Election 2004: Taxing times for working families

Patricia Apps, University of Sydney

Australian family tax policy has undergone major changes over the last two decades. In the early 1980s individual incomes were taxed at more progressive marginal rates and families received a ‘universal’ allowance for each child. The rate structure of this system was fundamentally sound but there was an urgent need for reform to reverse the loss of revenue from the excessive use of tax minimisation schemes.

Unfortunately, changes of the kind and on the scale required to stop tax rorting have never been central to the tax reform agenda. Instead, successive governments have introduced a system of highly targeted family benefits and a less progressive income tax, together with regressive indirect taxes. My analysis shows that two decades of reform have shifted the tax burden disproportionately to low and middle income families.

AUSTRALIA’S EVOLVING FAMILY TAX-BENEFIT SYSTEM

In the Overview to Budget 2004–5, the Treasurer described the $37 billion spending on tax cuts, family assistance, and superannuation measures as ‘a further major instalment in the ongoing reform of the Australian family assistance and tax system to help families raise their children, help them to balance their work and family responsibilities and improve rewards from work’ (Australian Government 2004, p. 2). My findings show that the additional family assistance and tax cuts are certainly consistent with the government’s ongoing tax reform agenda—and with its ideas about appropriate family arrangements. The major share of spending goes to families in which one parent withdraws from the workforce or opts for a minimal workforce attachment. In addition, the income tax cuts that apply above $52,000 annual income ensure that families with at least one higher income earner also gain substantially. This dual shift in the tax burden has been a priority of the Howard Government since it gained office, and was a central aim of the 2000 ‘A New Tax System’ (ANTS) package.

Two decades of reform have shifted the tax burden to low and middle income families.

Using a sample of 1098 ‘in-work’ two parent families from the Income Distribution Survey 2000 (ABS 2003), Table 1 sets out evidence about how changes to taxing and family payments affect families with different incomes and working patterns. The families in the sample are all surveyed families whose earnings were mainly derived from wages and salaries, and whose primary income earner was in full-time work and earning more than $5,000 per year. I’ve divided the families into three groups: one-earner families, two-earner families in which the second earner works part-time (PT), and two earner families in which the second earner works full-time (FT). The table divides families into quintiles of primary income (defined as the private income that the family would have if the second earner withdrew from work) and compares the average tax rates (ATRs) they face before and after the new tax and family benefit changes announced in Budget 2004–5.

The rates reported for one earner families are the ATRs that all families would face if the second earner withdrew from work. The rates for two earner families, in which second earners work either part-time (PT) or full-time (FT), are the ATRs faced by the second earner.

Table 1: Average Tax Rates for Working Families, per cent
 
Quintile 1 2 3 4 5 All
One-earner families            
  2003–4 rates -8.7 9.8 17.1 22.8 35.5 23.1
  2004–5 rates -13.1 5.4 13.2 18.7 33.5 19.9
Two-earner PT            
  2003–4 rates 43.8 32.3 29.9 31.4 33.3 33.5
  2004–5 rates 38.9 33.1 31.3 31.8 34.6 33.7
Two-earner FT            
  2003–4 rates 34.7 29.8 31.1 33.4 34.9 32.8
  2004–5 rates 34.3 31.5 33.1 34.8 34.8 33.8
 

The first row of the table reports the ATR, calculated as income tax net of family benefits, that families would face under the 2003–4 tax and family benefit system, if they have only one earner, and the second row, the ATRs they would face under the 2004–5 system. Under both systems, the quintile profile of ATRs suggests that the tax system is strongly progressive. Under the 2003–4 system, the ATR rises from a negative rate of 8.7 per cent in the bottom quintile (that is, in the poorest 20 per cent of families) to a positive rate of 35.4 per cent in the top quintile. The 2004–5 system is even more progressive, with ATRs rising from a negative rate of 13.1 per cent in the bottom quintile to a positive rate of 33.5 in the top quintile.

The contrast between the average tax rates faced by primary earners and second earners is stark.

