Children and taxes

CHAPTER 6

The case for family assistance presented in the previous chapter may or may not be successful.  The crucial arguments are admittedly somewhat speculative, and fly in the face of much informed opinion in this area, but at the least they seem to merit academic analysis and public discussion.  If they stand up to criticism then it would become a long-term social goal to move towards a family assistance policy.  But there is another, more compelling argument for alleviating the burdens borne by families that needs to be heard and considered.  The main source of difficulty for those who have favoured greater family assistance has been whether it should be implemented through the taxation or the welfare systems.  Majority opinion has favoured the welfare approach, but the problems that have emerged make that a much less attractive option than it once appeared.  This chapter will consider the merits of the taxation approach, but it will rest its central argument on criteria intrinsic to tax policy, and not on welfare assistance considerations.

In the past fifteen years the Australian taxation system has been analysed and assessed from almost every possible angle.  Almost, but not quite.  Remarkably, very little has been said in this debate about children.  Are children taxpayers?  The question seems an obvious one, yet it has not been squarely faced.  The obvious fact that children do not file an income tax return does not settle the matter;  economists are accustomed to dealing with income flows other than those in which actual dollars and cents change hands, and there is also no doubt that the burden of a tax can effectively fall on quite other people than those on whom the law formally imposes it.  We can phrase the question differently:  should adult taxpayers be taxed on their actual incomes or on their equivalent incomes?  The case for equivalent income taxation is argued by Alan Jordan in The Common Treasury, and will be restated here, though in a modified form.  This chapter will argue that children are taxpayers, and that the standard criteria of horizontal equity require that they not be taxed at higher rates than other taxpayers on comparable incomes.  As Jordan puts it, the basic intention "is not to provide assistance for families in consideration of the costs of raising children, or in recognition of the value of children to the community, but to tax both parents and children on the same basis as other people". ⁽¹⁾

The argument in favour of equivalent-income taxation -- known as quotient familial taxation in its French version, but to be referred to here as "family-based" or "family unit" taxation -- will be presented, and objections to it answered.  But, whatever the abstract merits of such a proposal, changes in the tax system must also be realistic from a variety of viewpoints.  After a general defence of family unit taxation, it will be argued that family-based taxation has a number of extrinsic virtues, two of which are particularly important.  It would significantly alleviate poverty traps which are at present caused by the interaction between the welfare system and the taxation system;  and it might also alleviate what is perhaps the most glaring inequity in the present taxation system, that between PAYE and self-employed taxpaying families.

It is not quite true to say that children have been ignored in the tax debate, for much has been written about the appropriate income unit for taxation purposes.  Should we tax individual incomes or joint family incomes?  The present argument favours the latter but it differs from the usual case for family unit taxation.  Past discussion of family-based taxation has usually involved some form of income-splitting between spouses.  Though no doubt well motivated, this proposal misguidedly makes the married couple the primary taxation unit.  Opponents of this proposal have objected that it would disadvantage secondary earners by raising their marginal tax rates.  Both sides have discussed the question as if it turned on the distinction between single people and couples.  But the main issue should be not marriage but children.  It is argued here that having a spouse at home should in itself offer no tax advantage;  if anything, in fact, the reverse.  What should count is the spouse's social role in caring for children and other dependants;  at present we give only token recognition to this role.  But more importantly, what should be valued is children themselves and the work which both parents contribute -- whether at work or in the home -- towards their well-being.

The argument turns on the notion of horizontal equity.  Jordan quotes Martin Feldstein's standard definition:  "in tax design ... individuals who would be equally well off in the absence of the tax should be equally well off with the tax.  The tax system should preserve the utility order of individuals". ⁽²⁾  All tax regimes acknowledge this principle but they vary greatly in their treatment of children.  The variation follows from the question of whether children are "individuals" for the purpose of taxation.  Systems which do not acknowledge children as taxpayers in their own right tend to treat them as consumption choices of their parents, as alternatives to a new car or a holiday abroad.  On this assumption the costs of children are reckoned to be either matters of indifference for the purposes of income taxation or matters subject to tax imposts on a consumption tax basis.  However, this is usually thought to be too harsh and punitive to be carried through completely, so some ad hoc mitigation in the form of child rebates or family allowances is introduced as a tax equity measure.  The ad hoc nature of the resulting compromises leaves the justice of any particular solution hopelessly confused.

The Australian taxation system is unusual in two respects:  it is one of the purest individual unit systems in the world;  and it relies very heavily upon personal income taxation and recoups relatively little from indirect taxes.  Both points require discussion.

