Taxing principles for a growing economy

Michael Cullen is softening us up for the abolition of the income tax rate threshold adjustment in 2008. He is thereby jettisoning an important principle — or is he?

The adjustment was never more than half-pie. The so-called “inflation” adjustment was to be fixed at an annual 2 per cent, the midpoint in the Reserve Bank’s target inflation range.

Given the bank’s habit of running inflation above the midpoint — right now it is projecting close to 3 per cent right through its forecast period — that meant the 2008 adjustment would have been sub-inflation.

So it was an ersatz indexation — doubly so, since for a couple of centuries incomes have risen faster than prices more often than not. That is the case now and will be for at least the next year.

Nevertheless, United Future’s Gordon Copeland won an important concession in getting Cullen to buy indexation. Bracket creep — incomes rising through rate thresholds — is a surreptitious sliding tax increase because the share of a person’s income going to tax rises when the income tops a threshold. If the rise in income does no more than keep pace with incomes generally, the taxpayer actually loses ground.

Thus someone on average weekly earnings who in 1999 was paying a top rate of 21 cents now has a significant portion of earnings in the 33 cent bracket. The number of taxpayers paying 39 cents at the margin is more than double the 5 per cent affected in 1999.

The threshold effect is now complicated by Cullen’s byzantine Working for Families rebates and credits (which, by the way, are indexed, as are benefits and superannuation.)

John Key’s big tax cuts promises last year were essentially a bold threshold adjustment — so big that he felt he could safely junk Copeland’s indexation (and Working for Families’ indexation). So there was every likelihood under some future government that bracket creep would revive.

Key can’t deal so big a tax hand next time. There will not be the fiscal leeway.

So Key aims to build broader foundations for National’s economic pitch in 2008. In a speech on March 6 he will examine the constraints on and realities in the economy and begin to build a set of evidence-based principles for growth-oriented economic policy.

In doing that Key is starting to sound more like a mainstream National shadow treasurer and less like a currency trader who has picked up some mnemonics as electioneering aids.

There is sense in that: National in 2005 had to make a splash to get its core vote back, which tax-and-spend jingles and other right-of-centre pitches achieved impressively; in 2008 its core vote will be locked in and its job will be to win voters across the line from Labour.

In this environment Key needs to come up not just with tax numbers but tax principles. And he will have to focus on tax rates, not thresholds. (In 2005 he effectively did both: his threshold lifts were so big they amounted to rate cuts for large numbers of people.)

Enter the Treasury.

The Treasury has not been keen on threshold indexation. That is not because it opposes cuts. Quite the opposite. It got into hot water for recommending in its post-election briefing a cut in high marginal tax rates on personal and company income tax and in effective marginal tax rates.

Cullen called that an “ideological burp”. As if he doesn’t do any of that.

In fact, the Treasury was pointing out a truism: other countries have been lowering tax rates and this country has not. And the Treasury was pointing out a consequence of that truism: that at some point doing nothing about tax rates will affect this country’s relative international competitiveness and so in due course the capacity to deliver what Cullen correctly divines most voters want by way of state services.

The Treasury is lukewarm on threshold indexation because it has concluded from international studies that it is marginal tax rates rather than average tax rates that affect growth. And in that context lifting thresholds “reduces marginal rates for people who are above the old threshold and below the new one but for people above the new threshold it only reduces average tax rates”.

So maybe in one sense Cullen isn’t so wrong in preparing to ditch his half-pie threshold indexation. If he is going to give away revenue, there are better bangs for his bucks to be had.

In fact, he has already given away some revenue by junking the carbon tax — though that was not as a matter of principle but because ad hoc adjustments to the original Kyoto policy had shot it full of holes.

But look again. Dropping the carbon tax highlights another principle: the principle of taxing undesirable activities and reducing taxes on desirable activities.

The carbon tax, imperfect as it was, was in principle a tax on activities the government wanted less of. Income tax, by contrast, taxes an activity most think desirable: people working to sustain themselves.

Cullen is heading exactly the contrary way. And Key? If he is to be a long-term Treasurer and Prime Minister, maybe taxing undesirables and sparing desirables is a principle voters could buy into.