Monday 1 September 2014

A Policy A Day: $20k Tax-Free Income and Flat Tax

In the lead-up to the election, we are going to examine one policy per (working) day. We've selected policies to be as balanced as possible across a range of policy areas and across the political parties. The idea is to explain the background, analyse the policy to investigate the pros and cons, and give a verdict on the policy at the end. Inevitably, some opinion will make its way in and we make no apology for that - after all, we're voters too. Also, I say 'we' because this series will feature some guest posts from other young people, to share their thoughts and ideas as well. A list of all the articles is available hereEnjoy!

Today's policy comes from the Conservative Party. It is one of Colin Craig's four main policies and follows the general ideology of the party. Giving the government less money means they have less to spend on things and are forced to become smaller, getting out of our lives. This post tries not to look too deeply at whether or not government should have a role in our lives, but just what the impact of the policy might be:
- The first $20,000 of income is tax-free (0% tax rate)
- All income above $20,000 is taxed at 25% (subject to affordability), including for companies

New Zealand has a progressive income tax system, where the tax rate increases as the "taxable base" (income) increases. The idea is that those who earn more money should pay a larger share of the total tax. The status quo is:
10.5% up to $14,000
17.5% from $14,001 to $48,000
30% from $48,001 to $70,000
33% over $70,001
(Company tax is currently at 28%)

It is important to note that if your income moves up a tax bracket, it doesn't mean that all of your income is taxed at the new rate. Only the income in that bracket is taxed at the new rate; for example, if your income was $50,000 in one year, your total income tax would be 10.5% x 14000 + 17.5% x 34000 + 30% x 2000 = $8,020, leaving you with roughly $42,000 to actually save/spend. Of course, this does not include GST, ACC, or tax credits from programmes such as Working for Families and KiwiSaver. According to Professor Rob Salmond, New Zealand has one of the most attractive tax systems out of 27 OECD nations due to its predictability, fairness, and minimum of loopholes.

Treasury has calculated the actual dollars contributed to income tax in each bracket, and it does seem to achieve the intended effect of a progressive tax. The top 3% of the population, earning more than $100k a year, pay for about 27% of the total income tax revenue. The bottom 80% of income earners (below $50k a year) pay for 47% of the total income tax revenue. Progressive taxation systems such as ours are generally considered (around the world) to be good at reducing income inequality, particularly when taxation from higher income individuals is used to fund programmes such as social welfare that generally benefit lower income individuals. Reducing income inequality has many positive benefits for a society, from an increase in economic participation to greater societal happiness

Analysis of the Policy
The first question to answer is how much would this decrease in revenue be for the government? The first half of the policy, allowing for the first $20,000 of income to be tax free, would be very expensive indeed. Ignoring feedback effects (for example, an increase in disposable incomes leading to an increase in spending leading to an increase in total GST), this policy would cost the government roughly $6.76 billion a year in revenue. The second half of the policy would firstly increase the tax rate for income between $20,001 and $48,000 from 17.5% to 25% - this increases the revenue by $3.32 billion. It would secondly decrease the tax rate for all income above that from 30%/33% to 25% - this decreases the revenue by $3.01 billion. This means that the 25% flat tax on all income above $20k would actually end up increasing government revenue by $300 million, shifting the balance of tax burden from higher income earners down to the $20k-$48k earners. A 3% decrease in company tax from 28% to 25% would cost the government roughly $1.14 billion a year in revenue. The working is based on data from the Treasury and the existing tax rates. I should probably disclaimer here that this is a rough estimate, and likely to be higher than the actual number due to feedback effects. So adding all these numbers together:
- First $20k tax-free = -$6.76 billion
- Increase income tax for the $20k-$48k bracket = $3.32 billion
- Decrease income tax for >$48k = -$3.01 billion
- Decrease companies tax = -$1.14 billion
Total change in revenue = -$7.59 billion

Let's put this in perspective: $7.59 billion is equivalent to the government's entire Transportation and Defence budgets combined. It's more than we spend on Early Childhood Education, Primary Education, and Secondary Education combined. It's more than we spend on Police, Justice, Corrections, Labour, Foreign Affairs and Trade combined. It's 20.2% of all direct income tax. It's 9.1% of the total government revenue. I started this analysis with a vague idea that the policy would cost money but didn't know it would cost this much. I could probably stop here and conclude that this is a ridiculous amount of money to cut out of the government's budget and on that alone no sane government would ever implement these changes. But let's see if we can find any benefits for this policy - we're going to mix the threshold and the flat tax together for this.