First, our individualism.  It is sometimes pointed out that the trend in OECD countries in recent years has been away from family-based and towards individual unit taxation.  But it is also true that by the standards of some OECD countries Australia provides a low level of support for families, in the tax system or otherwise.  After 1945, three decades of prosperity, with close to full employment, low inflation, low taxes, and low interest rates, kept family finances buoyant.  During this period living standards rose for everyone, though -- as we saw in the previous chapter when examining the changes in tax rates -- the standard for those without dependants rose faster than for those bringing up children.  This disparity became visible after the 1974 economic downturn, though its full significance is only slowly being appreciated.

The present personal income tax regime includes no allowance at all that is directed to families or children as such and universally.  There is a $200 rebate for first children in families with a dependent spouse, but not all spouses are dependent;  and there is a $1000 Spouse Rebate which goes to many couples who do not have dependent children and only to some of those who do.  The Family Allowance may be seen as a tax equity measure -- but it too is no longer universal.  Taxation on the basis of equivalent income would dispense with the need for both the Family Allowance and the Spouse Rebate/Additional Rebate as tax equity measures for families.

The second unusual feature of the Australian tax system is its heavy reliance on direct taxation, especially personal income tax.  Other OECD countries collect much greater proportions of their revenue from indirect taxes.  The direct/indirect tax mix has been much discussed from the point of view of economic efficiency.  There are many reasons for a shift to indirect taxation.  If this involved increased taxes on necessities it might be detrimental to family interests in the short run, but it should not be ruled out for that reason alone.  Compensation for families can be provided by adjustment of the income tax and/or welfare systems.  Practically speaking, however, this compensation might be difficult to arrange, and politically speaking it might be difficult to guarantee.  This proved to be one of the sticking points for the Option C consumption tax at the 1985 Tax Summit.  The steady erosion of family interests in the past two decades has been in part a reflection of the fact that families are, for reasons discussed in Chapter One, one of the most poorly-represented interest groups in our society, and have been unable to compete with the many other more formidable -- though less representative -- interest groups clamouring for government support.

The fact that consumption taxes impact more heavily on families than on individuals might be regarded as fair because all individuals in every family benefit from public goods such as law and order and defence, but not all pay income tax.  It will be assumed, somewhat arbitrarily, that the present tax mix reflects that greater benefit and is thus not unfair to families in that respect.  The case for reform will concern personal income taxation only.  (Nevertheless, people concerned about family interests should look at the other structural inefficiencies which hurt families, most particularly the very regressive impact of industry protection.)

It will be taken for granted that one purpose of the tax system is to redistribute income in some degree from rich to poor through a progressive adjustment of the tax scales.  The underlying assumption here is that wealthier income units have a greater capacity to pay than the less affluent, on the grounds that the last dollar earned by the former makes up a smaller proportion of his or her total income than does the last dollar earned by the latter.  It is sometimes added that the wealthy are likely to make more use than the poor of government services and benefits, but the best evidence we have suggests this is not the case.  The ABS fiscal incidence study indicates that all household income deciles get roughly equal benefits from government, with most going to the second and third deciles. ⁽³⁾

The same study gives some indication of the amount of taxes paid on average by each household income decile.  These figures, however, do not tell us whether the total tax system is progressive, regressive or proportionate.  Research by Neil Warren would indicate that (perhaps contrary to common belief) the present tax regime, taken as a whole (Federal, state and local, direct and indirect) and measuring its impact on households (not individuals), is progressive only between the second (28 per cent), third (29 per cent) and fourth (36 per cent) deciles (see figure 6.1 overleaf).  All other deciles, from the fourth onwards, pay between 36 per cent and 40 per cent of their income in tax.  The first decile also pays 36 per cent.  Warren's analysis is based on 1984-85 statistics.  Top income tax rates have been lowered from 60 per cent to 48 per cent since then.  At first sight this suggests that the heaviest burden is now borne by the middle deciles, but there is now worldwide evidence showing that lowering very high marginal tax rates tends to increase rather than reduce the tax take from the top deciles. ⁽⁴⁾  Nevertheless, the lack of progressivity in the overall tax system would be even more striking if we could measure tax avoidance and evasion and the receipt of non-taxable income such as fringe benefits and capital gains, things of which the upper deciles are best placed to take advantage.  As Warren observes, "The net result would be very much like an inverted 'U' tax incidence pattern across household income deciles". ⁽⁵⁾

Figure 6.1:  Tax incidence by Household Income Decile
(as per cent of gross money income.

