Bring effective tax below 100%

It is remarkable that this policy should even be necessary, but unfortunately the Australian tax and transfer system suffers from several instances where the effective marginal tax rate (EMTR) is well over 100%. That means when a worker earns an extra $1000 at their job, they will end up losing more than $1000 to the government in the form of extra taxes and lost welfare benefits.

Our tax and transfer system is far too complex to describe in a single article (and that is part of the problem), but to give an idea of the situation consider the example of a married couple with two children and one primary income-earner who are renting. The below graph shows their situation, with their income along the x-axis and their EMTR on the y-axis.

The first thing to note is that the EMTRs faced by this family (shown in blue) are far higher than the nominal tax rates that are reported by our politicians and journalists. It is the EMTRs that set incentives, and these excessive EMTRs discourage people from working hard, saving, investing, and becoming more productive. The government desperately needs to bring down tax rates across the board, but the focus on this particular policy is to address the absurd situations where the EMTRs exceed 100%.

These “poverty traps” are created by the sudden removal of welfare benefits that workers face when their incomes exceed a certain level. Most welfare payments are tapered out slowly. For example, if a worker on $90k earns an extra $1000 they will lose $200 of their Family Tax Benefit (FTB) Part A… which does increase their EMTR and create a work dissincentive, but at least they get to keep some of their extra income and so they still have some incentive to do the overtime or take the promotion.

However that isn’t always the case. The government’s Health Care Cards, FTB-A supplement, FTB-B, and Childcare Subsidy Supplement are all withdrawn suddenly, creating several situations where a worker will be made worse off if they earn extra money. In addition the Medicare Levy Surcharge is introduced suddenly, which creates another >100% EMTR situation.

This situation hurts workers and damages productivity, and doesn’t need to exist. While it would be ideal for the government to overhaul the entire tax and transfer system, the government should at least remove these EMTR cliffs by ensuring that all welfare payments are withdrawn on a taper, perhaps at the 20% or 30% rate used for FTB-A. This simple reform would still leave our tax system horribly complex and with poor incentives, but at least we would remove the most egregious anomalies of >100% effective tax rates.