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Taxation Basics 


This page looks at taxation basics. The next page, Tax and Basic Income, will look at how Tax and Basic Income work together and will assume that people are familiar with the concepts outlined on this page.

  • 1 April 2023 New Zealand tax rates are used on this page.
     

  • All references to the "present progressive tax system" or to a "progressive tax system" refer to the present New Zealand progressive tax system with existing tax rates and thresholds unless explicitly stated otherwise.
     

  • All references to cost are to the net expenditure by the government and not to costs incurred by individuals or firms.
     

  • A tax regime should apply equally to all.
     

  • Tax cuts and adjustments or the introduction of personal tax exemptions that benefit the wealthy or those on high incomes more than those on low incomes are not appropriate tax changes for a Basic Income Scheme as they undermine the principle objectives of a Basic Income.
     

  • There is a need to avoid the temptation to use a progressive tax and reduce the tax rates for the first tax steps or introduce a personal tax exemption in order to benefit those with the lowest incomes as this will:

    • reduce the overall taxes paid by those on high incomes more than those on lower incomes and

    • reduce total government tax revenue requiring higher marginal tax rates for those with higher incomes to compensate, which may in turn result in tax avoidance and evasion reducing government revenue.

    • Failure to compensate for tax cuts or personal tax exemptions with higher marginal tax rates on higher incomes will lead to reduced government revenue and may require a consequential reduction in government services due to the need to cut government expenditure. 

List of questions answered here.

The following questions are answered here. Scroll down to see the answers.

  • What are the three main tax types? Progressive, Proportional, and Regressive​ Tax.
     

  • What is the Effective Tax Rate (ETR)?
     

  • What is the Marginal Tax Rate (MTR)?
     

  • What is the Effective Marginal Tax Rate (EMTR)?
     

  • Why use a proportional ta?
     

  • Why not use a regressive tax?
     

  • How does the New Zealand Income tax system work at present?
     

  • How do tax cuts work and who benefits the most?
     

  • Would a personal tax exemption work? 
     

  • What happens with a change from a progressive tax to a proportional tax?
     

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What are the three main tax types?
 

1. Progressive tax

A Progressive tax is a tax where the marginal tax rate (MTR - see below for a further explanation of MTR) increases progressively as income increases. The increases in the marginal tax rate usually occur in steps so each time gross income exceeds a predetermined threshold, the tax on the next dollar will be at the next marginal tax rate. Alternatively, the marginal tax rate may increase progressively as the total gross annual income earned increases.

2. Proportional tax

A Proportional tax is a tax where the tax paid is at a fixed rate so the total tax collected is directly proportional to the income earned. The marginal tax rate does not increase or decrease as gross income increases. A proportional tax is also known as a uniform tax or flat tax.
 
3. Regressive tax
A Regressive tax is a tax where the marginal tax rate (MTR) decreases progressively as income increases. The tax decreases may occur in steps at specific thresholds or in direct relationship to the gross income earned.
 

What is the Effective Tax Rate (ETR)?

 
The Effective Tax Rate (ETR) is the effective rate that tax is paid on total annual gross income.

With a progressive income tax, the Effective Tax Rate paid on total income 
may be significantly lower than the Marginal Tax Rate paid on the last dollar earned.

With a proportional tax, the Effective Tax Rate will be the same as the tax rate or marginal tax rate. 

With a regressive tax, the Effective Tax Rate may be larger than the marginal tax rate.

When a tax-free Basic Income is paid, the Effective Tax rate will be lower than the Marginal Tax Rate paid on the last dollar earned.

 
What is the Marginal Tax Rate (MTR)?
 
The Marginal Tax Rate (MTR) is the rate at which tax is paid on the last dollar earned.

What is the Effective Marginal Tax Rate (EMTR)?

The Effective Marginal Tax Rate (EMTR) is the effective tax rate paid on the last dollar earned when other deductions or abatement of state grants are considered to be equivalent to additional tax paid.

The Effective Marginal Tax Rate (EMTR) will be higher than the Marginal Tax Rate when there are other deductions and may in some cases exceed 100%. When the EMTR exceeds 100%, earning extra income will result in a net reduction in income. This is a poverty trap.

Why use a proportional tax?

 

Many Basic Income advocates suggest that those who receive a Basic Income have all income taxed at a rate that is proportional to their income. This is a proportional tax, alternatively known as a uniform or flat tax.

Using a proportional tax ensures that those with few or no other sources of income receive the greatest possible value from a Basic Income while the overall cost of the scheme to the government is minimised. Nevertheless, some further gains in targeting can be achieved by taxing those on the highest incomes at a higher rate. 

See
Tax and Basic Income for details.