Source:  Tables 4 & 5 in N. Warren, "Changes in Australian Tax Incidence between 1975-76 and 1984-85", in N. Warren, Papers on Taxation and Tax Incidence, U. NSW Centre for Applied Economic Research, 1988.

Failure to index the income tax scales for inflation has resulted in the average wage earner now paying the top marginal rate, and this may explain much of the tax bulge in the middle ranges (compare Figure 6.1's curves for 1975-76 and 1984-85).  The most powerful reason for maintaining a progressive personal income tax is therefore to ensure that the overall tax take is not regressive.  If we wish to make the entire tax system moderately progressive from bottom to top, personal income tax alone would have to be substantially more progressive than it is now.  (We should also identify the most regressive other taxes and eliminate or minimise them.)  Increases in marginal rates for top income earners appear to be ruled out by the counterproductive "Laffer curve" effects that have prompted reductions in top marginal rates in most developed countries.  So the only practical way to make the system more progressive is to reduce the average tax rates on low and middle incomes.  A family unit tax system could be designed to do this.

Family unit taxation can nevertheless be revenue-neutral:  the scales can be arranged so as neither to lose revenue or increase the total tax burden.  (The trend in the near future in OECD countries seems likely to be towards lower taxation as some of the extravagances of government expenditure are wound back;  and major tax reforms are always easier if the total grab is simultaneously reduced.)  Other things being equal, reduction of taxes for families will of course entail a tax increase for persons without dependants.  But other things are not necessarily equal, and part of the cost can be met from reductions in public spending.  There are many ways to reduce the overall tax burden; ⁽⁶⁾  and taxpayers without the responsibilities of dependants are those in the best position to fight to reduce that burden.

One way of working towards the long-term objective of fairness for families is, for the time being, to pass on such tax reductions as are possible to families only.  This would mean postponing tax cuts for individuals until the more urgent needs of families had been met.  In the May 1989 Economic Statement this was done to some extent, though barely enough to compensate for bracket creep in the few previous years.  The proposal here is that this process should be taken very much further.

DESIGNING A TAX REGIME

There are a number of ways of implementing family unit taxation.  We shall sketch four -- and the subsequent discussion will reveal some of the difficulties and complications involved in any attempt to achieve an equitable tax system that yields the revenue demanded by the modern state.

The key factor in defining a "family unit" should be, as argued above, dependency.  The basic idea is that income should be taxed according to how many people it supports;  or, taxable income should correspond to equivalent income.

(1) Aggregate and divide

If we accept Jordan's estimate of equivalent income as real income divided by the square root of the number (N) of people in the unit, we get:  taxable income (TI) equals aggregate income (AI) divided by root N:

TI =   AI  
         √¯N

A single person with an income of, say $40,000 would pay tax (on a progressive scale not unlike today's) on the whole amount (less expenses and deductions much like today's).  With the same (aggregate) income, a married couple with no dependants, a single parent with one child, or a single person supporting an aged relative would pay tax as if their income was $28,280 (with no dependent spouse rebate).  And so on:  a four-person family would pay tax on $20,000, and a seven-person family would pay tax on $15,120.  (Jordan's square root formula may be inexact, and better measures may be devised, but here its role is only illustrative.)

This simple approach leaves significant inequities.  A $40,000 earner and dependent spouse would have the same after-tax income as a couple earning $20,000 each.  But although each couple has the same cash income, the second has spent perhaps twice as many hours earning it.  The other side of this coin is that the first has much more time available for "domestic production" -- housework, gardening, home improvements, etc. -- and for leisure.  By any reasonable measure this should make it better off.  To overcome this inequity, taxable income would have to be adjusted by imputing a value to the opportunity for domestic production and/or leisure.  The simplest way would be to add a notional amount to the taxable income of the single-income family.  (Alternatively, and more palatably, a corresponding amount could be deducted from the taxable income of two-income families;  but this would complicate matters elsewhere.)  The details of this calculation will be discussed below in the section on domestic production,

(2) Factoring Thresholds

The approach here is to aggregate the income, but also to increase the thresholds at which the various rates in the progressive tax scale cut in in accordance with household composition.

For example suppose the basic tax scale began with a 25 per cent rate on incomes over $5000, increasing to 50 per cent over $10,000 (figures chosen merely for convenience).  Single persons would be taxed on the basic scale.  A second full-time income-earner would benefit from the same thresholds as the first:  two full-time earners would pay 25 per cent on joint earnings over $10,000 (5000 x 2), and 50 per cent on earnings over $20,000.  A dependent spouse, however, would bring only partial (say one half) thresholds, for the reasons of leisure and domestic production discussed above.  Thus a single-income couple would pay tax at 25 per cent on earnings over $7500, and at 50 per cent over $15,000.  A sliding scale would be necessary, as before, to allow for part-time workers.

