A Policy A Day: Fiscal Drag

In the lead-up to the election, we are examining a policy a day. We're exploring a variety of policy areas, explaining the background and analysing some of the policy options, with a mixture of technocracy and values-based approaches. Inevitably, some opinion will make its way in and we make no apology for that - after all, we're voters too. A list of all the articles is available here. Enjoy!

Today's post is by Jason Armishaw

Background

Through the process of fiscal drag (sometimes called bracket creep), governments use inflation to slowly and subtly raise taxes on the population, particularly the nation’s poor. Fiscal drag happens when inflation pushes peoples income into a higher tax bracket than it was previously, causing people to be taxed more for functionally the same income. To understand its operation, its crucial to understand how the personal income tax system works to determine how much tax you pay to the government every year.

The personal income tax system is made up of three core parts. Firstly is Income, which is pretty straight forward: this is the amount of money that you earn from your job (or other sources) and isn’t controlled by the government [1]. Secondly is the Marginal Tax Rate, which is the percentage of tax you pay on a marginal dollar earned. The third component is the Tax Bracket, which is the focus of fiscal drag. The Tax Bracket is the income range that the marginal tax rate applies to; the rates for 2017 are shown below.

So no matter how much you earn, your first $14,000 will be taxed at 10.5%, then your $14,001st dollar will be taxed at 17.5%. This nuance exists to stop someone being better off earning $14,000 than $14,001 and thus being able to game the tax system. The way the brackets operate mean that there is a difference between the marginal tax rate, and your Effective Tax Rate. The effective tax rate is the percentage of tax you actually pay on your income. It can be best explained through an example of someone earning $55,000 a year, who despite having a marginal rate of 30%, pays an effective tax rate of 17.3%.

Fiscal drag becomes a problem when the tax brackets aren’t updated regularly enough, and inflation pushes people into higher tax brackets than they probably should be. The last time our tax brackets were changed was 2008 and are changed, on average, once every 10 years. However, since 2008, median income from wages has risen from $729 a week to $924 a week in 2016. This is annualised to $37,900 income per year in 2008 and $48,048 income per year in 2016. The effects of fiscal drag on these incomes are shown below.

What this shows is that the median wage earner in NZ is being taxed $1,750.80 more in 2017 than in 2008, or an extra $34.24 a week. That’s more than three whole blocks of cheese a week! The government is treating median income earners as if they are richer than they actually are.

Poor people are affected most by fiscal drag, as they are the ones that are pushed into higher tax brackets than they probably should be. We can see this when we show the tax receipt of a minimum wage earner in 2008 and today. A full-time minimum wage earner in 2008 earned $24,950, and $32,760 under the 2017 rate.

So the government is taxing a minimum wage earner $1,365.00 extra a year - two and a half blocks of cheese a week. 29% of the tax a minimum wage earner currently pays is attributed to fiscal drag over the last nine years. This tax increase can be felt fairly acutely by a low-income family.

Fiscal drag also undermines the progressivity of the tax system as the push of people into higher tax brackets slowly flattens out the system. If we assume the tax brackets aren’t updated for another 50 years, and the average wage has grown through inflation to $400,000, then everyone is going to be on the top rate of 33% meaning we functionally have a flat tax system.

Policy

The simple solution is to make sure that our tax brackets are updated fairly frequently, but that has political consequences, as updating brackets for inflation appears as a tax cut when it’s really reverting taxation levels back to the status quo. Updating tax brackets also appears at first glance to benefit the wealthy as they get more dollars back in their pockets (though this happens because the wealthy pay more tax, as a proportion of tax paid it’s actually less). These results often make it politically unpalatable to update brackets regularly, so we need some automatic mechanism.

The cleanest mechanism is to automatically adjust the tax thresholds based on the average wage growth for the previous year. For example, if wages in 2016 grew by 1.5%, then all the tax brackets would be increased by 1.5% in 2017 to apply to the tax year ending April 2018. While there is a slight bracket lag, it is much less than the average of 10 years to update our brackets. This small lag is necessary to gather the required data, and to make sure the tax brackets are available in advance of the year they apply.

The advantage of this mechanism is that it sits outside the traditional value judgements about the tax system, and can accommodate any number of brackets or any adjustment to the marginal tax rates. Should the Green Party get elected and pass their tax plan to add a new bracket and introduce more progressivity to the tax system, then a fiscal drag mechanism is still ideologically palatable. Similarly, if Act gets elected and massively reduce tax rates and flatten the system, a fiscal drag mechanism is unaffected.

At the moment, some of the parties have proposed adjustments to the brackets, such as the Greens adding a new bracket above $150k and National changing all of the tax brackets as part of their tax cut. However, none of the major parties have any policy on an automatic mechanism that takes the politics out of ensuring that the tax brackets keep up with inflation.

Overall, without correcting fiscal drag the government will slowly and invisibly continue taxing people more and more over time. Governments both right and left like fiscal drag as it sneakily pushes significant amounts of money into the government budget, and can indeed be the difference between a deficit and a surplus, such as when the Treasury’s Half Year Economic and Fiscal Update 2014 predicted (wrongly) that the government would not be in surplus. Policymakers need to create some automatic mechanism to prevent the erosion of the progressivity of the tax system.

Jason Armishaw is a graduate in Law and Economics from the University of Auckland, he has worked across the public and private sector at a number of institutions including the New Zealand Treasury and Deloitte. He currently works at a management consulting firm in Australia.

[1] Yes, the government controls the economic settings that affect wage and non-wage income, but for the purposes of simplifying this description all of that has been ignored.