Fair Personal Tax Reform An Economic Assessment April 2008.

Fair Personal Tax Reform

An Economic Assessment

April 2008

2

Preliminary Issues

► NZIER has undertaken this work independently of government or any other institution

► Focus is on personal tax and benefit reform. A reduction in GST is not considered to be a valid option

3

The Four Tests

► No borrowing or cuts in services (1 and 2)– Elasticity of tax revenue (may be a ‘cheap lunch’),

distinguish capital from operating expenditure, establish the counterfactual expenditure level

► Avoid exacerbating inflationary pressures– Real issue the inflationary effect of fiscal policy –

poorly targeted spending likely to be more inflationary than personal tax reductions

► Not leading to greater inequality– Better expressed in terms of fairness

4

Fairness

► Support for progressive taxation (varying tax liability according to ability to pay) does not equal envy. This can be read in two ways– Arguments for progressive taxation are more robust

than simply being based on envy– Arguments for progressive taxation do not justify envy

(need to consider change in proportion of income paid, not dollar reduction)

► Consistent treatment is important

5

Problem Definition

► The four tests do not give reasons for personal tax relief

► It is necessary to identify the policy problem (c.f. political problem)

► Changes should be kept in context (the personal tax scale collects $23 billion from 3.3 million taxpayers)

► Changes should be right and not rushed

6

Integrity of Personal Tax Base

► The personal income tax scale has remained unchanged since 1999

► Income growth has pushed more taxpayers into higher tax brackets (fiscal drag)

$9,500 $38,000 $60,000

15%

21%

33%

39%

Current Personal Income Tax Scale (IncludingLow Income Earner Rebate)

Note: Not drawn to scale

7

Integrity of Personal Tax Base

Source: IRD (2005) Briefing to Incoming Minister

8

Integrity of Personal Tax Base

Source: NZIER (2007) December Quarterly Predictions

9

Integrity of Personal Tax Base

Source: IRD (2005) Briefing to Incoming Minister

10

Integrity of Personal Tax BaseGrowth in average hourly wages 2000 to 2006

0%

5%

10%

15%

20%

25%

30%

35%

40%

2000 2001 2002 2003 2004 2005 2006

Cumulative Wage Growth

NZ Gross AU Gross NZ Net AU Net

Source: NZIER, based on 40 hours work per-week, incomes net of personal income taxes

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Poverty Traps and Marriage Penalties

Key areas of family income assistance (2007-08)

Recipients $ Billion

Total tax revenue 49.6

Total social assistance 16.3

Key areas of social assistance:

New Zealand Superannuation 505,900 7.3

Working for Families Tax Credits 350,000 (1) 2.6

Domestic Purposes Benefit 96,400 1.5

Unemployment Benefit 41,400 0.5

Invalid’s Benefit 81,100 1.2

Accommodation Supplement 251,500 0.9

Notes: (1) Approximate figure based on MSD Statement of Intent

Sources: Estimates of Appropriations (2007), Vote: Social Development, Vote: Revenue, Ministry of Social Development (2007), Statement of Intent

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Poverty Traps and Marriage PenaltiesMaking work pay for a sole parent (2007-08)

$-

$100

$200

$300

$400

$500

$600

$700

$800

0.0 10. 20. 30. 40. 50. 60.

Hours of Work

Net Income

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

EMTR

Market Income Domestic Purposes Benefit Family Assistance EMTRs

Note: Assumes two children under 12, minimum wage

Source: NZIER

13

Poverty Traps and Marriage Penalties

► Major contributor main benefit abatement– DPB relatively strong incentives for part-time, poor

full-time incentives– UB poor part-time incentives, easier to earn income

above ‘welfare wall’

► WFTC– MFTC creates high ‘EMTRs’, which mostly face sole

parents– Trade-off between lowering abatement rate (30 → 20)

and poverty traps (lower rate shifts disincentives higher)

14

Poverty Traps and Marriage Penalties

► Marriage penalties (before accounting for cost differences and child support liability)– Highest for (largely) single income families on around

$50,000 to $60,000 with multiple children and receiving Accommodation Supplement

– Followed by beneficiary families with multiple children and receiving Accommodation Supplement

► Key Qn: which disincentives should we be concerned about?