Children too would bring partial thresholds.  In the previous scheme, gross income was divided by a factor based on family size;  here, the tax thresholds would be multiplied by a factor.

(3) Rebates or credits

The basic feature here would be an income tax rebate or credit for each dependant.  In a single-income household, a "gross" amount of tax would be calculated by applying the tax scales to taxable income;  the "net" tax -- the amount actually payable -- would be gross tax minus the sum of the rebates or credits.

The difference between rebates and credits counts at the bottom of the income scale.  With a system of rebates, if the sum of the rebates exceeds the household's gross tax figure the result is simply that no tax is payable.  With a system of credits, if the sum of credits exceeds the gross tax, then the difference is paid from the revenue to the household.  Tax credits can thus be made to take the place of Family Allowance and Family Allowance Supplement.

Where there is more than one income-earner in the family, several approaches are possible:  (a) the two incomes would be taxed separately as at present except that the rebates or credits could be divided between the two earners;  (b) the incomes would be aggregated, with a suitable rebate (or extra threshold) for the second earner, before gross tax is calculated;  (c) both the incomes and the rebates or credits could be split between the earners.

(4) Modified splitting

The simplest tax reform to assist families would be to let couples with dependent children, but no others, split their incomes for tax purposes.  This would be most help to the single-income families who, we have seen, most need assistance.  The benefits would not be especially well targeted, but as far as horizontal equity goes it would at least be an improvement on the present system.

COMPARISON

Clearly, methods (1), (2) or (3) are preferable to (4) because less ad hoc.  The main difficulty with (2) is to find some way of setting appropriate threshold levels.  We would need to design "equivalent" thresholds, thresholds which are a function of family size.  It may also be objected that high thresholds for families with children are inefficient because they benefit middle and high income families at the price of raising their top marginal tax rates.

Method (1) appears more promising:  by building in the equivalent income concept it allows us to arrive at a calculation of taxable income, based on an apparently objective measure of capacity to pay.  The most obvious difficulty with (1) is that it seems to favour high-income families.  A high-income family with only one child, say one earning $50,000, would get greater benefit than a low-income ($20,000) family with four children.  Thus, solving the horizontal equity problem seems to lead to "vertical" inequities.  This is puzzling -- both vertical equity and horizontal equity are attempts to respect and measure "capacity to pay".  How can they conflict?

We might contend that there is no conflict here.  Alan Jordan takes this view when he claims that "The possible objection that greater benefit would accrue to families on higher incomes is groundless because, under whatever progressive scale was found necessary, all members of those families would be taxed more heavily than people on lower incomes." ⁽⁷⁾  No net gain accrues to those richer families who get more tax relief than poorer ones, because they pay for that relief out of their taxes at other stages in their life.

Nevertheless, it can still seem unjust to allow greater reduction for one child and less for another.  There is a strong intuition that all children are to be thought of as equally valuable, or at least that their value bears no necessary relation to their parents' income.  On this view the tax system should be designed so that, as far as possible, each child counts for the same.  In other words, the system would represent something like a universal tax allowance for children.  The preference to be adopted here is for this approach, number 3 of the list above.

One very important advantage is that it would permit tax credits for large, low-income working families, a possibility not catered for under Jordan's arrangement.  As we shall see, this solution will help us to eliminate poverty traps.  However, in doing this we need not abandon Jordan's central notion, the equivalent income.  The function of this notion in this modified version of equivalent income taxation would be to set the benchmark for comparing average families with average individuals without dependants.  It would be from this test that the tax value to be imputed to all other children could be derived.  These are of course only the most general guidelines for a tax scheme.  Exactly how the whole tax formula is to be calculated is a matter for expertise, and would require considerable and complex analysis.  But difficult though it would be, there is no apparent reason why it cannot be done.

It should be emphasised that family unit taxation, though it takes family size into account, does not "equalise" after-tax incomes of those with and those without families.  It merely adjusts the taxable income and thus the amount of tax paid by those two classes of taxpayer.  The standard of living enjoyed by a single earner will still be considerably better than that of families, at the same level of gross income.  Income equivalence could be achieved only if wages and salaries were determined by family size.

POVERTY TRAPS

The most important extrinsic advantage of family unit taxation is that it provides a way of removing or reducing poverty traps, and to some extent also employment traps.  Welfare disincentives come in two kinds.  One kind arises at the point of transition from benefits to work, the other at the transition from part-time or low-paid work to full-time or better-paid work.  The first is an employment trap, the second a poverty trap, though they both concern the movement out of poverty and into employment.