 

Why not use a regressive tax?
As a general rule, a regressive tax is not recommended for use with or without a Basic Income as it will penalise those on low incomes with higher tax rates while rewarding those on higher incomes with lower tax rates. This increases the transfer of wealth from the poor to the wealthy.

Despite this, New Zealand welfare benefits, including Jobseeker Support, are paid in conjunction with a 70% abatement rate. This high abatement rate produces Effective Marginal Tax Rates (EMTR) of 80.5% (70% abatement + 10.5% income tax) or 87.5% (70% abatement + 17.5% income tax) before the Jobseeker Support payment is fully abated. The EMTR may exceed 100% when transport, clothing, and other costs associated with work are included. 

The high EMTRs faced by those with low work incomes are well above the EMTRs faced by those with higher incomes.  This is highly regressive. High EMTRs create a poverty trap that may result in reduced net income for those who move from unemployment to paid employment at the minimum wage. Consequently, they are a major disincentive to work and may also result in increased tax avoidance or non-disclosure of work income.
How does the New Zealand Income tax system work at present?

New Zealand has a progressive tax system with tax rates that increase progressively as income increases. There are five steps.
  • The first tax rate of 10.5% applies to all income up to $13,999
  • The second tax rate of 17.5% applies to all income from $14,000 to $47,999
  • The third tax rate of 30.0% applies to all income from $48,000 to $69,999
  • The fourth tax rate of 33% applies to income from $70,000 to $179,999
  • The fifth tax rate of 39% applies to all income above $180,000 
 
A person with an income greater than $180,000 will have:
  • the first $14,000 of their earnings taxed at 10.5% and 
  • the next $34,000 at 17.5%,
  • the next $22,000 taxed at 30%,
  • the next $110,000 taxed at 33%, and
  • all income over $180,000 taxed at 39%.
These are the marginal tax rates.
 
The marginal tax rate is the rate at which the last dollar earned is taxed.
  • A person's marginal tax rate may be 10.5%, 17.5%, 30%, 33% or 39% depending on a person's income
  • Thus, for a person earning more than $48,000 but less than $70,000, the marginal tax rate is 30%
  • for a person earning more than $70,000 but less than $180,000, the marginal tax rate is 33%,
  • for a person earning more than $180,000, the marginal tax rate is 39%.
The average tax paid is often considerably lower than the marginal tax rate, perhaps less than 25%.
How do tax cuts work and who benefits the most?
 
People's incomes and pay rates tend to increase with time due to inflation. If the tax margins are not increased in line with inflation, people will end up paying a greater percentage of their income in taxation. Real incomes after tax will reduce.
  • When the economy is doing well, governments, even when they increase expenditure in line with inflation, may end up with surpluses.
  • One reaction is to talk of tax cuts, but Basic Income is a better alternative.
  • In difficult times, governments may incur a deficit - this is when government expenditure exceeds income. 
  • Again, some people call for tax cuts to boost the economy. However, the proven link between tax cuts and a boost to the economy is very very dubious. A Basic Income is a better alternative because it will boost both the economy and government revenue.
  • When applied correctly with an appropriate tax regime, a Basic Income is a better alternative to tax cuts because it will target the money toward those most in need of income while maximising the boost to the economy.
 
There are two ways tax may be cut.
 
  • The first method is to increase the tax margins or thresholds, the point where the tax-rate changes from one tax rate to the next, while leaving the rates unchanged.
    • This method is usually justified as being necessitated by inflation or as a way of reducing a surplus.
       
  • The second method is to reduce the tax rates.​
    • This may occur if the government still has an annual surplus after the first method has been applied.​
       
  • Whichever method is applied, those with no income will receive no benefit and the benefit will progressively increase until income reaches $180,000.
    • Those who receive the greatest tax reduction in total dollars will be those with incomes greater than $180,000, that is, those with the highest incomes.
       
  • With a progressive tax system, tax cuts, even when restricted to the lower margins and rates for the lowest incomes, are not a good method of targeting the benefit of the cuts to those on the lowest incomes.
    • This is because those on lower incomes will receive only part of the benefit of the tax cuts while those on higher incomes will always receive the full benefit. Tax cuts invariably favour those on high incomes or the wealthy.
  • A Basic Income is a more efficient way of distributing value to those with the lowest incomes, as explained on the Tax and Basic Income page.
     
  • The following is reproduced from Realising a Basic Income 2022 by Iain B Middleton. The full paper is available on the Resources page. 
     
