Foundation system

Australian tax and social security benefit system

Imagine a government giving subsidies to single parents that actually raise tax rates on overtime work. This is the case of an Australian single parent who earns less than the average wage. With a pay rise of just AUD 983 more, he would face a marginal tax rate of 652%. Therefore, despite the salary increase, this worker will face a net loss and will see their income reduced by AUD 5,428. An Australian parent who benefits from a government program worth AUD 21,000 could lose 100% of that benefit if they earn above the income threshold.

This is why the marginal tax wedge is relevant to understanding how workers might benefit (or not) from a wage increase once taxes kick in.

While Australia’s tax and benefit system may be successful in keeping low-income working households out of poverty and encouraging labor market participation, high marginal tax rates, such as that seen in the of this Australian working parent, act as barriers to upward mobility, discouraging parents from advancing in their careers. Very often, these high rates are hidden in complex tax structures. However, a recently published study by the Archbridge Institute and the Tax Foundation highlights the underlying policies that drive the spikes in marginal tax rates that workers face in a number of countries.

Moving up the income ladder, an Australian worker with children can face a tax rate hike of over 100% at four different points
Australian single worker with two children Average labor cost: 98,269 AUD (65,689 USD)
Total labor cost A$60,927 A$83,528 A$105,147 A$114,974
Net profit before increase A$71,249 A$74,071 A$83,323 AU$82,990
Increase amount AUD 983 AUD 983 AUD 983 AUD 983
Amount of tax reduction/additional benefits due to the increase A$6,410 AU$2,120 A$4,045 A$1,842
% of increase gobbled up by MTR 652.31% 215.77% 411.60% 187.40%
Net profit after increase A$65,821 A$72,934 A$80,261 A$82,131
Source: OECD, “Taxing Wages – Tax Wedge Decomposition”, https://stats.oecd.org/Index.aspx?DataSetCode=TXWDECOMP; OECD, “Taxing Wages – Comparative Tables”, https://stats.oecd.org/Index.aspx?DataSetCode=AWCOMP; and Tax Foundation calculations.

As they move up the income ladder, an Australian worker with children can face tax rate spikes of over 100% at four different levels due to the Family Tax Benefit and Single Parent Payment.

In 2021, the first peak in the marginal tax rate occurred at 62% of the average wage and around 73% of the median wage. If this Australian worker’s employer increased his pay by just AUD 983, the worker suffered a net loss and saw his earnings reduced by AUD 5,428. This Australian parent faced a marginal tax wedge of 652% for a 1% increase in gross earnings on top of gross annual salary of AUD 57,854. This is due to the clawback of Parenting Payment income support to which single parents in Australia are entitled. For a single parent with two children, the income ceiling to access Parenting Payment is reached at this income level.

Moving up the earnings ladder, this worker faced a marginal tax wedge of 216% for a 1% increase in gross earnings on top of gross annual earnings of AUD 79,316. This Australian single parent faced a net loss and saw his income reduced by AUD 1,138. This is due to the Family Tax Benefit Part A as for the year 2020-21 an end of year supplement of AUD 781.1 per child has been made available to parents with taxable income below 80 AUD 000.

Moving up the earnings ladder, this Australian worker faced a marginal tax wedge of 412% for a 1% increase in gross earnings on top of gross annual salary of AUD 99,845. Therefore, despite the salary increase of AUD 983, this Australian worker faced a net loss and saw his earnings reduced by AUD 3,062. This is due to Family Tax Benefit Part B (AUD$3,314.2 and a one-time supplement of AU$379.6), which ends when taxable income reaches AU$100,000.

Moving up the income scale, this Australian single parent faced a marginal tax wedge of 187% for a 1% increase in gross earnings on top of gross annual salary of AUD 109,176. This is due to part A of the family tax benefit which disappears completely at this level of taxable income.

Previous research analyzing marginal tax rates in Australia has shown that the design of income support payments generates effective marginal tax rates of over 69% for an unemployed couple with two children if the one of the couple gets a full-time job with low pay. Even though the system has been reformed since the publication of this research, confiscatory marginal tax rates of more than 100%, also known as “income traps”, can still be observed.

The tax and benefit system in Australia is extremely complex with many thresholds and different types of benefits depending on the taxable income of workers and the age of children. Moreover, the existence of different tax advantages for single parents and single and dual earner couples generates a series of marginal tax rates that could keep some workers in Australia just below the income threshold that triggers the peaks of tax rate. Removing these barriers through a more consistent tax and benefit system will allow workers to access higher wages without facing these barriers.

Learn from Finland

Australia could follow Finland’s example, where a single parent with two children faces a progressive marginal tax wedge profile, ranging from 49% to 65.7%, and no peak marginal tax rate cannot be observed. The increase in the marginal tax wedge in Finland is due to a progressive central income tax, while social security contributions have a flat rate. Finland also offers a fixed family allowance independent of taxable income which prevents the formation of peaks in marginal tax rates such as those observed in Australia. Nevertheless, marginal tax rates above 50%, such as those seen in Australia and Finland, especially for workers earning less than the average wage, could discourage employment and labor supply. Even if marginal rates do not rise in a way that traps people in poverty, high marginal rates still have a direct impact on workers.

The loss of benefits that particularly poor Australian single parents face when they accept overtime work may deter them from advancing in their careers, showing that the tax and benefit system, while successful to keep low-income working households out of poverty, is ineffective in promoting the upward mobility of lone parents. Australia’s tax and benefit system comes with trade-offs that policymakers should keep in mind when considering tax policy reform. In Australia, two of the peaks in the marginal tax rate have a direct impact on single parents who earn less than the average wage. Therefore, redesigning some of these policies to generate a smoother variation in marginal tax rates across different income levels would likely increase labor supply and encourage upward mobility of low-income Australian single parents. .

To note: This is part of a five-part blog series that sheds light on the findings of a recently published study by Archbridge Institute and Tax Foundation and explores the underlying policies that drive the spikes in marginal tax rates at which workers are submitted in a number of countries.