In the Australian tax/welfare system, poverty traps are most severe in three situations:  for families on Unemployment Benefit;  for families on Sole Parents Benefit;  and for families on Family Allowance Supplement (FAS).  As this indicates, poverty traps are a form of disincentive which affects families more than people without children.  The reason for this is that, because families have high needs, assistance to families must approximate more closely to potential earnings than it does for individuals.  All kinds of assistance may increase effective marginal tax rates (EMTRs).  EMTRs are a measure of the combined effect of taxes and welfare assistance withdrawals on each extra dollar of earnings.  Thus, an EMTR of 80 per cent represents a loss of 80 cents in tax and assistance for an extra dollar of earnings.  Persons facing such high rates, as many welfare and social security recipients do, have little incentive to work their way out of poverty.  The range of factors that can create high EMTR barriers is great.  As tax economist Terry Dwyer puts it, "EMTRs depend upon ordinary personal income tax rates, exemptions, rebates, thresholds, the Medicare levy, social security and other income tests, indirect taxes, income-tested subsidies [childcare] and pensioner concessions".  Dwyer adds that "because of other factors (e.g. costs of working or childcare) EMTRs of 50 or 60 per cent may mean that social security recipients have virtually no incentive to achieve additional earnings".

We have seen in the previous chapter how tax increases in the past twenty-odd years have been levied disproportionately on families with children.  Something similar can be said regarding EMTRs.  Comparing EMTRs in 1968 with those in 1986, Dwyer observes that

The most striking change has been in the pattern of EMTRs faced by taxpayers with dependants.  The move from deductions through rebates and universal cash payments for dependants combined with the increase in tax rates generally has resulted in such taxpayers facing higher standard [marginal tax rates] at lower levels of income than formerly.  In addition, the introduction of income-tested, non-taxable FIS/FAS has meant that such taxpayers may face EMTRs as high as 110 per cent over large income ranges near median and sometimes average full-time earnings. ⁽⁸⁾

Figure 6.2 illustrates the extent of these disincentives for two representative families.

Figure 6.2:  Equivalent Marginal Tax Rates

(a) for a one-income couple with two children

(b) for a single mother with two children

Notes:  Calculated as at 31 December 1987.  Both families in NSW public housing.  Children in (a) are assumed to be 10 and 16 years old;  those in (b) are assumed to be both under 13.  Adult male full-time average weekly earnings were about $518, and adult female ordinary time a.w.e. were about $392.

Source:  Based on charts 3.1 and 3.4 in EPAC Council Paper No. 35.  Data supplied by EPAC.

The severity of poverty traps is a function of three factors:  the income tax rate;  the level of welfare and family assistance payments;  and the rate at which those payments are tapered off with increased earnings.  High levels of payment with rapid tapering rates produces the sharpest form of trap.  Slower tapering rates will reduce the EMTRs by spreading them across a wider range of earnings, but it is not at all clear that this spreading will reduce the net disincentive effect on behaviour.  Some analysts favour high but narrow EMTR "walls";  others prefer relatively low but widely spread disincentives.

Dwyer ranks different kinds of family assistance according to their effects on EMTRs as follows:

• means-tested cash payments will create higher EMTRs;
• universal payments will not directly affect EMTRs;
• tax rebates will reduce MTRs by extending the tax-free threshold higher up the income scale;
• additional thresholds or deductions will reduce EMTRs by shifting all tax brackets up the income scale. ⁽⁹⁾

The EPAC paper on Income Support Policies, Taxation and Incentives (of which Dwyer was a co-author) lists five possible strategies for reducing these EMTRs:

• Taxation changes -- tax thresholds could be increased or social security payments (such as family allowances) which are paid to large numbers of taxpayers could be converted to tax allowances.
• Social security income test changes -- involving adjustments to the free areas and the tapers, especially for certain types of recipient.
• Administrative measures (such as waiting periods for benefit, the treatment of temporary incomes and reviews of the continuing eligibility of recipients for payment) -- these can influence the number facing high EMTRs.
• Ambitious schemes for the integration of taxation and social security (e.g. that proposed by the [Henderson] Commission of Inquiry into Poverty).
• Equally ambitious schemes for the separation of taxation and social security -- ensuring that no persons simultaneously receive benefit and pay tax. ⁽¹⁰⁾

