Who pays the highest tax burden?

Low vs high-income earners… where does the tax burden hit the hardest?

Many think high-income earners face the heaviest tax burdens but when rising taxes meet decreasing benefits, low-income earners can see earnings slashed. Welcome to a complex policy conundrum.

On his Twitter feed in March, David Plunkett [@DPlunky], a former policy analyst with Australia’s Department of Social Services, made a comment that succinctly expressed decades of frustration with the Australian taxation and benefits model.

“Interesting/sad that doubling private income from around $21K to $42K results in no change in disposable income,” he tweeted. 

The comment was supported by a graph (see below) that showed the disposable income – as it is impacted by the effective marginal tax rate (EMTR) – of a single-income couple, both tertiary students receiving Austudy benefits, paying HELP debt (a government loan to pay student fees) and with no private health cover. 

As they earn A$21,000 of private income and receive Austudy, their annual disposable income is around A$37,000. When their private income doubles to A$42,000, their disposable income refuses to shift, stubbornly remaining at A$37,000 as a result of increases in tax and reductions in benefits. 

EMTRs, as defined in a paper published by Plunkett and David Ingles in August 2016, measure the losses “resulting from income taxation combined with the withdrawal of a cash transfer or welfare benefit, applied to earning an extra (marginal) dollar of income. EMTRs are a result of the interaction of tax and welfare systems.”

As Plunkett explains, a high EMTR comes as a consequence of progressive personal income tax rates, means-tested cash welfare benefits and means-tested in-kind benefits such as childcare assistance. The people hardest hit are those on lower incomes, individuals attempting to make their way into (or back into) the workforce, and (mostly) mums returning to work.

It’s a problem that goes back several decades in Australia, says Associate Professor Bruce Bradbury from the Social Policy Research Centre at UNSW.

“Until the 1980s, people receiving unemployment payments had their benefit reduced dollar for dollar for any other income above a small free area. This effectively meant you couldn’t combine casual work with unemployment payments,” he says.

“Since 1980, we’ve had a policy where individuals receiving unemployment payments could be doing some part-time work, which would reduce their benefit payment. The range of incomes where this applies has increased over time as part-time work has grown in importance to the economy.”

Back to basics

In order to understand the issues around EMTRs, it’s important to appreciate the intended purpose behind income support systems, Bradbury says.

“We have a benefits system that provides a low base rate of payment to prevent poverty among people who satisfy certain conditions, such as looking for work or raising children, being disabled or retired and so on,” he says. “The primary objective of these programs is poverty alleviation.”

It’s a fine intention, so what’s the problem? 

“If you fit those criteria [to receive benefits] but also have some other income, payments are reduced. That reduction in payment, in conjunction with simultaneous increases in taxes, can discourage people from work,” Bradbury explains.

Paul Drum, CPA Australia’s head of policy, says that broader societal issues flow from individuals or couples being discouraged from entering the workforce. 

“It’s often working families that are hit hardest because in a dual income family you’ll often have someone working part-time while they’re raising kids,” Drum says.

“If they work extra part-time hours, or go back to full-time [work], they lose welfare payments. All of a sudden it doesn’t make any economic sense for them to work more than a certain number of hours a week. That’s an economic handbrake.” 

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The problem naturally expands and multiplies, says Drum, as mums in childcare groups speak to each other, friends discuss the issue, and family members tell each other about how they are being punished for working harder. Soon, the problem compounds. 

“Remember, we’ve just had a government elected on the back of jobs and growth,” he says.

“We’ve got an ageing population, so there are going to be more retired people per working person every year. We have passed the tipping point of the baby boomers retiring. That ratio of non-working person to working person is only going to grow.”

In other words, Drum says, we need as many people as possible to be working. We want people to get ahead; to add to the nation’s tax revenue, increase productivity and – at the same time – raise their own standard of living. But EMTRs act as a block to that.

