Sort out the tax system!

Tomorrow’s federal budget must address two key problems: the work disincentives created by an onerous income tax system, and the dependency culture fostered by a bloated welfare system.

On tax there is now a clear consensus across the ideological spectrum that we must stop penalising people when they try to improve themselves.

Business groups like the ACCI say it is more important to fix the problems in personal taxation than to reduce corporate taxes.

Australian Workers Union leader, Bill Shorten, thinks “our rotten tax system needs root-and-branch reform” in order to improve incentives for the middle class as well as for low income workers.

ACOSS believes the tax system penalises those who seek to move from welfare into work.

Labor’s Lindsay Tanner urges the Government to “give its surplus funds back to Australian taxpayers,” and his colleague Craig Emerson thinks a tax revolt is “just a matter of time.”

At times it has seemed the only people in the country who do not favour radical tax cuts in the coming budget are John Howard and Peter Costello.

As I have argued in the past, there is a strong case for raising the tax-free threshold above the welfare minimum floor so that people do not start to pay tax until they have earned their own subsistence. Had it been indexed to wages, the threshold today would be over $14,000, yet workers begin to pay tax at $6,000. The Australian Democrats have endorsed the idea of raising the threshold, and some Liberal backbenchers also see the logic in this proposal, but the argument is being muddied by misleading government statements.

The Government likes to claim the tax-free threshold is “really” much higher than $6,000 because families with children can claim tax back in the form of the family tax benefit (FTB). In his speech to the Menzies Research Centre on May 3, the Prime Minister claimed: “A family on a single income of $35,000 with two dependent children … pay no tax until their income reaches $41,808. Some dual income families with two children now enjoy the equivalent of a combined tax-free threshold of up to $43,000 a year.” But this is misleading.

FTB is a welfare payment, not a tax reduction. Recipients pay tax and are then given government payments to make up the income they have lost. Ninety per cent of FTB claimants collect this money as fortnightly payments, just like any other welfare transfer. And like other welfare payments, FTB is means tested - its value declines as earnings increase. If it really were the case, as Mr. Howard claimed, that a family with two children on an income of $35,000 “pay no tax until their income reaches $41,808,” then they would obviously pay no tax on the next dollar they earn. In reality, they pay 30 cents income tax on that dollar, as well as losing 20 cents in FTB entitlement. Furthermore, to be eligible for FTB, you have to have children - singles and childless couples get nothing.

The point about an increase in the tax-free threshold is that it is not means tested (so unlike FTB it does not penalise people when they increase their incomes). It also applies to every worker, not just those with children. And it involves leaving people with their own money rather than taking it away in tax and then returning it as a welfare payment (so-called “churning”). When it comes to promoting independence and self-reliance, a dollar earned and retained is worth much more than a dollar handed out by the government.

In addition to raising the tax-free threshold to improve work incentives at the lower end of the income scale, there is also a compelling case for lowering the top marginal rate at the upper end. Australia has one of the highest top marginal rates in the OECD cutting in at one of the lowest income thresholds (just one and one-third average income).