Back to Flat Tax? The Coalition and the Henry Review

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.