Economists in general agree that a tax-free threshold is a bad idea. Lots of jargon is involved in explaining why, so I won't go into it too much detail. However, the arguments generally assume that the government has to provide the same level of public services after reducing the revenue. This made sense when it was 2011 and the Labour Party was proposing a $5,000 tax-free threshold (estimated cost of $1.7 billion), but forcing the reduction of public services is part of what the Conservative Party stand for. There is this argument than we as individuals know how to use our money better than the government, and we should be allowed to make those decisions ourselves. So if you're keen to force the government to cut services like education, health, and social welfare, then this may be a good way of achieving that.

Underpinning a lot of the rhetoric used by the politicians when discussing flat taxes is this concept of equality and fairness. The Conservative Party argues that a progressive tax is unfair because it penalises hard workers for being successful. It's unfair because higher income earners have more of their income taken away from them than lower income earners, even though arguably they receive the same level of public service from the government. On the other hand, there is the argument that those who can contribute more to society to cover public services should do so - after all, they benefitted from government services from education to health to transportation, and even though we reward them for being successful in a capitalist society we also expect them to ensure that the social welfare state can continue to run. A flat tax would be unfair on the poorer members of our society, who would have even less hope of ever breaking out of the poverty cycle. On this side of the argument, fairness is ensuring that everyone is on a level playing field - no one starts with 20 points on the board before the game starts. Ultimately it comes down to what you believe "equality" and "fairness" to mean - this is inherently subjective.

There is an argument that the $20k tax-free threshold would be more advantageous for the poor than for the rich. This is because it's important to look at what the relative effect of the threshold is on the total income. To help with the math, the $20k tax-free threshold means that everyone can get up to $2,100 more a year (by paying that much less tax). If your total income a year is $44,000 (the median income), then $2,100 is quite a large difference to your total disposable income. It might make the difference in being able to put food on the table and pay all your bills. If your total income a year is $200,000, then the $2,100 doesn't make that much of a difference. $2,100 isn't going to buy another boat. This concept is the "marginal benefit" - how much of a difference does an extra $1 make to your life? So a tax-free threshold is likely to have a larger positive impact on the livelihood of the poor, and that's probably a good thing.

How does your tax situation change if the 25% flat tax is introduced too, and you're paying more tax on your income between $20k and $48k? You'll be paying 7.5% more on that income, which equates to $1,800 in the worst case where you're earning exactly $48,000 a year. So you're still getting $300 a year more in this case. This still sounds like it's better than nothing, and will probably make an impact in the poorest communities. It almost sounds like a good deal! Except then we look at what happens to the individual earning $200,000 a year. They get the $2,100 a year from the $20k tax-free threshold, and it doesn't make too much of a difference. But add another $11,620 in tax savings from the flat tax, and now there's quite a lot more money to play with. Is this fair? Is this what we want as a society?

Verdict: The government could not possibly cope with such a large decrease in revenue, even if only the $20k tax-free threshold was implemented. The flat tax rate would actually shift the tax burden from high income individuals to the middle and lower class. The policy would move further away from equality and exacerbate income inequality. I really tried to give this policy a fair go but the numbers are just boggling. This policy makes no sense and clearly no one in the Conservative Party has bothered to cost it.

1 comment:

  1. You should have a read of "The Flat Tax" by Robert Hall and Alvin Rabushka when you have some time. Each chapter is available at I actually found it quite interesting and it has some compelling reasoning for why a country might introduce a flat tax and how it would be successful. I don't think it applies as well to modern day New Zealand as it did to the US when it was published, but I think that a perfect Hall/Rabushka flat tax could work, but would never come to fruition.