be subsidised (i.e the one page tax return) and just change FBT benefits into pure income - i.e the employer simply deducts 30% of your "benefit" from your income as "FBT".
    The outcome: guaranteed minimum wage pay for everyone (you get the $15,000 tax credit regardless of any condition). Simple straightforward income tax system - no FBT, franking credits, deductions. Get accountants, ATO and Centrelink staff re-employed somewhere more productive.
    Want to change the system? You only need to change the MTR (in my example 30%) at a whim to adjust demand/control inflation - a better tool than interest rates.
    I'd like to see this reform on top of a 50-100% increase in the GST, so we punish consumption and encourage more savings (say reduce the MTR to 25% or even 20%).
    Keep up the good blog Cameron!
    Chris B (from TalkFinance)

  2. Chris B,

    That seems like a very good solution. Do you know of any countries that use such a system? Only problem is that no politcal party has the courage to make any decent changes to tax system in austraila (3 out 150 reccomendations form the Henry review.)


  3. Like it! - Never understood why GST isn't greater and all other taxes are simplified??

  4. Thanks Pete and anon. It is completely unrealistic because it would require a wholesale change to our current welfare and taxation system, and the political will to do so would be non-existent, except in crisis conditions, which is why I believe a probable derivative would be a flat rate above 30% for high income earners.
    The problem is two fold ideologically: first, it implies that everyone gets guaranteed welfare. Labor/Greens love this, but Coalition does not. Second it implies rewarding people who earn income. Coalition like, Labor/Green no like.
    Add it the fact that you might be "punishing" people if you raise GST (even though they are better off income wise for no net loss) it is almost impossible to "sell" the idea to the public as well.
    I would prefer to see a change in how we tax capital first before tackling this subject, by punishing speculation (buying and selling shares and houses on a secondary market) and rewarding investment (financing new shares for companies and building new houses/factories/powerplants).
    Again, ideologies would probably collide here, even though both sides (i.e workers and business) would benefit in the long run.
    Chris B.

  5. Good idea Chris B, interesting concept and possibly more elegant than my simple belief - like you remove all benefits/perks/initiatives except disability/study/pensions.

    Flat 20% tax-rate on every dollar above $15k income, GST scaled up from 10% to 20% over 4 years on everything applicable except renewable energy and Australian made food/materials/produce/finished products (not services). Corporate tax would be 15% for small businesses (<15 employees), 20% for medium businesses and 30% for large businesses.

    I guess the issue with GST changes is that we are heavily orientated as an economy towards debt-based consumption and trading paper and services around and around and around.

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  7. Awesome ideas. I also have a bit of a crackpot theory that in the current system where middle class welfare is periodically increased to cope with inflation, that it may actually be middle class welfare that plays a big part in driving inflation. As an example, if a household with one wage earner on $45,000.00 a year was to receive the equivalent of $10,000.00 a year in tax breaks/rebates, direct welfare payments, discounted rent on the public housing scheme etc, that person has an effective income of $55,000.00 per year.

    Now I'm not suggesting that many people supporting a household with 2 kids would be wasting this on luxury items, however luxury item is a very subjective term. Maybe with the extra money the family is able to buy the new car as opposed to the used, or the 60" TV as opposed to the 36". If you apply this to every family in this bracket across Australia that will surely put upward pressure on inflation which doesn't just make luxury items cost more, it makes everything cost more.

    So next year when the budget is back in surplus (?) and the government is willing to go on a middle class welfare spending spree, cost of goods will go up and my wage will stay where it is while people on welfare will be compensated. Talk about a disincentive to work. This is why I am now looking at leaving full time employment to pursue a career in small business. When cost of living goes up, so do my prices. Also as a small business my tax isn't automatically withheld and therefore gives me the ability to be more "creative" with how I manage it (not to get too political but given that we have had free education for all to grade 12 for like over 30 years now why am I paying anyone's welfare who isn't sick or disabled?).

    That's my bit.

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