The next two sections of the table report ATRs faced by part-time and full-time second earners under the same systems. There are two important things to note here. First is the stark contrast between the average tax rates faced by second earners, whether part-time or full-time workers, and the average rates on primary income. The strong progressivity we saw for tax rates for primary earners is entirely missing. Under the 2003–4 system, part-time second earners in the bottom quintile face the highest ATR of 43.8 per cent, and ATRs for second earners average over 33 per cent. Second is the fact that for most income groups, ATRs for second earners in two income families actually rose with the changes to the tax and family payment system for 2004–05. Clearly low to middle wage families facing the greatest difficulties in trying to balance work and family responsibilities—that is, families in which both parents work significant hours—receive relatively little to no additional assistance under the recent reforms.

I noted above that the 2004–5 changes increased the progressivity of the tax and family payment system for primary earnings. Primary earners in the top quintile faced an ATR of 35.5 per cent under the 2003–04 system; this rate fell to 33.5 per cent with the 2004–05 changes. However, Table 2 shows that, in dollar terms, primary earners in the top quintile will receive average tax cuts of $2837, and in the fourth quintile, $2863. Poorer single earner families receive lower tax cuts, down to an average of $1297 for families in the bottom quintile.

Table 2: Changes in average tax for working families, 2004–5, dollars
 
Quintile 1 2 3 4 5 All
Single earner -1297  -1917 -2178  -2863 -2837 -2227
Second earner PT -722 161 295 82 293 55
Second earner FT -101 513 793 515 -63 365
 

Table 2 shows that with the exception of families in the bottom quintile, and of families with a full-time earner in the top quintile, taxes increased for all second earners, both full-time and part-time. In other words, the 2004–05 changes shift the tax burden from the primary to the second income earner within households across the middle of the distribution of primary income. The 2004–05 Budget changes are designed to ensure that gains for two-parent families decline as the income of the primary earner (the partner with the higher income) approaches the middle of the wage distribution and as the second earner takes on more paid work.

The high effective ATRs on the incomes of second earners are due to the withdrawal of FTB Part B on the income of the second earner and FTB Part A on combined family income. The large increases in these benefits, together with tax cuts for families with at least one high income earner, in the 2000 tax changes contributed significantly to increasing ATRs on the second income, with two important effects.

Higher effective tax rates on second earners have provided an important source of revenue.

First, the ANTS package achieved a further significant shift in the Australian family tax system towards one with the effective rate structure of joint taxation, across much of the distribution of primary income. A crucial implication of this is that in families in which both parents work, the second earner effectively faces a higher tax rate than other individuals with the same income. Table 1 shows that this is now, on average, a strong characteristic of the Australian tax-benefit system for second earners, apart from the very few with high incomes. For example, under the 2003–04 system, a second earner with an income of $20,000 would, as a single individual, face an annual tax bill of $2,680, or an ATR of 13.4 per cent, while second earners in part-time work with equivalent income face an ATR of 33.5 per cent. The ratio between these two rates, called the ‘tax wedge’, places Australia as the highest among comparable OECD countries (Jaumotte 2003).

Second, as we have seen, higher effective tax rates on second earners have provided an important source of revenue and/or cost saving. In effect, by raising taxes on working married mothers, the government has been able to collect additional revenue for the purpose of funding tax cuts at the top and larger family payments. This approach to tax reform, with its emphasis on shifting towards a more highly targeted family support and welfare system and a flatter income tax, began in the 1980s and, despite extensive criticism by economists, has been pursued ever since.

IS THE SYSTEM FAIR AND EFFICIENT?

The answer to this question is an unequivocal ‘No’, on both efficiency and distributional grounds.

A tax-benefit system with the rate structure described above can be expected to discourage women’s participation in paid work, due to high effective rates on the second income, especially when combined with limited access to affordable child care. Empirical studies find that the labour supply of married women tends to be much more responsive to a change in the net wage than that of prime aged men. This result is easy to understand. With the arrival of children, household production becomes a close substitute for market output and therefore for market work—in other words, it often makes as much sense to do something yourself as it does to go to work to get money to buy it. The most important example of this is child care, which can be provided at home or bought on the market. If the second earner, typically the mother on a lower wage, faces a high effective tax rate and quality child care is not available at an affordable price, she is likely to switch from market to domestic work. This substitution contracts measured GDP and expands the domestic sector. Jobs go from the market place to the home. Employment and the tax base of the economy contract.

