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Incentive to work fades at the point where income tax kicks in

By Peter McDonald and Rebecca Kippen - posted Friday, 11 June 2004

Changes to Australia's income tax system usually happen through arbitrary shifts in the income thresholds at which different tax rates apply or sometimes by changes in the tax rates.

These changes return to taxpayers some of the government's cash gain from bracket creep, spreading the rewards in varying ways across people on different incomes. The changes are not driven by fundamental principles or objectives. Income tax reform is the unfinished agenda of tax reform in Australia.

Beyond raising revenue and contributing to social equity, economic theory suggests that income-tax reform should seek to improve work incentives. This becomes more important as Australia's ageing population produces a reduced supply of prime-age workers.


In a society such as Australia, which has a broad-based social safety net, it is important that the tax system encourages people to move from social security to paid work. The best way to do this is to have a high tax-free income threshold. At present, people start being taxed on incomes above $6000. Ideally, people should be able to earn more than the social security payment before they start being taxed.

Under the present system, the cash benefits of lifting the tax-free income threshold would flow in full across the entire range of incomes - any change to this threshold delivers the same cash benefit to those at the bottom of the tax range as to the highest. Ideally, this policy reform instead should be structured to mainly benefit low-income earners, progressively removing the gain from the higher tax-free threshold as income rises.

Another way to confine the reform benefits to low-income earners would be through an income-tested tax rebate. But this would lead to higher, incentive-blunting effective marginal tax rates for middle-income earners as the rebate is withdrawn.

It is also important to improve work incentives for higher-income earners. This rewards creative ideas and the use of capital in ways that stimulate jobs for others and increase the wealth of the nation. The best way to improve higher-income work incentives is to lower the top marginal tax rate, now at 47 per cent. As Neil Warren and others have argued, there are also good efficiency reasons to reduce the gap between the 30 per cent company tax rate and the top marginal income tax rate.

We have set out to devise a new income tax system that achieves these two aims while avoiding income-tested tax rebates. The system turns out to be relatively simple.

Instead of a stepladder series of tax rates cutting in at different income thresholds, the marginal tax rate in our proposed system increases progressively along a straight line between the bottom and the top thresholds. The tax-free threshold and the top marginal tax rate then become our principle targets for reform.


This system is simple but flexible. Most important, it enables changes to be made to both the tax-free threshold and the top marginal rate while providing a smooth and fair transition of benefits to all income groups between the bottom and top thresholds.

Having devised this system, we have since discovered that something almost the same has been implemented recently in Germany. There, this new system is driving tax reform in much the way we have described by increasing the tax-free threshold and lowering the top marginal rate.

Because of the simplicity of this system, it is very easy to model alternative tax scenarios and to calculate their cost. For example, we have calculated that, using this system, the tax-free threshold could be raised to $10,000 over five years from 2005-06 while the top marginal tax rate was lowered from 47 per cent to 42 per cent. Assuming the bracket creep that would be produced from average wage growth of 3.5 per cent and an inflation rate of 2.5 per cent, the government would come out with a tax revenue profit above inflation. Instead of some people suddenly stepping up into a higher tax bracket as their income rises, people's average tax rate would rise gradually as their income increases.

The Germans are using this same system to reduce the top marginal rate from 53 per cent to 42 per cent over seven years. The approach also makes it possible to build equity into the reforms - for example, by deciding what percentage of tax should be paid by the bottom or top 20 per cent of income earners.

Tax paid in such a system is determined by the average tax rate at any income level using the simple formula: tax paid = taxable income multiplied by average tax rate. The formula could be programmed simply into the employer's salary software. Average tax rates can be published at $500 intervals up to the top threshold so that employees can see how much tax they would pay at any income level.

This is not a reform that can be achieved in the heat of the present election climate because there are complications related to existing rebates and the fringe benefits tax. But it remains open to political parties to at least commit to a process to fundamentally reform the income tax system when in government.

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This article was first published in The Australian on 2 June 2004.

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About the Authors

Professor Peter McDonald is Coordinator of the Demography Program in the Research School of Social Sciences at the Australian National University.

Dr Rebecca Kippen is a Research Fellow in the Demography & Sociology Program, Research School of Social Sciences at The Australian National University.

Other articles by these Authors

All articles by Peter McDonald
All articles by Rebecca Kippen
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