Tax-Free Threshold Awful Policy

The Labour Party’s proposal to introduce a zero rate of income tax on the first $5,000 of taxable income may have populist appeal but it is seriously bad policy.

New Zealand once had a tax-free threshold. Even the Great Populist Sir Robert Muldoon was sensible enough to abolish it.

All subsequent reviews of tax policy have rejected the idea. The best and most comprehensive, the 2001 (McLeod) Tax Review, had this to say in its Final Report:

… while poor people have low taxable incomes, low taxable income is not a good proxy for need.  Beneficiaries have their benefits set net of tax, so only their non-benefit income is affected by tax rates.  Low-income working families receive a variety of forms of assistance, which offset the impact of tax, depending on their income.  Many people with low taxable income are not needy.  These include second-income earners in middle- and high-income households, some self-employed, and people with income for only part of a tax year (for example, immigrants and emigrants).Given that income is a poor indicator of need, proposals for a tax-free zone poorly target those in need and have large fiscal costs.  These fiscal costs would raise marginal tax rates for most taxpayers.

Former finance minister Michael Cullen also rejected the idea, saying it would have “minimal benefit for a very small number of low income earners”.

Here are some ballpark numbers on Labour’s proposal:

According to Treasury, in 2010/11 total taxable income in the income band 0-$5,000 amounts to about $15,058 million.

At the current rate of tax of 10.5% (from 1 October 2010), a zero rate on the first $5,000 of taxable income would cost about $1,581 million in a full year. This assumes that the first step is split into two. The cost would be higher if all subsequent income thresholds were increased by $5,000.  It also assumes no change in the behaviour of taxpayers, and no change in other rates of tax. It is based on the 2010 budget forecasts.  Indirect tax and other flow-on effects are ignored.

Labour suggests that some of the lost revenue will be recouped by a higher top rate of personal tax and from a crackdown on tax avoidance. The rate has not been set “but it will only affect incomes comfortably into six figures, the top few percent of earners.”

Suppose the new top rate applies to incomes above $120,000.  Treasury estimates that $6,986 million of taxable income in 2010/11 is within that income bracket. To recoup all of the $1,581 million forgone from a new top rate, the additional rate of tax would need to be 22.6 percentage points, ie the rate on income over $120,000 would need to rise from 33 percent to up to 55.6 percent, an increase of 68 percent. With GST now at 15 percent, taxpayers in the top bracket would be paying combined income tax and GST of 61.4 percent of their earnings when spent.

What is happening to the company and trust rates? Labour has not said but it has alluded to the problem with trusts. If the company rate is retained at 28% (from 1 April 2011) and the trust rate at 33%, there would be strong incentives to divert income, so the cost would be higher than a static analysis suggests. Tax avoidance, which Labour says it wants to crack down on, could only increase.

Labour will find few tax professionals in support of this proposal. There is a strong consensus in favour of a broad-based, low-rate tax strategy.