15

Personal Tax Options

► Broad approaches include– Income splitting– Tax-free threshold– Threshold change– Rate change– Some combination of threshold and rate changes

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Income Splitting

► Couples would be allowed to ‘split’ their income for tax purposes (e.g., a single-income family on $100,000 would be taxed as a family with two earners on $50,000)

► These families would benefit due to the progressive income tax scale (they would face lower rates twice)

► Everyone else would face the individual personal income tax scale

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Tax-Free Threshold

► No personal income taxes would be levied on incomes below a particular threshold (say, $5,000)

► E.g., all people with total incomes below $5,000 would pay no income tax, people with incomes above $5,000 would only pay income tax on income above the threshold

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Threshold Change

$9,500 $38,000 $60,000

15%

21%

33%

39%

Adjusting Thresholds for Fiscal Drag

Gross IndividualIncome

MarginalTax Rate

New Thresholds

Current Personal Scale

$11,875 $47,500 $75,000

Note: Not drawn to scale

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Rate Change

$9,500 $38,000 $60,000

15%

21%

33%

39%

General Reduction in Rates

Gross IndividualIncome

MarginalTax Rate

New Rates

Current Personal Scale

13%

19%

31%

37%

Note: Not drawn to scale

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Recommended Approach

► A simple policy is a good policy► Income splitting and tax-free thresholds are

unfair, inefficient and not cost-effective (detailed slides on these options are included as annexes to this presentation)

► The appropriate approach would be to shift thresholds, lower rates or undertake some combination of both

► The appropriate approach should be considered within a longer-term revenue strategy

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Recommended Approach

► A calculator for modelling detailed options for personal tax reform is available at www.nzier.org.nz/Site/Publications/reports/2007_Reports.aspx

Hypothetical Rate and Threshold Changes

Option Fiscal Cost ($b)

Static Distributional Effect

Raising Thresholds for Fiscal Drag

1.4 Largest reduction in ATRs from $40,000 to $50,000

2% All Rate Reduction 1.9 All ATRs fall by 2%

37% Top Rate 0.3 Largest reduction in ATRs above $100,000

31% Upper Middle Rate 0.3 Largest reduction in ATRs from $50,000 to $60,000

19% Lower Middle Rate 0.9 Largest reduction in ATRs for $25,000 to $40,000

13% Bottom Rate 0.5 Largest reduction in ATRs below $10,000

33% Top Rate 0.8 Largest reduction in ATRs above $100,000 Note: Due to data limitations all figures should be seen as indicative only

Source: NZIER

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Broader Tax-Benefit Interface Issues

► Unit of assessment ► Definition of income and means► Time period for assessment► Abatement rates► Provision to breadwinners or caregivers, and

addressing shared custody arrangements

► The combination of these issues leads to much complexity

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Timing

► Timing is a major issue– Inflationary expectations increasing. Market

commentators do not expect inflation to fall back within the RBNZ target band until late-2008 or early-2009

– Administrative systems stretched. A change to personal rates has implications for other taxes (e.g., FBT, RWT)

– Employers facing fast growing non-wage labour costs (including KiwiSaver obligations)

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Recommendations

1. Note the need for a clear definition of the policy (c.f. political) problem

2. Note the need to consider personal tax changes within the context of a broader tax-benefit and revenue system

3. Note that market commentators do not expect inflation to fall back within the RBNZ target band until late-2008 or early-2009

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Recommendations

4. Report on a range of options for changes to personal tax thresholds and/or rates

5. Rule out income splitting and tax free thresholds as options

6. Report on changes to other taxes required as a result of personal rate changes

7. Report on compliance implications of tax policy changes

26

Recommendations

8. Undertake consultation as required by the Generic Tax Policy Process

9. Report on approaches for longer-term reform to the tax-benefit system

27

Annex One: Income Splitting

► Horizontal equity: single income couples pay same tax as dual-income couples → is this treating ‘same’ as the ‘same’?

► Vertical equity: tax relief increases with household income (due to progressivity) → is this basing liability on ‘ability to pay’?

► Efficiency: reduce EMTRs and ATRs of primary earners, increase those of secondary earners → would this increase labour participation and/or increased work effort?

► Fiscal cost: every dollar in tax revenue foregone requires a tax dollar elsewhere, a reduction in spending, or increase in government debt (all else being equal) → does the reduction in revenue justify the opportunity cost?

► Administration and compliance: how would the boundary between couples/non-couples be policed, and are there better policy tools (e.g., family tax credits) available?

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Annex Two: Tax-Free Threshold

► Horizontal equity: most individuals would be treated the same, however some households may benefit from the change more than once

► Vertical equity: the level of tax relief would rise with income up to $5,000 gross, but then would remain unchanged. Tax relief would be limited to $750 per-individual per-year ($5,000 x 15%), but some relief would be received by most personal income taxpayers (except for people who rely solely on a main benefit)

► Efficiency: average tax rates for all people above $5,000 would fall (no change in their marginal rates), marginal and average rates for people below $5,000 would fall

► Fiscal cost: fiscally costly policy as received by almost all personal income taxpayers

► Administration and compliance: increased incentives for reallocating income within households to avoid income taxes