Back to Flat Tax? The Coalition and the Henry Review

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With the Coalition making noises about tax reform, Ben Spies-Butcher looks at the implications of the Henry Review proposals on a flat income tax

Last year I reported on a proposal from Henry Ergas to the Liberal Party for a flat income tax.  Ergas argued that it could improve work incentives and reduce complexity. I pointed out that it would also significantly reduce the progressivity, or fairness, of the tax system by giving large tax cuts to those at the top.

This week it appears the Coalition is back to the same game, saying it will look into a proposal from the Henry Tax Review. The proposal has been described as ‘almost’ a flat tax. But in reality it is a much more sensible reform than that proposed by Ergas, and if it were combined with other reforms from the Review, could be an improvement to the tax system.

What makes the Henry Review proposals different? The Review combines the best elements of a flat tax, with some modifications that substantially increase its equity. For virtually all full time workers, the tax rate will be the same –35 per cent. That rate kicks in just before the minimum wage, and goes right through to all but the top few percent of income earners.

So in this sense it is a flat tax, because workers do not find themselves bumped up into higher tax brackets as they get a pay rise or do some overtime. But the real concerns of a flat tax – that those on low incomes pay the same tax rate as high-income earners; and that the highest income earners get windfall tax gains, are reduced substantially.

The Review answers these concerns by including two other tax rates. The first is a generous tax-free threshold, going all the way up to $25,000 a year. This has two effects. First it reduces the interaction of the welfare are tax systems, and so reduces the poverty trap effect of losing benefits and paying tax as people enter the workforce.

Second, it means that a person’s average tax rate is closely related to their income. Someone earning $30,000 would only pay tax on the last $5,000. That would mean a total tax bill of $1,750, or 6 per cent of their income. Someone on $90,000 would pay $22,750, or 25 percent of their income. So the system would be progressive.

The Henry Review proposal also maintains the top tax rate for those on the highest incomes, over $180,000 per annum. This means high-income earners do not get the windfall gains of a single tax rate. That is also important for protecting the tax base as currently almost half our income tax revenues come from those earning over $150,000. But because very few people earn that much, keeping this top rate has virtually no effect on the vast bulk of workers and so still achieves greater simplicity.

In many ways, the Henry Review proposal is a logical response to the growing complexity of the income tax system. Governments have been cobbling together small-scale solutions to individual problems, but in turn simply creating new ones somewhere else in the system.

The tax threshold has been increased for very low-income earners, but then phased out, meaning even higher tax rates for those earning just a little more. There are also a series of offsets for groups like pensioners that would be better delivered as a higher benefit. Simplifying the system is a welcome move.

However, the other side of the Henry Review proposals is to broaden the tax base. In particular this means cracking down on fridge benefits and trusts, so that the same tax rates apply to all those earning the same income.

Interestingly the Coalition has yet to comment on this aspect of the proposal.

Full costings are not yet available, so some caution is needed. Simplifying the tax system by undermining the tax base and reducing funding for needed public services is not a useful reform. But it is good that our political leaders have started to engage with the Henry Review. Let us hope they also examine the reforms to housing, investment and tax concessions too.

POSTSCRIPT: Since initial publication it has been correctly pointed out that under the Henry Review proposal there is a higher tax burden on many full time workers, and an effective tax cut at the top due to the removal of the Medicare levy. I accept these are undesirable outcomes. The point of the article was to highlight that progressivity can be achieved with fewer tax rates, so long as the highest tax rate is maintained and there is a generous tax free threshold. This can be achieved with minor modifications to the Henry proposal, by increasing the tax free threshold and fully incorporating the Medicare levy into the top tax rate. The article should have clarified that it was the principle of a three tiered tax system built along these lines, rather than the specific Henry proposal per se, that warranted greater investigation.


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  • http://mattcowgill.wordpress.com Matt C

    You say “The Henry Review proposal also maintains the top tax rate for those on the highest incomes”.

    That’s only true if you ignore the Medicare Levy and Medicare Levy Surcharge. If you include both of those things, the Henry proposal actually reduces the top marginal rate by 2.5%.