Tax cuts are often portrayed as a means of boosting an economy when there is an economic downturn but there is little real evidence that this works in practice. In 2012, L. Hungerford in a US Congressional Research paper looking at tax rates from 1945 concluded that:
 
The results of the analysis suggest that changes over the past 65 years in the top marginal tax rate and the top capital gains tax rate do not appear correlated with economic growth. The reduction in the top tax rates appears to be uncorrelated with saving, investment, and productivity growth. The top tax rates appear to have little or no relation to the size of the economic pie. However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution.(7, 8)
 
n 2022, Cloyne, Martinez, Mumtaz, and Surico, in a National Bureau of Economic Research working paper reported that:
 
Personal income tax cuts trigger a short-lived boost to GDP, productivity and hours worked but have no long-term effects.(9)
 
Rather than boost the economy, tax cuts may achieve the opposite. Economic downturns often follow tax cuts. Reductions in government tax revenue resulting from the tax cuts often lead to cuts in government spending to match the fall in revenue. The spending cuts further reduce economic activity which reduces government revenue further, leading to further tax cuts, and so on. Cuts in government spending accentuate economic downturns. The reduction in economic activity during an economic downturn impacts on the poor but also reduces company profits and the incomes of those who have plenty. When the poor have little money to spend, companies suffer, profits reduce, and there is pressure on those with higher incomes.
Would a personal tax exemption work?
  • A personal tax exemption is an amount that people are allowed to earn before they are taxed. It is a special case of tax cut where the tax on the first income band is reduced to zero.
     
  • The suggestion is that those on low incomes will benefit from being able to work and earn a relatively low income before being taxed. For example, the first $500, $1,000, or $2,000 per week earned may be tax-free. These amounts are equivalent to $26,089, $52,178, or $104,355 per annum.
     
  • However, as the total annual tax that an individual pays is calculated on their total annual income, a personal tax exemption is subtracted from the total annual income earned before the annual tax is assessed. This means that the tax savings a person receives will be calculated at their marginal tax rate - the rate that their last dollar earned is taxed.
     
  • Thus, a person on a low income will have their tax savings calculated at 10.5 cents in the dollar while those on the highest incomes will have their tax saving calculated at 39 cents in the dollar. 
     
  • This means that a personal tax exemption will always benefit the wealthy more than the poor. 
     
  • Personal tax exemptions tend to be expensive from the government's perspective due to the loss of tax revenue and will target the benefit to the wealthy rather than the poor. This is the exact opposite of what a Basic Income does. Introducing a personal tax exemption with a Basic Income will undermine the Basic Income.
     
  • For example, for a small tax-free personal allowance of $1,000 per annum:
    • With a uniform tax:
      • Those who earn no income will receive no additional income from the proposal.
      • Additional income after tax will progressively increase up to the threshold of $1,000 where incomes begin to be taxed.
      • All those earning more than the tax-free threshold will receive the maximum increase in income. For a tax rate of $33%, this will be $330.
         
    • With the current progressive tax system, a personal tax exemption of $1,000 per annum will produce the following results with earnings quoted in annual figures:
      • Those with no other income will receive no benefit from the personal tax exemption.
      • Those earning between $1,000 and $14,000, MTR = 10.5%,  will be $105 better off.
      • Those earning between $15,000 and $48,000, MTR = 17.5%, will be $175 better off.
      • Those earning between $49,000 and $70,000, MTR = 30%,    will be $300 better off.
      • Those earning between $71,000 and 180,000, MTR = 33%,    will be $330 better off.
      • Those earning over $181,000, MTR = 39%, will be $390 better off.
         
  • In another example, if the first $500 per week was to be made tax-free, that is a personal tax exemption of $500 per week or $26,089 per annum, those who have no income will receive no benefit while those in the highest tax bracket of 39 cents in the dollar (over $180,000 per annum) will receive a tax reduction of $10,174.71 per annum. Thus, the personal tax exemption is in reality a tax reduction aimed at the highest-income earners. 
     
  • The results above show that the benefit to an individual of introducing a personal tax exemption increases progressively in steps as annual income increases. While those on low incomes may gain more as a percentage of their annual incomes than those on higher incomes, those who gain the most benefit in absolute dollars from a personal tax exemption are those who earn the most. The benefit goes to those who need it the least. 
​  
  • Thud, it is seen that personal tax exemptions target money toward those who earn more and this holds true for both a progressive tax system and for a uniform tax above the personal tax exemption threshold. Personal tax exemptions give more to the wealthy than to the poor and considerably increase the cost of a Basic Income scheme that includes a personal tax exemption.
     
  • In contrast, A Basic Income coupled with an appropriate tax works better by ensuring that the maximum benefit is received by those with the lowest incomes with the increase in net income reducing as gross income increases. This ensures that money is targeted toward those most in need. See Tax and Basic Income for more details.
     
