More tax incentive needed at all levels

Our tax system is holding back Australia. It is holding back Australians wanting to move from welfare to work. And it is holding back Australians in work who want to get ahead.

Labor's Treasury spokesman Wayne Swan has been pointing out the crushing disincentives in the tax and welfare systems for seven years. In recognition of this, the tax blueprint Labor released at budget time was found by the Melbourne Institute to be far more likely to encourage people to participate in the workforce than the Federal Government's package.

Australia's incentive-crushing tax and welfare system is giving unemployed people little financial reason to move from welfare to work. A recent report by the National Centre for Social and Economic Modelling confirms that under the Howard Government's so-called welfare reforms, single mothers will lose up to 75c in every dollar they earn from taking a part-time job, and that's not counting the cost of child care, travel and work clothes.

Middle-income earners aren't getting rewarded for their effort either. They have to pay 42c in tax on every extra dollar they earn. Many are deciding it's just not worth working overtime or going for promotions. One million working Australians face the 42c rate. In the next three years almost 400,000 more Australians will be hit by an incentive-crushing 12c leap in tax on the extra money they earn as they move from the 30c rate on to the 42c rate. Australians facing the 42c rate earn between $70,000 and $125,000 a year. They are trying to improve themselves and make a better life for their children. They are not rich, especially if they live in high-cost cities such as Sydney, Melbourne and Brisbane.

All up and down the income scale, the tax system is crushing incentive. And this is happening just five years after the government delivered what it described as "a new tax system for a new century".

Australia needs genuine tax reform to restore incentive, to reward hard work and enterprise. That means cutting the punishing rates faced by most Australians. If 47c in the dollar is considered too high for top income earners, then the 75c faced by many people seeking to move from welfare to work is far too high.

Tax reform cannot be achieved in a single budget. To be fiscally responsible, a tax reform plan should be implemented over several budgets, as financial circumstances permit. And as I said in my recent Progressive Essay (reprinted in The Weekend Australian, August 27-28), all the squawking about tax reform is just a cacophony of sound unless funding sources are clearly identified.

In its 2006-07 budget, the government has an opportunity to deliver a big down payment on comprehensive tax reform.

First, it could abolish the 42c rate altogether. Under this proposal, no taxpayer earning between $21,600 and $125,000 would pay more than 30c tax on any extra dollar earned. Now that's incentive! It would cost about $4.2 billion.

Second, the low-income tax offset could be increased from $235 to $600 at a cost of $1.2 billion. This would raise the tax-free threshold to $10,000 for every taxpayer earning less than $21,600: a powerful incentive to move from welfare to work.

Third, the top marginal rate could be lowered from 47c to 45c as a first instalment on possible further reductions as the wealthy gave up their welfare and tax lurks. Trimming the top rate to 45c would cost $600 million and should be funded exclusively by the wealthy.

The total cost of this proposal is about $6 billion.

Malcolm Turnbull's preferred option (On Line Opinion article) - dropping the top rate to 40c, leaving the 30c rate where it is and raising the tax-free threshold to $10,000 - would cost $8.2 billion. Where's the money coming from?

The tax reform down payment outlined here costs $2.2 billion less than Turnbull's, limits the top marginal rate to 30c for 97 per cent of taxpayers, increases incentives to move from welfare to work and trims the top marginal rate for people earning more than $125,000 a year.

If an extra $2.2 billion were available, as required by Turnbull's proposal, it could be used to provide tax relief for Australians earning between $21,600 and $70,000 a year by extending the low-income tax offset up the income scale.

Economists agree that reductions in the top rates of income tax should be financed by broadening the income tax base. Turnbull advocates removing the 50 per cent discount on the taxation of capital gains. Does Treasurer Peter Costello agree? And Turnbull supports a crackdown on deductions enjoyed by the better off for work-related expenses that have ballooned in the past few years. It's refreshing to see a Liberal supporting the repair of the income tax base as a means of financing reductions in the top rates of income tax.

Another source of funds could be the wealthy giving up their welfare. A 10 per cent tightening of means testing of payments to families would save $2.7 billion, more than enough to abolish the top tax rate altogether.

The proposal outlined here has a top rate of 30c for anyone earning up to $125,000. Turnbull's proposal taxes Australians earning between $70,000 and $125,000 at a 40c marginal rate, a full 10 percentage points higher for one million taxpayers, and for 400,000 more in the next three years.

A more expensive Turnbull option, costing more than $11 billion, also abolishes the 42c rate, while cutting the 47c rate to 35c. It could be afforded only if serious repair work were done on the income tax base. But there is no evidence that Costello is remotely interested in repairing the income tax base. Whether it be middle Australia or people seeking to move from welfare to work, the proposal outlined here creates more incentive than the less costly of Turnbull's options. They are but two ideas. There are others.

But the most important feature of both proposals is that they are genuine attempts at tax reform. The take-home message is that large reductions in the top income tax rates are possible if the government had the stomach for repairing the holes it has opened up in the income tax base and cutting back welfare for the wealthy. We shall see.