Brian Fallow: Tax cuts? That won't come cheap

The problem is that reducing tax on lower and middle incomes is really expensive because that is where most taxable income is, Brian Fallow writes. Photo / Mark Mitchell

Seven years since the income tax scale was last adjusted, it is good to hear the new Finance Minister reaffirm the Government's commitment to tax cuts "when we have the room to do so".

Half way through the current financial year, the fiscal bottom line (the operating balance before gains and losses) is running two-thirds of a billion dollars ahead of forecast, though Steven Joyce warns that it is still too early to be sure a surplus will be achieved this year, particularly given the costs associated with the Kaikoura earthquakes.

Under the accrual accounting system, the expected hit to the Crown's finances from such a shock has to be booked in the year the event occurs, not when it actually parts with the money. It is why there was a deficit of more than $18 billion recorded in the year of the Canterbury earthquakes.

But for May's Budget it is the next couple of financial years that are relevant, and at this stage the economic forecasts underpinning projected surpluses of $3.3 billion and $5.4b respectively still look plausible.

However, tax cuts face stiff competition for a slice of that pie - assuming there is no shock that keeps the pie in the sky.

The other three key areas Joyce says he is thinking about in preparing the Budget are improving public services, infrastructure and reducing public debt, at least relative to the size of the economy.

So while he talks of "reducing the tax burden and in particular the impact of marginal tax rates on lower and middle income earners", it is anyone's guess how much might be on the table for that purpose.

It is semantically generous to talk about "tax cuts" when at least part of what we might hope for is a reversal of seven years of stealth tax increases through fiscal drag or bracket creep. That is the effect of inflation pushing people into higher tax brackets.

Inflation has admittedly been relatively low in recent years, but not non-existent. The consumers price index has risen 9.3 per cent since the 2010 tax changes came into effect.

Someone on the average wage in 2010 (ignoring any other income and Working for Families tax credits) would have paid just over $8000 in income tax or 16 per cent of their income.

Someone on the average wage today faces $10,400 in income tax or 17.4 per cent of their income. Even though their marginal tax rate - the rate they pay on the next dollar of income - has not changed from 30c in the dollar, the proportion of their pay incurring that rate has increased, raising their effective average tax rate - the share of their pay the taxman gets.

The effect of fiscal drag is even more apparent for those in the top bracket, earning more than $70,000. They comprised 11 per cent of taxpayers in 2010 and they collectively paid 48 per cent of the revenue from income tax.

Now those in the top bracket present 17 per cent of taxpayers and contribute 60 per cent of the income tax take.

If the coming Budget were to adjust the tax thresholds to compensate for CPI inflation since the September 2010 quarter, the top of the lowest band would be raised from $14,000 to $15,300. The boundary between the lower middle and upper middle brackets would rise from $48,000 to $52,500, and the top rate would kick in at $76,500 rather than $70,000.

The problem is that reducing tax on lower and middle incomes is really expensive because that is where most taxable income is.

The revenue cost of those adjustments would be around $800 million, according to a helpful tool the Treasury publishes. It factors in the 15 per cent or so the revenue clawed back from any income tax reduction, mainly through GST.

If you also wanted to reduce tax rates, by say 1c in the dollar, for all but the top bracket, that would raise the fiscal cost to around $1.9b.

That is a pretty hungry bite out of the forecast fiscal surpluses.

Clearly, there are any number of other possible combinations of threshold adjustments and rate cuts you might envisage.

Making the first $10,000 of income tax-free, for example, while leaving the rest of the scale as is would also cost around $2b a year.

The problem is that reducing tax on lower and middle incomes is really expensive because that is where most taxable income is.

And the benefit of cuts there is spread thin, because that is where most taxpayers are.

Currently, about $42b of taxable income, or 27 per cent, is in the lowest band (up to $14,000).

In the lower middle bracket ($14,000-$48,000) there is another $62b of income, or 40 per cent of the total.

In all, 2.5 million taxpayers, or nearly 70 per cent of the total, earn less than $50,000.

And this at a time when the average wage (based on average weekly earnings from the quarterly employment survey) is $60,000 a year.

That puts someone on the average wage in the second highest tax bracket, with a marginal rate of 30c in the dollar. Surely they should be included in the "middle income earners" whose marginal tax rate the minister talks of reducing.

After seven years of bracket creep, the case for unwinding the stealth tax increase it represents is pretty strong.

Beyond that, though, if the Government really wants to make life a bit easier for struggling households, it probably needs to look beyond the income tax scale to things like Working for Families and the high effective marginal tax rates it gives rise to. It might also want to reconsider whether those tax credits should continue to be denied to benefit-dependent families.

And in the light of the housing crisis, and its ideological preference for the funder/provider split approach, the accommodation supplement cries out for adjustment.

It's just a shame the laws of arithmetic are so pitiless and unyielding.