Joe Hockey wants tougher means testing of welfare, but more targeted means testing will decrease people’s incentives to work
The treasurer is worrying about whether the right people are getting welfare. Photograph: Daniel Munoz/AAP Image
In the run-up to the May budget Joe Hockey has suggested we need tougher means testing of welfare to ensure it only goes to those who “need” it. He has also suggested we need to increase people’s incentives to work.
However, the solutions to these two problems actually conflict because tighter means testing can actually decrease people’s willingness to work, because the more you earn the less you receive from the government.
Australia, as I noted a couple weeks ago, already has arguably the most targeted means testing in the world.
This was further highlighted by the preliminary release of the OECD’s 2014 Taxing Wages report, which noted that Australia has one of the most progressive income taxation systems globally.
But the main reason it is so progressive is not because our tax rates increase sharply with our income but because, as the OECD noted, as our income increases there is a sharp “withdrawal of the generous benefits (e.g. in relation to children and/ or in-work benefits)”.
This is revealed by looking at the “tax wedge” across the OECD for couples with children. Tax wedges in essence measure the tax burden, as they take into account not just the taxes and social security payments paid by employees, but also the benefits received from the government.
On this score we can see how the tax burden in Australia significantly increases for a couple with two children as the second partner earns more money.
The tax wedge for a couple with only one partner earning the average wage is 16.9%; when the second partner earns 67% of the average wage as well, the tax wedge rises to 25.2%, one of the biggest jumps among the OECD.
And this brings us to the problem of Hockey wanting to tighten the means testing and also increase people’s incentive to work. The OECD notes that the highly progressive tax systems in countries like Australia “have to be designed with care in order to prevent too large work disincentives”.
This is because tightening the means testing of welfare actually increases the disincentive to work. To understand why, we need to think about the effective marginal tax rates we pay at certain incomes. Effective marginal tax rates calculate not just the extra income tax you pay by earning an extra dollar, but also the amount of welfare you lose.
For example, the Family Tax Benefit A base payment for one child under 13 is $4,489.50 a year. But it is reduced by 20 cents for every dollar that the combined income of the parents goes over $48,837. This means the effective marginal tax rate they pay increases once they earn more than $48,837.
In essence, earning under $48,837 means they only have to pay income tax. Earning over it means they pay income tax and also lose welfare payments.
As Canberra blogger David Plunkett shows with some excellent effective marginal tax rate graphs on his blog, there are a number of situations where for people on Newstart or other benefits, where you are actually better off not earning any more money because while you might earn more money, you will lose a greater amount in welfare payment reductions.
And this is where the problem for the government arises.
If Hockey, for example, wanted to reduce the number of people receiving Family Tax Benefit A, he could do it by reducing the base payment of $4,489.50. At this amount and with the 20 cents per dollar reduction rate, the maximum you can earn and still get this payment is $64,350. But if the base amount was reduced to (for example) $3,500 it would cut out much earlier – at around $59,000.
But that would mean everyone on the payment would now get less money, not just the higher income earners.
Hockey could instead tighten the payment by increasing the rate at which it is reduced – say to make it reduce by 30 cents for every dollar you earn over $48,387.
This would again reduce the maximum income threshold, while still seeing the poorest getting the same amount, but it would also reduce people’s incentive to work.
Whereas before, earning over $48,837 saw you only lose 20 cents of welfare per extra dollar of income, now it would be 30 cents – meaning your incentive to work is reduced because you end up getting less money than you did before from doing the same amount of work.
The government is currently spending a lot of time worrying about whether the right people are getting welfare, and also about people being encouraged to work. Given our welfare system is already among the most targeted in the world, perhaps they should be less concerned about whether the right people are getting welfare, and more concerned about whether the right people are getting enough.