  • In his book, Basic Income: And How We Can Make it Happen, Pelican 2017, Guy Standing shows how countries with personal tax exemptions can achieve significant tax increases that will at least partially fund a Basic Income by abolishing personal tax exemptions. He notes:
     
"While raising the personal tax allowance has been presented as a measure to help low earners, high earners gain most of the benefit because more of their income escapes tax and there are knock-on increases in the level of earnings at which higher rates of tax kick in. Meanwhile, low earners already below the threshold gain nothing."  
 
Abolishing a personal tax exemption and using the money to pay a Basic Income would increase the net revenues of those on lower incomes and improve the targeting of the money toward those on lower incomes. 
 
  • New Zealand abolished personal tax exemptions during the 1980s and it would be unwise to reintroduce them now as personal tax exemptions produce results that counter the benefits of a Basic Income, and further increase the wealth of the wealthy while doing less for the poor than a Basic Income would. 
     
  • Other forms of tax cuts, such as reducing tax rates or increasing tax thresholds, will also reward the wealthy more than those on lower incomes and are not desirable for the same reasons. A Basic Income works better.
     
  • Another way to look at a progressive tax is to consider it as a uniform tax with a series of tax cuts applied to the lower-income steps.
    • As each tax cut will benefit those on higher incomes more than those on lower incomes, the result is a tax system that provides significant and more benefit in absolute dollars to those on higher incomes.
    • There is also a loss of government tax revenue due to the lower taxes raised on the lower income steps.
    • To counter this loss of revenue, the government must increase the taxes on higher-income bands. But, because all or most taxpayers benefit from the tax cuts on the lower bands and only a minority of taxpayers pay tax on income in the high-income bands, the percentage increases in tax on the high-income bands must be significantly more than the percentage reductions on the low-income bands.
    • The very high Marginal tax rates (MTRs) that result are likely to lead to tax avoidance and tax evasion.
    • A better Net to Gross income profile can be achieved by combining a Basic Income with a tax system with fewer steps. 
       
  • A Basic Income is a more efficient way of distributing value to those with the lowest incomes, as explained on the Tax and Basic Income page.
     
What happens with a change from a progressive tax to a proportional tax?
 
  • As the progressive tax system gives an effective tax discount on the first $180,000 of income, converting to a proportional tax usually involves removing the discounted or lower tax rates so that all income is taxed at a higher marginal tax rate. In New Zealand, this may be a proportional tax in the range of 33% to 39%. 
     

  • Changing to a proportional tax of either 33% or 39% without some form of compensation for those on lower incomes will significantly hurt those on low incomes.

    • With a 33% proportional tax, those with low incomes will have a 22.5% tax rate increase, from 10.5% to 33%. 

    • With a 39% proportional tax, those with low incomes will have a 28.5% tax rate increase, from 10.5% to 39%.

    • This increased tax can be offset by providing a Basic Income. 
       

  • Reducing the proportional tax rate to less than 33%, to say 30% in an attempt to benefit those on low incomes will, however, give those with incomes between $70,000 and $180,000 a 3% cut in marginal tax, and those with incomes over $180,000 a 9% cut in marginal tax while still significantly increasing the tax on those with the lowest incomes.

    • With a 30% proportional tax, those on an income of $180,000 or greater at present will receive a 9% cut in their marginal tax rate.

    • Changing to a proportional tax without a Basic Income will hurt those on low incomes and will benefit people on high incomes.
       

  • Changing to a proportional tax of 33% will result in a person on a minimum income of $21.20 per hour (p.h.),  $44,247 per annum (p.a.), paying an additional $7,838 p.a. (18%) in tax while a person with an income between $70,000 and $180,000 will pay an additional $9,080 in tax (13% for those on $70,000 and 5% for those on $180,000).

    • As a percentage, the tax increase declines as income increases so the greatest negative impact is on those with the lowest incomes. Those on the lowest incomes are hit the hardest.
       

  • A change to a proportional tax will give the greatest percentage increase in tax to those on the lowest incomes while making very little difference in total taxation as a percentage to those on very high incomes.

    • Without a Basic Income, a change to a proportional tax favours the wealthy while driving those on low incomes into poverty. Without a Basic Income, this is a regressive change as it hits those on lower incomes harder than those on higher incomes.
       

  • Because a change to a proportional tax hits those on the lowest incomes hard while having little impact on the wealthy, a change to a proportional tax without a Basic income should not be contemplated.
     

  • However, when a proportional tax is combined with a Basic Income, a desirable outcome is achieved. This will be demonstrated in more detail on the Tax and Basic Income page.

END

Revised. 14 July 2023, 18 July 2023.

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