The Inconvenient Truth about Tax Credits
Everyone loves tax credits. At least, left of centre parties
do. In 1993 Bill Clinton greatly expanded an old scheme; in Britain New Labour
introduced them in imitation in the 1990s, and now the Coalition government - at
Liberal Democrat instigation - have substantially increased them. The post 2007 Labor government in Australia has
recently inaugurated their use there.
The beauty of a tax credit for the Left is that it is
equivalent to an increase in the tax-free threshold (or ‘allowance’) that the ‘better
off’ don’t get. That is to say, it is an increase in the tax-free threshold that is ‘means
tested’; as income rises the size of the increase is reduced, at some point to
zero. This means testing not only reduces the revenue cost of the
measure (obviously), it has another merit: unlike a universal increase in the tax-free
threshold, a tax credit will not reduce the supply of labour of those
sufficiently well off as to not receive it. For such
persons there is no incentive to ‘buy leisure’ with the tax credit, for the very solid
reason that they don’t receive any credit
But all is not good. The worm in the apple is found is in very
means testing of the increase in the threshold. This means testing has both an equity and
efficiency cost.
With respect to equity, the ‘shading out’ of the credit as
income rises clearly constitutes an increase in the effective marginal rate of
tax of all those who receive a positive tax credit (but don’t get the full
amount). This increase in the effective marginal rate of tax obviously doesn’t apply to
anyone whose income is sufficiently high that they don’t get any credit. The upshot is that a less well-off person on
some tax credit will face a higher effective marginal tax rate than a somewhat
better-off person on no credit; and the effective marginal tax rate falls with income.
This seems to offend our sense of equity:
not only should average rate of tax not fall with income, the marginal
rate should not fall, either. It seems inequitable, to illustrate, for a
better-off person to pay in tax a smaller fraction of their extra income from,
say, working a public holiday, than a poorer person.
But there is also an efficiency defect in the tax credit
system. It is a simple matter to demonstrate the following proposition:
For any person you care to nominate who is receiving some
credit less than the maximum, there will always be some simultaneous (i) reduction
in the size of the credit, and (ii) reduction in the rate of shading out, that
will increase that person’s hours worked, consumption, utility and tax paid.
To put it another way, for any nominated tax payer receiving some credit, one can always
craft a revision of the credit that makes it smaller, but more universal, so that
the person is better off; and the Treasury too!
This conclusion constitutes an inconvenient truth for tax
credit schemes. These schemes are meant ‘to
help’ those receiving it. But for anyone not receiving the maximum it can
always be dominated by a reworking that seems to dilute that scheme, by
reducing the size of ‘help’ to those right at the bottom, but creating a ‘help’
to some towards the top who previously received nothing.
Such is one of the dilemmas of those who would contrive a tax
system to secure their vision of a fairer society.
But how does the ‘dilution’ mooted
above work that minor miracle of longer hours, higher consumption, increased utility and more tax paid?
Wait for the next installment.