  • Grant B

    Comparing those marginal rates and thresholds to the current structure (including the Low Income Tax Offset, which Henry recommends be abolished) means all singles with annual incomes between $32,000 and $110,000 would pay MORE tax under this proposal. And 60% of all taxpayers fall in this income range. Your calculations showing that average tax rates increase with income under K Henry’s scheme are right, but you should point out that the rise is less than under present arrangements. Yes Ben, K Henry’s is better then Henry E’s, but it is still flat and would be more regressive than the current personal income tax structure. The comparison between K Henry and Henry E is between bad and even worse.

    • Peter Whiteford

      Grant B

      The abolition of the Medicare levy means that most of the people in the groups you identify do get tax cuts but these are least valuable between $70,000 and $90,000 and there is a tax increase at around $80,000.

      • http://mattcowgill.wordpress.com Matt C

        Hi Peter,

        That does not seem right to me.

        My calculations are as follows, assuming a single taxpayer on $50 000 per annum.

        They currently pay $8550 in tax (=(37000-6000)*0.15+(50000-37000)*0.3).
        They receive $700 in LITO (=1500-((50000-30000)*0.04)).
        They pay $750 in Medicare Levy (=50000*0.015).

        Their ordinary tax ($8550) plus their Medicare Levy liability ($750) minus their LITO ($700) leaves them paying $8600 per annum net tax.

        Under the Henry MTR structure, they would pay $8750 per annum tax (=(50000-25000)*0.35).

        The Henry system therefore leaves a taxpayer on $50 000 per annum $150 worse off than under the current system.

        It is admittedly a relatively small tax increase, but it is nevertheless an increase. I believe there are other increases, some larger than that, along a span of middle incomes similar to the range Grant suggested.

        If my analysis is wrong, I’d very much appreciate you pointing out the deficiency to me.

  • Nerissa

    A flat tax rate will always hit those in the lowest income brackets, it is an inequitable system. Even with modifications the actual rate is still in favour of the high income earners. Horizontal/Vertical Equity taken into account.

    There were some great proposals out of the Henry Review, but it is disappointing that only a handful were chosen to be implemented. The review needs to be thought through more seriously by the next government and if this is the Coalition…I’m moving to scandinavia.

  • brian toohey

    Having spent years warning about the disincentive effects of marginal tax rates, Henry now proposes to increase them sharply for those between $25,000 and $37,000. Their marginal rate will go from 15 percent at present to 35 percent (less the present clawback of 4 percent under the Low Income Tax Offset which Henry will abolish).

    Having the same flat rate to $1800, does almost nothing for simplification, as all employers use simple software (eg MYOB) or ATO tables (printed or off net) to calculate withholding tax.
    It is hard to see how Henry broadens the base. He recommends that income from passive assets be taxed at a lower rate than income from working — and not just for superannuation. His scale will also greatly encourage income splitting, which is hardly progressive. Unfortunately, the government has halved the tax on first $1000 of interest income. Part of the given reason was to induce retirees to save more this fashion. But thanks to Henry’s zero tax on super payouts and the seniors tax offset, most retirees, including ones much better off than many workers, don’t pay tax.

    There’s not a lot of difference between Labor and Coalition on Henry’s proposed personal tax scale. Each have said they will consider it down the track. Also Swan said in 2007 that Labor’s aspirational goal was to have a flat rate of tax of 30 percent between$ 37.000 and $180,000. Brian t

  • Ben Spies-Butcher

    Thanks for the comments, very thoughtful and insightful. And I agree there remain significant issues with the Henry model. But I still tend to be in favour of a high tax free threshold rather than lots of rates, and a rebate that then phases out. My main point was that this is not really a flat tax, and indeed progressivity does not require lots of rates, a large tax free threshold does a similar job. But I agree the middle rate is relatively too high to the top rate and the tax free threshold too low.

