Tax Changes the Work Equation

By Hielke Buddelmeyer and Guyonne Kalb

The Australian Financial Review,
18 October 2007, p. 79

In recent years, the Government has been promoting the importance of policies that raise labour force participation and hours of work. It is therefore good to see in the press release on the recent tax reforms that attention was paid to the expected positive labour responses arising from the proposed policy changes. An added advantage of positive labour supply effects is of course that it makes the changes more affordable than anticipated at first sight. Nevertheless, the overall elements increasing tax thresholds, reducing tax rates and increasing the low income tax offset (LITO) may give some a sense of dj vu and it remains to be seen if the proposed changes will be regarded as genuine tax reform.

Examining the tax reform more closely, two questions rise to the fore. Firstly, are all components of the policy changes contributing to the same extent to the positive labour supply response? Secondly, are there better ways to lighten the tax burden while at the same time maximising labour force participation?

In the past few years, the top two thresholds of the income tax system have been increased substantially and the corresponding marginal tax rates were cut to 40 and 45 per cent. Nowadays the top tax rate is only paid by individuals earning over $150,000 ($180,000 next year). Looking at the work incentives the reduction in top tax rate provides, which are as one would expect only a minor proportion of the overall incentives provided by the changes, we argue this is not an important part of the tax package with regard to labour force participation. Of course, due to the small proportion of individuals at this level of income, this part of the reform is only a small proportion of the cost as well.

The government recognised that if the aim is to increase the financial incentives to work, it is far more important to reduce the effective marginal tax rates of low-wage earners, particularly in low-income families. Despite several recent tax policy changes, these families still face the highest effective marginal tax rates in Australia. The LITO is an important tool in reducing marginal effective tax rates for these families. In fact, in the current package of proposed tax changes it is the main contributor to the increased labour force participation. A close second when it comes to boosting labour supply is the increase of the $30,000 tax threshold to $37,000 by 1 July 2010.

The key to effective use of the LITO is to balance the positive labour supply effects at lower income ranges with the potential negative labour supply effects for middle income ranges that arise when the LITO is withdrawn. If the withdrawal rate remains at 4 percent and the threshold at which withdrawal commences remains at the second income tax threshold, individuals with an income up to $74,499 will receive some rebate in 2010.

This means that the effective marginal tax rate of this group of middle-income earners that will now be caught in the LITO phase-out for the first time increases by 4 percent.

This may possibly have a negative labour supply effect for this group.

To our second question now, on whether there are better alternatives to lighten the tax burden while maximising labour force participation. For single-adult households, even more effective than tax offsets are tax credits, which increase the attractiveness of labour force participation from the first dollar of earnings onwards. The disadvantage of tax credits lies with the couple families, where this policy could have a negative effect for partnered women, as such a credit is usually withdrawn on the basis of household income. In the US and the UK where tax credits are an integral part of the social security system, it is found that this scheme is particularly effective for single parents. Recent changes to welfare payments for single parents require them to look for work once their youngest child turns seven years of age while increasing their previously more generous welfare payment withdrawal rate from 40 to 60 percent. A tax credit targeted towards this group could provide a carrot approach, encouraging entry into the labour force, to complement the recently introduced stick approach. Given the small size of this group and the expected large labour supply responses, the cost of introducing such a change would be small.