Working for Families tax trap

By Simon Collins

Nearly 378,000 New Zealand households get a bit more money each week through Working for Families tax credits. But a system designed to help young families actually punishes them as extra income earned from hard work is taxed at rates as high as 90c in the dollar. For some families, the dole is a better option. Simon Collins investigates what's wrong and how a failing system could be fixed.

David Hall and Anne Mason opted to put Ryan, 5, and Sophia, 3, before their careers, a decision with economic implications. Photo / Christine Cornege
David Hall and Anne Mason opted to put Ryan, 5, and Sophia, 3, before their careers, a decision with economic implications. Photo / Christine Cornege

Anne Mason and David Hall are at the stage in life where their top priority is their children.

Hall teaches fulltime at a Hamilton high school, earning about $50,000 a year.

Mason, after 16 years teaching English in Asia, chooses to work only part-time now, on about $12,000 a year, so she can look after their children Ryan, 5, and Sophia, 3.

"It's what I want," she says. "I waited a long time to have my children. I worked for a long time, I've been there, done that. Right now I'm very committed to my children, they're only young for a very short time. I can go back to work any time."

But the couple pays a price for their choice to put their children first, for two reasons.

The first reason is, ironically, because the Government helps them with $125 a week in tax credits through Working for Families. Although the credits are reducing as Hall moves up the teaching salary scale, they will not disappear completely until the couple's joint income reaches $90,457.

"Right now those benefits are great," says Mason.

But clawing back those credits takes 20c out of every extra dollar that either Hall or Mason earns. Piled on top of the standard tax scale, that means Hall ends up keeping less than half of any extra dollar.

That "tax trap" was identified by the Government's tax working group last week as a key factor holding back New Zealand's economic growth. Three-quarters of all our families with children, 377,800 families at last count, receive Working for Families tax credits.

And the second reason Mason and Hall pay a price for their choice to keep one parent mainly at home is that the tax system treats their incomes as completely separate. Hall pays tax at the second-to-top rate of 33c in the dollar just as if he was single, even though his income is shared with his wife and children.

Mason has joined a lobby group, Parents as Partners, which sees this as a kind of "tax trap" too. The group wants to let two-income families split their incomes for tax purposes.

For Mason and Hall this would mean paying tax on $31,000 each, lowering Hall's tax rate sharply to just 21c in the dollar.

The problem

The tax working group found that the combination of tax rates and welfare clawbacks, especially for Working for Families, doesn't just hold back thousands of people from increasing their incomes. It also diverts their efforts into finding ways to hide whatever they do earn.

"Expansion of the Working for Families tax credits in 2005 has increased the incentives for people to shelter or split income, undermining the integrity of the system," it said.

Economist Gareth Morgan, a member of the group, is blunter.

"The thing is completely broken," he says. "Many people with low taxable incomes are actually rich people who are getting benefits just by spreading their incomes across different entities. The system works like a sieve."

The group recommended "a comprehensive review of welfare policy and how it interacts with the tax system".

Christina Reymer, a Hamilton mother-of-five who started the kindergarten that Ryan and Sophia Hall attended and also founded Parents as Partners, says the system also fails to recognise the value of unpaid parenting.

Separately from the tax working group, the Inland Revenue Department has published an issues paper on allowing "income-splitting".

Submissions are due by February 5.

How the system works

The current tax system works purely on the basis of individual income, regardless of how many other adults or children depend on that individual's income.

The income tax scale rises progressively from 12.5 per cent on the first $14,000 a year to 38 per cent above $70,000.

Hall, on $50,000, pays 33c out of every extra dollar in income tax, plus 1.7c (rising to 2c from April) for accident insurance (ACC).

Mason, on $12,000, pays only 12.5c plus ACC.

In contrast, the welfare system, including Working for Families, is based on the total family income. So both Hall and Mason lose an extra 20c out of every extra dollar they earn through reduced family tax credits, raising Hall's effective marginal tax rate to 54.7 per cent and Mason's to 34.2 per cent.

That's bad enough, leaving Hall with less than half in his pocket out of every extra dollar he earns - and that's without counting the 4c out of every dollar that both he and Mason pay into KiwiSaver.

But the highest clawbacks are actually at lower incomes, where income taxes are piled on top of a 70c clawback of the unemployment benefit above a family income of $80 a week, to give Hall effective marginal tax rates of slightly over 84 per cent up to $14,000, and briefly over 92 per cent before the benefit cuts out at $15,731 (assuming Mason earns a steady $12,000).

Some families can easily end up worse off working than they would be on the dole if they also have to pay student loan repayments or child support, which both increase with income, or have income-related accommodation supplements or Housing NZ rents.

The social context

Married couples' incomes were taxed as a single unit until 1962, but the tax system has shifted gradually since then to treat all individuals equally.

As late as 1982, 52 per cent of two-parent families with at least one full-time worker still comprised one full-time paid worker (usually Dad) and one parent at home (usually Mum). Both parents worked full-time in only 20 per cent of families.

By 2007, that picture had almost reversed itself. Families where both parents work full-time (37 per cent) now exceed those with just one paid worker (34 per cent) and those where one works full-time and one part-time (30 per cent).

