Tax Free Threshold
This post is by PaulL, a regular commentor and occasional contributor. It is the eleventh post in a series on the financial incentives to work and the impacts of our tax and transfer system on household formation, and the fourth post on the “what could we do” subsection. The index to all posts in the series can be found here.
Apologies for the delay in this one, real life things intervened. Since I last posted it seems that the Ardern government has been reading Kiwiblog, and has provided some tax and transfer changes relating to child care. Knowing that they are avid readers and are taking my advice (albeit only partially) it is probably time to move on to the next set.
Twitter is currently full of discussion about tax free thresholds, and TOP have announced a tax-free threshold as part of their policy set. Prior to commencing the analysis for this series I was reasonably in favour of a tax free threshold.
A tax free threshold provides everyone in the country with income higher than that threshold with a tax cut. It provides the same amount of tax cut for everyone. As a method of delivering a tax cut it is politically attractive because it isn’t vulnerable to the accusation that it’s a tax cut for the rich.
As a method of addressing incentives to work it’s very poor. It doesn’t change marginal rates for anyone who earns more than the threshold. Any affordable change would have a threshold in the $10K – $15K range, anyone in receipt of the main benefit has total income of $18K or more, and therefore their incentives won’t change.
In terms of cost, Grant Robertson said that a tax free threshold of $40K would cost around $30 billion a year.
Calculating more directly, this information from Treasury says that there are 3.6M income tax payers with non-zero income. Of those 374,000 earn under $10K. So between 3.3M and 3.6M people would get the reduction.
If we eliminated the bottom tax bracket of 10.5% that means a tax free threshold of $14K. Every non-zero income tax payer would get a tax reduction of $1,470. Therefore the total cost to revenue is $4.85B to $5.3B.
Consider our sole parent with two children. This was their graph beforehand (note: a couple of minor calculation updates make this graph slightly different than previously).
Then consider their graph of returns to additional hours after the tax free threshold. Their marginal rates are exactly the same, their income is simply $30 a week higher.
Overall, the introduction of a tax free threshold does nothing for incentives to work, other than for groups with income under the threshold (in this case, under $14,000). Usually the only earners in that category are those with second incomes in a household and those who for other reasons aren’t eligible for a benefit (e.g. students with wealthy parents). It isn’t clear to me that we should be aiming tax policy changes at these groups.
If the problem we’re trying to solve is “how do you provide income tax cuts in a way that doesn’t draw political ire”, then a tax free threshold would be an answer to that question. It gives everyone the same tax cut irrespective of the amount of tax they currently pay. For some people that is “fair.” Another argument is that it would be “fair” to give people a tax cut in proportion to the tax they pay – those who pay more tax get more cut. That is a political argument I won’t engage in here, other than my observation that a tax free threshold seems to be mainly about winning that argument, not about good tax policy.
If our aim is to change incentives to work, then this policy won’t do that. Some similar analysis of why this isn’t a great policy is here. If we’re going to reduce revenues by circa $5 billion, we can do much more good in terms of moving people off benefits and into the workforce.