    On broadening the base, the Henry Review does look to expand the definition of fringe benefits tax. I wholeheartedly agree with the Brian’s criticism of Henry’s lower tax rate on investment income (something I’ve taken up elsewhere with Adam Stebbing in relation to super). Although interestingly the review also raises the prospect of a bequest (or inheritance) tax. Which would address some of the issues raised by the low rates of tax on investment.

  • Paul Loring

    I don’t think either the Henry Review or other reviewers since have given sufficient consideration of Deductions.

    For a short while I worked as an H&R Block tax consultant, and from the amount of time I spent every day on deductions, and also as seen on their TV ads with the man smothered in receipts, you realise just how big an issue this is for tax payers, but also the impact it has on tax paid, and equity amongst tax payers.

    A simple example is the best way of getting to the crux of the matter. Two workers, low paid whose marginal rate is 15% and high paid who is 45%, each buy a work related diary for $10. The low paid gets 15% reduction, ie, effectively pays $8.50, the high paid gets a 45% reduction, effectively pays $5.50 for the exact same work related expense, ie, a Deduction.

    In reality this is compunded many fold as gross income rises. Eg, the high income earner actually buys a laptop depreciates it over two years, the low incomer earner can’t even afford the laptop let alone get it at a discount, a much smaller discount than the high paid.

    The high paid doesn’t just have a laptop but also an investment property or two, a share portfolio, negatively geared loans, etc.

    A flatter system may flatten this descrepency, but it still remains and very much for the benefit of the higher paid.

    A system that I think meets several of the Henry Reviews needs, eg, simplier, still gives benefits across the board but with assistance giving the greatest benefit to low paid, reducing progressively with gross income is:
    Effectively calculate gross tax on gross income, then reduce gross to net tax, applying a common system to everyone. The expense transfer would start with everyone receiving the same highest rate on the initial band of expense, with succeeding lower rates for subsequent bands, eg, say first $1000 at 40%, $1001 -$2500, 30%, $2501- 10,000 15%, zero beyond!

    As now this would apply to all income expenses, work, investment, property, negative gearing, etc.

    In this example both would get the same benefit for the $10 diary. If the high income earner wanted to buy a laptop, property, shares, then the decision would increasingly become one based on genuine viability of the investment, not merely the tax benefit. That would better for a sustainable economy.

    I think this approach, would also work well with a flatter and lowering of all marginal rates. Acturaries would need to calculate the balance of gross income rates and the expense transfer rates, to both fill the coffers, and distribute wealth.

    There are other benefits. Still maintains a graduated taxation approach, a stronger one in fact. It effectively caps negative gearing. It also reduces the need for the massive expenditure currently wasted on tax consultants/accountants, as once the ceiling level for Expense Tranfer is reached, there is no point considering additional expense.

  • Ben

    Thanks Paul.

    I agree the system of deductions needs significant reform. Adam and I have done a little work on this in relation to the super tax deductions (which follow the same logic as work expenses). I also agree that a system that provides some uniformity in the rebate it offers would be much fairer. One option is the one you outline, another is to have the percentage rebate decrease with income (rather than expenses), for example those on $40k might get 30% back while those earning $100k might get only 10%. Or we could extend the approach taken already by the Government, which is to offer a standard deduction to all regardless of their claim.

    The advantage of this last approach is that it would reduce complexity and administrative costs as only a few tax payers would need to then lodge a tax return. The disadvantage is that workers with large expenses might be disadvantaged, especially compared to those doing similar work set up as small businesses or contractors and therefore able to deduct work expenses as business expenses. It also raises the question of charitable donations, because it eliminates the tax incentive to donate. Personally, I’d prefer this incentive to be given to the institution, not the individual, along the flat-rate line. That is if you donate to a charity, then the government will match 30% of it to the charity (not you). This gets rid of the administration for individuals and cuts it down for the state (it only needs to deal with a few thousand charities not several million tax payers. And it means everyone’s money gets the same benefit.

    It is an area well worth reform. I tend to favour a flat rebate – but the issue of equity between workers and business/contractors remains a real one. Your option could be a good way forward.

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