Welfare reform: let's stop taking with one hand and giving with the other

Recently The Australian led with a story that many low-income workers are losing 60c in every dollar they earn as a result of tax and welfare deductions.

Then there is Labor frontbencher Mark Latham's proposal for a system of "matched savings accounts" for low-income households. There is a common thread linking these two stories and it relates to the way we tax the less well-off in this country.

The first story reported that almost a million low-income Australian families are being penalised by "effective marginal tax rates" of 60 per cent or more. The more they earn, the more they lose their means-tested welfare benefits as well as paying more tax.

In an editorial, The Australian backed a plan for "tax credits" to improve rewards and incentives for the low-paid. Tax credits would counter the tax and welfare deductions imposed as people get better off by boosting their pay with extra cash provided by the government.

"Does someone have a better idea?" the editorial asked. Well yes, actually. Like the lady who swallowed the spider to catch the fly, tax credits displace the problem rather than solving it.

The disincentive problem in our tax and welfare system derives from our commitment to progressive taxation coupled with means-tested benefits. If you take more tax from higher earners and limit welfare payments to those who most need them, it is inevitable that you will doubly penalise people as they improve their incomes.

Tax credits try to get around this by cushioning low-income earners with a top-up but this only displaces the problem further up the income scale. Like any other means-tested income transfer, tax credits eventually taper off. If you reduce them sharply, you create a huge work disincentive in the income band where they are phased out. If you reduce them gradually, you end up supplementing the incomes of high earners who do not need help (and spending huge sums in the process).

Because tax credits are calculated on total household income, they also discriminate against second earners. Many women working part-time would find that it no longer paid them to go out to work.

Rather than creating yet another means-tested benefit to sit on top of all the others, we would do better to rectify the source of the disincentive problem. This is that low and medium-paid workers are paying too much income tax in the first place.

We tax workers on everything they earn over $6000 per year. This means we are taxing people long before they have earned their subsistence, which is why we then have to give them income support to compensate. It is this absurd system of taking money with one hand (as tax) and returning it with the other (as benefits) that creates the problem of high effective marginal tax rates.

The simplest way to extricate ourselves from this mess is to raise the tax-free earnings threshold above the welfare minimum floor (about $12,500 for a single person). Workers could then retain more of what they earn and would require less in the way of welfare top-ups. Rather than giving them another welfare payment, let them keep what is already theirs.

Which brings me to the second big social policy story of recent days: Latham's proposal for matched savings accounts for poorer households. The idea is that government would encourage low-income households to save (for example for a deposit on a house) by giving them $2 for every $1 they put aside in a special account.

This idea has a lot in common with the tax credit proposal; both involve using government cash transfers to top people up. Both also involve more means-testing (matched savings are only offered to poorer households and would be withdrawn as incomes rise). So here we go again, introducing another set of penalties for people who improve themselves.

If we want to help low-income working people to save, the chief priority is surely not to give them money but to stop taking money away from them when they do save. This means setting up tax-exempt savings instruments, so that people can save without the taxman raiding the interest they earn.

The lesson is simple. If you want to provide stronger incentives for lower-income people to work and save, you don't need to give them more government payments. Just stop taxing them so heavily.