Brian Fallow: Who said tax was meant to be fair?

The Government has given the Tax Working Group chaired by Sir Michael Cullen a well-nigh impossible task.

Its terms of reference are peppered with the word "fair". It occurs seven times. How can the tax system be made "fair, balanced and efficient"?

But the terms of reference go on to rule out all the obvious ways of making it fairer.

For a start, the working group is not allowed to recommend any increase in income tax rates.

Yet there might well be a case for a more progressive income tax scale on vertical equity grounds. That is, the principle that those with higher incomes, or ability to pay, should pay a greater amount of tax.

And if they wanted to reduce the impact of bracket creep in the middle of the income distribution, the revenue cost could be reduced by introducing a new top rate for those with most ability to pay. Too bad, it is forbidden.

Inheritance tax is also ruled out of consideration, despite the obvious equity argument for having one. Yet legacies fall within economists' conception of income — what can be consumed in a given period while keeping real wealth intact — and if you have an income tax, you should tax income. The broader the base, the lower rates can be.

• Details of Government's tax working group revealed

Real capital gains are also income, and the Government has clearly pointed the tax working group's gaze in that direction.

But the family home is off limits for any capital gains tax, and the ground under it for any land tax.

That is despite the fact that housing equity represents the lion's share of household wealth, which is distributed even more unequally than income is.

The "third rail" (touch it and you die) status of owner-occupied housing would also rule out any attempt to tax imputed rents, which also count as economic income.

The major part of a homeowner's return on investment is the avoided cost of renting a similar property. It falls within the purist definition of income, but the electoral fate of Gareth Morgan's party last year suggests that persuading voters of the merits of such a reform is a forbidding challenge.

But perhaps the most unfortunate restriction on the scope of the Tax Working Group's task, from the standpoint of fairness, is that it has been instructed not to consider the interaction between the tax system and the transfer (welfare) system.

Victoria University of Wellington economists Simon Chapple and Toby Moore, in a wide-ranging and trenchant submission to the Tax Working Group, argue that this makes no sense.

It is the net effect of both tax and transfers which reduces the stark inequality of market incomes into the (still substantial) inequality of disposable incomes.

And, it turns out, less so here than in most other developed countries. Officials, in a background paper for the working group on tax and fairness, point out that the OECD reckons New Zealand has the fourth least redistributive tax and transfer system among 30 rich countries it looked at.

[People] could significantly increase the number of hours they work and be not one dollar better off, because of the thresholds and abatement rates which apply.

As one example of the incoherence of the tax/benefit system, Chapple and Moore cite child support payments.

For someone on one of the main befits, like Sole Parent Support, every dollar of child support reduces their benefit by $1 — an effective tax rate of 100 per cent — until the benefit payment is entirely clawed back by the Government.

For someone else who has a job well enough paid not to need a benefit, the same child support is tax-free income. How fair is that?

The tax/welfare interface is riddled with such anomalies and perverse incentives.

Research by Patrick Nolan at the Productivity Commission, into the effective marginal tax rates which arise from the targeting of income support policies, indicates it is not uncommon for people to find themselves facing rates as high as 100 per cent. That is, they could significantly increase the number of hours they work and be not one dollar better off, because of the thresholds and abatement rates which apply.

These poverty traps are not so much a ditch as a crevasse.

Chapple and Moore also highlight the inconsistency between the tax and benefit systems in terms of the units they apply to — individuals or families: "The benefit (or negative tax) system assesses need on the basis of family income. The income tax system assesses ability to pay on the basis of individual income." We assess fairness or equity issues in terms of families, not individuals' circumstances.

"Yet we have a tax system which bases income tax — which has as an important goal equity — on individuals rather than families."

They urge the Tax Working Group to look into the pros and cons of a family-based tax system.

"A lot of OECD countries, including the United States, adjust income tax to family circumstances," says Chapple, a former chief economist at the Ministry of Social Development who now heads the Institute for Governance and Policy Studies.

All this would not be so bad if the newly formed Welfare Expert Advisory Group was going to get to grips with the complexities of the tax/welfare interface.

But it is not clear that it will.

Its brief does include giving "high level" recommendations for improving Working for Families.

And it is instructed to give "due consideration to interactions between the welfare overhaul and related Government work programmes such as the Tax Working Group".

So it arguably does have a mandate, should it wish, to get to grips with the often toxic interaction between the tax and welfare systems.

But it is far from clear that the Welfare Expert Advisory Group has the expertise, or for that matter the budget, to do so.

More likely, the issue will fall between the two stools.

For a Government that proclaims the reduction of child poverty to be a central goal, it is a striking omission.