More families are also breaking up. A Waikato University study based on 1995 data found that 46 per cent of New Zealand mothers became sole-care parents at some stage before they were 50. The number has almost certainly increased.

Arguably, the shift towards taxing individuals rather than families reflects these social changes and, in economist Susan St John's words, "it's the welfare system that is out of line".

But the alternative view sees the tax and welfare system as actually contributing to family breakdown. Act candidate Lindsay Mitchell says the state has increasingly replaced the traditional male breadwinner.

The conservative Maxim Institute argues that both the tax and welfare systems should treat the family as the basic taxable unit.

Option 1:
Welfare for individuals

"Tax traps" are caused by piling tax rates on top of clawbacks of multiple welfare benefits such as Working for Families.

In principle, the best way to remove tax traps is therefore to integrate the tax and welfare systems so that state support is removed gradually before taxes cut in.

The ideal is what Gareth Morgan, in this week's Listener calls "the Big Kahuna" - an integrated system that pays out a benefit to anyone earning less than a basic income, then claws it back at, say, 25c in the dollar as the person earns more part-time income up to the basic level.

Above the basic income, the 25c clawback rate continues as a net tax rate so that no one across the whole income scale ends up losing more than 25c out of every extra dollar earned.

The general idea has support across the ideological spectrum. On the right, Act shadow finance minister Roger Douglas has proposed a scheme with a tax-free income threshold of $31,200 ($600 a week) for individuals, plus extra for children, but without the net payout below the threshold.

He would have an even lower flat tax rate of 16.66 per cent, funded partly by a capital or wealth tax and partly by shifting much of the cost of sickness, unemployment and pensions to private insurance.

On the left, Susan St John and Unitec economist Keith Rankin have proposed a guaranteed minimum income of around $8000 for each individual, plus $2000 for every child, clawed back by a flat tax of 33 per cent.

Unlike Morgan, they acknowledge that $8000 is not enough to live on, so they would also have a second tier of targeted benefits for people with special needs such as sole parents and the elderly, but the basic guaranteed income would mean the tax trap would be much reduced.

In principle, these systems could be made more progressive by keeping higher tax rates on high incomes too, but Rankin says the tax-free basic income gives them a built-in progressive structure.

Almost all other developed countries have at least a tax-free low income zone. Australia has a tax-free zone and a low-income rebate, which means no Australian pays tax on income of less than A$15,000 ($19,000).

The lack of a tax-free zone here is the main reason why the tax working group found that New Zealanders pay more tax than Australians at all incomes up to $240,000 a year.

Rankin and St John also propose paying all primary benefits such as the dole on an individual basis, regardless of a partner's income. Australia allows an unemployed person's partner to earn A$375 ($476) a week before reducing the dole.

"For someone to lose their individual income from an unemployment benefit because they happen to be living with or married to someone who is fortunate enough to have a job seems to be anachronistic," St John says.

National has promised to raise the family income limit before reducing the dole from $80 to $100 a week, but St John believes it needs to be much higher to allow for the multiple, part-time and fluctuating jobs that people moving off welfare often have to take.

"The benefits that would flow from giving people more opportunity to help themselves and participate in the more-casualised labour market would be huge," she says.

Left-leaning economist Brian Easton suggested in a recent book that the casualised job market also requires a new second-tier European-style "social insurance" above the dole, with workers and their bosses paying into a fund that pays out if they become sick or unemployed, regardless of their partners' incomes.

"The aim today has to be to minimise the stress on the unemployed, with an acknowledgement that jobs are no longer guaranteed for life," he says.

Option 2:
Tax the family

The Maxim Institute argues that welfare is correctly based on the family unit, and that income tax should be too.

"A family is a unit so that the income that each partner earns to support the family should be regarded as having been earned by and for both partners," it says in a submission on Inland Revenue's income-splitting plan.

Even though most of the gains from income-splitting would go to high and middle-income couples like Mason and Hall, Maxim believes that fairness should be judged by whether a fair process has been followed, not by the outcome.

Maxim researcher Steve Thomas says income-splitting need not challenge the individual basis of taxation generally, and suggests that the aim should be a flat tax rate of perhaps 27 per cent funded, partly by lifting GST to 15 per cent.

But in principle an integrated system that phases out welfare before it starts taxing income could be based on family income, at least as an option for families that can show that they share their incomes.

Christina Reymer from Parents as Partners says the current system provides subsidies for outside childcare, and a benefit for sole parents, but nothing for stay-home parents in two-parent families.

"The real problem is the lack of recognition of the unpaid work of parenting," she says. " Ask any child who do they want to look after them and they will say, 'I want to stay home with Mummy or Daddy'."

Inland Revenue says income-splitting would cost $450 million a year. Reymer says that investment would be recouped many times over in the future if it enables more parents to be home when their children need them.

Anne Mason tried going back to work in the afternoons last year, but says it "didn't work out".

"My son actually needed more time off than he was getting," she says. "It was fine when he was at [kindergarten], but at home he was having these horrific meltdowns. I actually took him to a psychologist because he was hitting himself and saying, 'I hate the world, I want to die'.

"She said, 'he's over-tired and you need to take him out some afternoons'. I couldn't because I was working. So this year I've told them [her employers] that I can't make such a big commitment."

- NZ Herald

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