The tax and family payment system is neither fair nor efficient.

A longstanding argument in support of joint taxation, and therefore of higher tax rates on the income of second earners, is that horizontal equity requires the equal taxation of households with the same joint income. This argument is fundamentally flawed because it ignores the benefits of withdrawal from the labour market. A parent who switches from working in the market place to working at home on the arrival of children is switching to the home production of close substitutes for market output. If she works in the market place she is taxed on her income, and she is also taxed on the market goods she buys with her income. By switching to home production she avoids both income taxes and the GST. Thus, if the single earner household pays the same amount of tax as the two-earner household with the same joint income, there can be a severe problem of equity.

There is a further point to note. It is usual to define a joint tax (or income splitting) system as one under which combined incomes are taxed at progressive marginal rates. When joint taxation is introduced by switching to a system of family benefits withdrawn on combined income we have, in effect, an inverted U-shaped schedule of marginal tax rates. The highest effective marginal tax rates apply across the middle of the distribution of combined income, not at the top.

A clear result of the detailed design of the tax cuts and additional family assistance in the 2004–05 Budget is to move the family tax-benefit system closer to one of joint taxation. Two strategies are used to close the gap between the amounts of tax paid by one and two-earner families with the same joint income. The first is to limit the tax cuts to individual incomes above $52,000. This reduces the progressivity of the personal income tax, to shift the overall burden to lower wage workers and, therefore, to most working married women. Second, the Family Tax Benefit changes are structured to redistribute the tax burden more towards two earner-families with a more equal intra-family income split. The effects of both these strategies are evident in the cases of two-earner families with a 50–50 income split whose individual incomes are too low to gain from the tax cuts but whose joint incomes are too high to qualify for additional family tax benefits.

CONCLUSION

After two decades of tax reform, the Australian system of family taxation now closely approximates one of joint taxation. This has shifted the overall tax burden disproportionately towards low and middle wage families working longer hours by having a second earner. In effect, a two-earner family, in full time employment and on relatively low wages, now works much longer hours for the government than a single earner family on a higher wage.

Governments have avoided reforms to reduce revenue losses from tax minimisation schemes.

The higher taxation of low and middle wage two-earner families has provided revenue for tax cuts at high income levels and for increasing family benefits to alleviate child poverty caused by more unequal labour market outcomes. Tax system changes have allowed successive governments to avoid much needed reforms, on the scale required, to reduce revenue losses from the excessive use of tax minimisation schemes.

My analysis highlights the need for a change in direction, towards a policy agenda that:

  • introduces measures to cut revenue losses from the use of tax minimisation schemes.

  • develops a high quality, efficient public sector child care system.

  • reverses the trend towards an inverted U-shaped effective tax rate scale. The simulation analysis in Apps (1991), using wage elasticities estimated on Australian data, shows that a more progressive rate scale would result in an increase in female labour supply and in the tax base required for funding pensions.

  • eliminates Family Tax Benefit Part B. This would help to achieve a more ‘neutral’ treatment of single and two-earner families, and a more progressive tax system with respect to two-parent family living standards.

Consistent with the findings of theoretical and empirical studies for OECD countries, reforms of these kinds can be predicted to increase female labour supply, GDP and fertility, simultaneously (Apps & Rees 2004).

REFERENCES

Australian Bureau of Statistics 2003, Survey of Income and Housing Costs, Australia, Cat. no. 6541.0.30.001, Australian Bureau of Statistics, Canberra.

Australian Government 2004, More Help for Families, 2004-05 Budget—Overview, Canberra.

Australian Government 2004, Australia’s Demographic Challenges, Canberra.

Apps, P. F. 1991, ‘Tax reform, population ageing and the changing labour supply behaviour of married women’, Journal of Population Economics, vol. 4, no. 3, pp. 201–216.

Apps, P. F. & Rees, R. 2004, ‘Fertility, female labour supply and public policy’, Scandinavian Journal of Economics, forthcoming [Online], Available: http://www.iza.org.

Jaumotte, F. 2003, Female labour force participation: past trends and main determinants in OECD countries, WP No. 376, Economics Department, OECD.

Patricia Apps is Professor in Public Economics in the Faculty of Law at The University of Sydney.