The paper briefly discusses each of these.  It concludes that the second option, the selective easing of income and means tests, as recommended by the Social Security Review, deserves tentative approval, but rejects the others as being unproven, too drastic and not likely to be cost-effective.  However, what is "cost-effective" depends very much on how we estimate the cost of the problem as well as the cost of the solution.  Otherwise intractable problems may require drastic measures.  The EPAC paper has set out the issues very clearly but it has not weighed them correctly.  The disincentive effects are more serious than it allows, and far more serious than is admitted by the Social Security Review.  And correspondingly, the solution is likely to require a re-arrangement of our basic priorities, rather than a mere readjustment of present policies.  It is because those policies have for a long time been moving in the direction of making welfare subsistence more bearable, and ordinary (two-parent) family life more difficult that we have created a barrier between the two.  Removal of that barrier requires a change in basic direction, towards easing the tax burden on working families and making welfare subsistence less like a possible permanent way of life.  This needs to be done for reasons both of fairness and efficiency;  and it can be done if we remain clear about the basic direction.  But before presenting a possible strategy for achieving that goal, the magnitude of the problem, which is usually underestimated, must be fully appreciated.

One cause of this underestimation is the artificially sharp distinction between poverty traps and employment traps which the EPAC paper rests much of its argument on.  It treats the first as a relatively minor force, but regards the second as relatively powerful.  The relation between the two is important, and it seems implausible to divorce them as this paper does.  Both have the same general disincentive tendency.  Both affect much the same population, those in the border area between economic hardship and economic self-sufficiency.  And the argument used to distinguish between them is not persuasive.

The paper contends that, if they could get a job, most of the unemployed would be likely to earn incomes considerably above the level of unemployment benefit payments, and it concludes from this that those payments are unlikely to serve as a disincentive to job-seeking. ⁽¹¹⁾  This presumes that the unemployed, many of whom have been out of work for a year or more, are capable of winning and holding down something approaching an average-income job.  This assumption is at odds with Bettina Cass's demonstration that "The burden of unemployment in terms of both rates and durations has fallen most heavily on people with a lower level of educational attainment and job skills. ..." ⁽¹²⁾  In the past fifteen years the median duration of unemployment has risen dramatically.  Replacement rate estimates which fail to take this into account (such as those in the EPAC paper and the accompanying working paper) are obviously out of touch with reality.  If Cass is right then we have little reason to believe that the long-term unemployed are capable of stepping "over the wall" of high EMTRs, into a median income job.

Recent research by the Brotherhood of St Lawrence provides direct evidence that families find unemployment benefits preferable to low-paid work.  A study by Jenny Trethewey reports that "Twenty-four adults (38 per cent of all adults interviewed) said they were concerned that if they returned to work they would lose eligibility for government concessions". ⁽¹³⁾  The sample is small, but the result may be significant.  These were families who would have received the Family Allowance Supplement if they took a job but who still thought the advantages of unemployment outweighed the losses.  If 38 per cent were prepared to say that they would work were it not for the loss of fringe benefits then presumably there were others who thought the same but would not say so.

If the distinction between poverty traps and employment traps is an artificial one, and if both present severe disincentives, then tax/welfare policy seems to require more than the probably ineffective "fine tuning" advocated by both EPAC and the Social Security Review.  Two questions must be asked which are not commonly asked:  Are welfare payments too high in relation to ordinary wages for a working family?  Are taxes too high and allowances too low for that same family?  Reducing welfare payments, lowering taxes on families and increasing family allowances will all tend to ease poverty and employment traps.  The introduction of the Family Income Supplement (later the Family Allowance Supplement) was implicitly a recognition that, in 1983 at the time of introduction, welfare payments were too high in relation to low-level wages.  Since that time poverty trap disincentives have come to be seen as not less, but much more serious than was previously thought

In Chapter Eight of this book it will be argued that the present level of payments to the great majority of sole parents can be safely lowered quite considerably (down to a level which equalises the position between broken and intact families) without consigning those families to destitution.  Such a lowering would eliminate the poverty trap in that situation.  If, however, we are going to continue with the present system of payments to sole parents, then modifying the taper rate by relaxing the means test is unlikely to lower the general level of work disincentives.  It will lower the level over one range of incomes merely by spreading it across a greater range of incomes.  Many sole parents, unlike most of the unemployed, are capable of winning average income jobs, but their childcare responsibilities predispose them (like married mothers) to seek part-time work.

It might also be contended that, in the buoyant labour market such as has existed in the past five years, unemployment benefits could also be lowered or durations restricted.  Plausible as this claim is, in a highly regulated labour market it is difficult to know whether all those presently unemployed could find work when benefits cut out.  This may be a limitation on this method of abolishing poverty traps.  Further, these solutions may not be politically acceptable.  Governments certainly would prefer an easier way out of the present impasse.  The most obvious, and probably the most popular solution is a system of family unit taxation.