It’s not just the present we should be worried about. Longer-term socioeconomic issues can result from the effects of EMTRs. 

“A lot of families will ultimately still be welfare-dependent long after the kids have left home and long after the child care has stopped, because they didn’t continue to refine their skills. They effectively dropped out,” Drum says.

“This is an example of EMTRs contributing to long-term socioeconomic issues.”

The carrot or the stick?

Policymakers have a serious dilemma on their hands with this issue, Bradbury says. He has been studying the EMTR phenomenon for several decades and knows there is no obvious solution. As an individual’s income rises so does tax paid, and it is natural for benefits to drop away. At some stage the two will meet and financial pain will result.

"In the Scandinavian welfare state, a lot of money goes into providing support so that people can go to work, or go back to work, with far greater confidence." Bruce Bradbury, Social Policy Research Centre, UNSW

However, other nations have achieved a better mix. Success often relates to the use of carrots instead of sticks, according to Bradbury.

“In the social policy area, we always discuss the Scandinavian countries as being the exemplar,” he says. “In the Scandinavian welfare state, a lot of the money goes into providing support so that people can go to work, or go back to work, with far greater confidence.

“The state will support thorough training opportunities and high-quality child care. It is very heavily focused on getting people into employment, so it’s using carrots to draw people in. While this system focuses on bringing people into the workforce, the Australian model focuses on poverty alleviation.”

Is there a solution?

The only solution that really presents a win for individuals and government is one that increases people’s capacity for work, Bradbury argues. “This involves putting a lot more money into training and supporting people. 

People who are long-term unemployment beneficiaries, for example, need a lot of support to get back into the workforce. The sticks of the current system might be necessary, but we also need more carrots, such as more effective subsidies for high-quality child care and subsidised work for the most disadvantaged people.”

Drum says that the system can’t be fixed as long as means-tested welfare exists, but that means-tested welfare programs are appropriate. The system can only be improved. 

“If we recognise that it’s a problem that can’t be done away with, you’ve either got to look at having lots and lots of families involved, each feeling a small amount of pain, or you have less people involved and a cataclysmic impact on those few families,” Drum says.

“I think it’s more sensible for more people to bear a little bit of the burden.”

Of course, the political viability of any solution is always going to guide policy thinking. A solution that shares lesser pain among more families might be politically unacceptable. What does Australia’s prime minister think?

"...high EMTRs are an inevitable consequence of means-tested welfare payments. There is, therefore, no silver bullet." Prime Minister Malcolm Turnbull

Interestingly, back in 2005, Malcolm Turnbull (then simply the Member for Wentworth) wrote a paper titled Taxation Reform in Australia: Some Alternatives and Indicative Costings. Part of that paper focused on the problem of EMTRs. It discussed how the loss of income felt by those going back to work relates far more heavily to lost welfare benefits than rising taxes.

“This insight is important, because it underlines the difficulties confronting government in dealing with this problem,” Turnbull wrote. “It doesn’t matter whether a benefit is called a transfer payment or a tax credit. Any benefit that is means-tested creates the same disincentives.”

He added: “At the most elementary level, this barrier to increasing labour market participation affects the Australian economy through increased welfare payments and [the] loss of taxation revenue.”

In his paper, Turnbull admitted that removing welfare payments and scrapping means tests are not options. The main option was around reducing the taper rate at which individuals lose benefit payments and structuring benefits so that means tests kick in at different levels, making it less likely that a family will lose several benefits simultaneously.

He wrote: “… high EMTRs are an inevitable consequence of means-tested welfare payments. There is, therefore, no silver bullet. But apart from continuing to tweak the interaction between tax and benefits to ensure the loss of benefits tapers smoothly, we need seriously to examine the state of government expenditure … and question the efficiency of churning taxpayers’ money: taken from taxpayers in tax and then returned to them as expenditure in the form of benefits, tax concessions, etc.” 

It continues to be a vexed question with no obvious solution, regardless of whether you use a carrot or a stick.

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