The Flat Tax War Begins

If there has been one aspect of the debate over superannuation taxes that has become clearer to me as it has gone on is that it is really just the first salvo in the war by vested interest groups, and equally vested media groups for a move to a flat income tax.

We now live in an environment where the suggestion of progressive taxation results in media articles accusing proponents of indulging in class warfare.

The front page of today’s Oz made it clear that superannuation is just the small fry. The bigger game is income tax.

The front page featured an article by Adam Creighton – he who last year called for policy to be less evidence based and more ideology driven (oh and democracy isn’t sustainable either) – which argued against progressive income tax.

The article’s headline gives away its intent:

Wayne Swan's rich targets already pay the bill

Creighton notes in the third paragraph that:

Australia's tax system is highly progressive, with a top marginal tax rate of 45 per cent - above New Zealand's at 33 per cent and the US at 35 per cent.

Now that would seem to make us the very epitome of socialism, but Creighton fails to mention a few other countries. Thankfully for us the OECD has the information and we can see that the UK for example has a top tax marginal rate of 50% [Neerav Bhatt on Twitter has reminded me that the Cameron Govt has just reduced this to 45%], Belgium has 50%, Germany has 45%, Israel has 48%, the Netherlands has 52%, and Japan is just below us with a 40% top tax bracket.

Now actually comparing the progressivity of different country's taxation system by looking at what is the top marginal tax rate levied by the central government is actually quite simplistic (borderline stupid, really), especially when you consider if you include (as the OECD does) Personal income tax PLUS employee social security contributions from the central and the “sub-central” (ie state Govts in the USA) then the USA’s top marginal tax rate comes in at 43.2%, and Australia is pretty much right in the middle of the OECD pack.

But as there are much better ways to look at progressivity of tax and I’ll do that another day.

For now let’s keep to flat tax and Creighton’s argument, which he states here:

Overall, the top fifth of taxpaying households are the only net contributors to Australia's welfare state, once handouts and use of government services such as education and healthcare are taken into account. The more you earn the more you pay, and at an increasing rate. A chief executive earning $1 million a year is required to pay more than $423,000 in annual tax, almost 40 times as much tax as a high school teacher earning $60,000 a year.

A junior apprentice pays an average tax rate of a little over 9 per cent compared with 38.3 per cent for the successful barrister.

Now I don’t know about you, but I am not too stunned by the fact that someone earning a million dollars pays a shirt load more tax than a school teacher, but apparently this is news (front page news at that). Indeed get me some feathers and knock me down, because did you know a barrister pays more tax than a junior apprentice?!

!!! (I mean wow!!)

Yes boys and girls, Adam Creighton has discovered that Australia's income tax is …. (get the kids to leave the room, this is pretty shocking stuff) progressive. (The Tele is right, Stalin is in control!)

There’s even a handy little graph provided (on the front page) to show us the injustice:

Now a few things about this graph. First. How about that scale! It certainly make for a big bow of progressivity!

But that diagonal red line is the key. That is The Oz letting you know that those teachers, public servants are getting in their view the equivalent of a tax concession!

OK. Let’s get to the graph. Here’s what Creighton’s graph looks like with the correct scale.

Not quite as impressive is it? That’s because the first 4 categories in the Oz’s graph occur in the first three income instalment in the real to scale version.

So OK, they use dodgy graphs to sell their point (beats the hell out of being honest with your readers I guess).

But let’s get down to it. Here’s the current Marginal Tax Rates, and I’ll go to $1m to match Creighton:

But the thing about taxation is just because you are in the marginal tax bracket of 45%, you don;t actually pay 45% of your income in tax, because of course the 45% rate only applies for that part of your income that is above $180,000. So a much better way to look at things is average tax rates:

So as you can see the line goes up fairly steep (as sign of progressivity) and then flattens out. From this you can work out that if say you earn $100,000 you’ll have to pay (before deduction and not including the Medicare levy) around 25% in tax, even though you are in the 37% tax bracket.

Now if we were to apply the logic of The Oz’s flat tax diagonal line, here’s what the average tax rate would look like compared to the current:

As you can see everyone except anyone earning $1m dollars pays more under this flat tax rate of 42.35%

Now maybe The Oz does think everyone should pay more tax, but no one – not even the lobbyists for rich people, says a flat tax should start at zero. There are many good reasons for having a tax free threshold, and other than social reasons, economically it make little sense to tax someone when they earn so little that the tax would actually be a disincentive to work and also would likely encourage cash in hand work.

The current tax free threshold is $18,200. Up till last year it was $6,000. But there is also a low income tax offset, which meant till last year the effective tax free threshold was $16,000, and now is $20,542.

Let’s assume the flat tax folk want to simplify the tax scheme (that’s often the reason given when they want to hide their real reason). So let’s not bother with the low income tax offset, but let’s start our 42.35% flat tax at $18,200, and see what happens to our average tax rates:

Notice anything that happened because of that tax free threshold? Yep. Because it lowers everyone’s average tax rate and because the top marginal tax rate is now 42.35% and not 45% that means those at the higher end actually would pay less tax!

How does that look in terms of difference of total tax paid? Have a look:

Yep, under this flat tax rate everyone who earns less than $707,400 pay more tax, those who earn over pay less.

But even the flat tax disciples don’t want this scenario. We only have to go back to Creighton’s article – it is the top marginal tax rate that is the problem. The Henry Tax review called for a flat tax of 35% starting at $25,000 and going to $180,000, at which point the 45% would kick in as usual. And because we’re dealing with real world ideas now, I’ll include in the current average tax rate the impact of the low income tax offset:

As you can see there is not as much change – because the rate isn’t as high, and also because the 45% top tax rate still exists. But some people still need to pay more tax, and some pay a bit less:

Those from $25,000 to around $165,000 pay more, and those after pat $297 less – it stays flat because that top tax rate remains as before. You can see there’s a big decrease in tax for those between the current effective tax free threshold and the $25,000.

But note who is paying the most extra  - those earning between $50,000 and $100,000 – ie those pretty much in the median income grades.

Equitable? I think not.

And remember as well that 45% tax rate is still too high under the Henry recommendation. The IPA in its infinite, paid for wisdom, suggests in it’s 75 big ideas that:

“Number 45. Introduce a single rate of income tax with a generous tax-free threshold”.

So let’s put that threshold at $25,000, where the Henry Review suggested and keep the 35% of the Henry review as well, but we’ll remove the 45% rate at $180,000 because the flat taxers only want one tax rate.

Let’s look how that compares:

And now we see the real reason why those who favour flat tax rates are usually those who either are rich, write for newspapers read by the rich, or receive donations from the rich to lobby on behalf of the rich.

So who would pay more or less compared to now?

Kind of stunning ain’t it.

But because looking at things in $ amounts can be misleading, let’s look at the change in tax paid as a percentage of income:

Always remember when someone starts talking to you about how there should be just one flat tax rate for everyone who really will be winning out of the change. Unless you happen to be one of Creighton’s barristers or chief financial officers, it most likely is not going to be you.