Family unit taxation removes or reduces the income tax component of the poverty trap.  The proportion of the high EMTRs which is income tax varies from situation to situation.  In the standard cases presented in the EPAC paper income tax constitutes between one third and two thirds of the poverty trap barrier.  (See Figure 6.2 above.)  In these cases the family is taxed to provide revenue which is then returned to the family in the form of pensions, benefits, allowances and rent subsidies.  Part-time work in particular is heavily discouraged.  A family tax regime which required families with two or more children to pay tax only as their income approached average weekly earnings would reduce the poverty trap disincentive by at least a third and often by much more.  Such a regime is thus both required by the principle of tax justice for children and desirable on welfare efficiency grounds.

It will be presumed here that, in general, tax reductions are preferable to universal allowances for children.  There are two preliminary reasons for this assumption.  Allowances, like appearances, are deceptive;  they look bigger than they actually are.  If one half of taxpayers -- those with dependent children -- receive allowances and the same half pay one half of total personal income taxation, then one half of their allowances will have come out of their own pockets.  (This is roughly true of the present Family Allowance.)  Politicians might prefer allowances as a means of making themselves seem more "generous".  As Thomas Sowell has remarked, "Ninety per cent of the political art consists of ostentatious giving and surreptitious taking". ⁽¹⁴⁾  With allowances, the taking is real enough, but the giving is partly fake.

This "churning" means that family allowances raise marginal tax rates in order to give the money back to the taxpayer.  Raising marginal tax rates reduces work incentives which leads to a "deadweight" loss of both efficiency and equity.  As a tax equity measure for families, allowances should be used only if the desired result can not be achieved by tax reductions.

INTRA-FAMILY EQUITY

One common argument for preferring family allowances to tax reductions is that, because they are paid to the mother, they tend to bring about a better balance of income and power within the family.  Two matters arise here:  should the state play a part in determining the distribution of incomes within the family?  and if it should, is there any evidence that family incomes are at present unfairly distributed?

It has been the general position of this book that only extremes of injustice within the family fall within the state's domain.  The basic reason for this is that the family is a voluntary association which can be presumed competent to manage its own internal affairs.  The opposite assumption requires us to believe that legislators and administrators are in a better position to determine those affairs than are family members, an improbable assumption and one which should be adopted only on very strong evidence.  As Jordan observes, "Stable relationships of dependency entered into privately must be assumed reciprocal, and any disappointed expectation creates, as such, no public obligation". ⁽¹⁵⁾

No doubt there are some cases of extreme injustice within families, but how prevalent they are is a matter of dispute.  According to one survey, "The vast majority of both men and women saw household income as 'ours', to be spent in ways mutually agreed on".  Peter Whiteford, on the other hand, confidently asserts that "Evidence on income-sharing within the family is scant ... but there is general agreement that resources are often very unequally shared". ⁽¹⁶⁾  What is the basis for this "general agreement", and how often is "often"?  Whiteford refers only to a 1980 survey of fifty families in Queanbeyan by Meredith Edwards, which argues for the view that considerable injustice may occur within families.

Apart from its very small sample, Edwards's survey is of doubtful validity.  She found considerable diversity in the control and management of family finances, but in the majority of cases there was joint control, with management by the wife.  When comparing men's and women's personal spending she concludes that "in only one family was the wife's personal spending money a higher proportion of family income than that of her husband", but she seems to include petrol and lunch costs in men's personal spending when they might be better considered as work-related.  In the most extreme cases of apparent unfairness the wife, as Edwards notes, explicitly accepted her husband's greater spending power.  "Most wives and husbands considered the expenditure of their partners on pastimes to be reasonable", she remarks. ⁽¹⁷⁾  A considered reading of Edwards's survey suggests that, contrary to the common interpretation given of it, there is rather littie injustice in family income allocation.  Whiteford's "often" is unfounded, and the traditional assumption of income pooling should be allowed to stand.

Edwards has argued that her survey shows that "tax cuts or concessions provided to the husband as taxpayer but designed to benefit all members of his family may not in fact do so.  Tax concessions may well cause some redistribution of income within the family in favour of the husband". ⁽¹⁸⁾  However, her own survey contradicts this conclusion.  When asked how they would spend an extra $20 a week, only one in five men said they would spend it on themselves, compared with two out of five women. ⁽¹⁹⁾  The rest of the men favoured spending it on more generally beneficial objects.  All in all there is no evidence that intra-family income distribution is so badly skewed as to require corrective policy action.

It is curious that in discussing this topic no-one seems to ask whether expenditure is skewed in favour of or, more importantly, against children, who are far more vulnerable than spouses.  Jane O'Donohue claims that "income splitting is likely to be a less effective means of providing assistance to children than direct assistance to the primary carer of children", and cites Edwards' study as "evidence that family income is frequently not pooled and shared". ⁽²⁰⁾  Apart from the fact that Edwards has not demonstrated anything to warrant the term "frequently", her survey also does not support the conclusion that direct assistance to the mother is more effective than tax cuts for children.  About five out of eight women spent the present Family Allowance primarily on the children.  Whether or not this ratio would improve if it was directed through tax cuts the evidence does not permit us to say.  Surprisingly, Edwards found that "the majority of women [three out of five] said they would not mind if family allowances were paid to their husbands". ⁽²¹⁾  This proposal was opposed most by women in high income families where the women were not in paid work and the husband controlled family expenditures.

The goal of assisting homemakers, while it is only one element of family assistance, is to be taken seriously, as the Women in the Home survey showed.  However, a basic decision has to be made about whether that goal stands on its own or is a by-product of family assistance.  The view to be taken here is that whether a family has one or two income earners is an internal family decision.  It is to be regarded as a form of specialisation in which both partners are working equally for the general family good whether they are in the home or in the workforce.  Assistance to homemakers is then part of family assistance, along with assistance to children.  The assumption will be made that (there being no good evidence to the contrary) income is pooled, and benefits to the family in general benefit all the members of the family.  How that assistance should be allocated they are competent to decide.

Despite the fact that there is no good evidence that family incomes are unfairly allocated in more than an indetectable proportion of cases, we need not assume that family assistance should be directed through the primary breadwinner.  One way of giving tax assistance to all family members is to require that any tax refunds on a jointly-filed return be paid into a joint family account.  Being optional, no injustice would be done by this arrangement.  In families with two earners such a solution is the obvious arrangement.  In single income families where both partners recognise the importance of each other's contribution there is also no conflict.  In those few cases where the parties are at odds this arrangement might gently impose some redistribution.

WOMEN'S LABOUR FORCE PARTICIPATION

Family-based taxation schemes are often suspected by feminists of having the effect, or even the intention, of driving women out of the workforce and back into the home.  Their argument comes in two versions, one to do with equity, the other to do with efficiency.  Both hinge on the claim that family unit taxation raises effective marginal tax rates (EMTRs) for secondary earners, and thus constitutes a work disincentive for married women.  The equity version contends that this is both unjust in itself and a setback for women's aspirations towards equality with men in the public domain.  The assumptions are that work in the home is mostly done by women;  that women are just beginning to break free from the shackles of housework and childcare;  that this process is at a vulnerable stage, and that any incentives offered women to remain at home will be all too effective.

This objection is unfounded:  family unit taxation does not discriminate against women.  For one thing, the reasoning employed could just as easily be used to show that the opponents of family-based taxation intend to force women to remain in the workforce.  Secondly, it does not follow automatically that the spouse who stays at home, if one does, will be the woman.  Experience shows that it will be mostly women, but some will be men.  Family unit taxation offers this freedom to men as well as to women.  Thirdly, the feminist objector presumes to be a better judge of each family's arrangements than are those families themselves.  This is both illiberal and irrational.  No arguments are offered to show how the critic gets into this superior position.  Fourthly, feminists are themselves at odds on this issue.  The "Wages for Housework" movement must surely approve any move to reward the work of those who look after children.  And in this they will be reflecting the feelings of many ordinary women and men, both feminist and anti-feminist.

The efficiency argument is more reasonable.  The issue is the effect of family unit taxation on the marginal tax rates of secondary earners.  The objection is that joint taxation lifts the secondary earner's marginal tax rate up to that of the primary earner, and thus discourages him or her from working.  Most secondary earners are women, and women generally have greater elasticity of labour supply than men, so high marginal tax rates affect them more than they do men.  Taxation and economic efficiency requires that those with high elasticities should be given lower marginal tax rates.

It is not necessary to contest this objection.  The objection holds against the jointness of family taxation, but it is not essential that family taxation (unlike marriage-based income splitting) be joint taxation.  The only essential feature of family taxation is that it takes account of children.  The system could perfectly well be set up so that a couple with children could arrange their tax so that they submit separate tax statements, dividing the child component between them (or assigning all of it to the secondary earner, if that was thought preferable). ⁽²²⁾

DOMESTIC PRODUCTION

It is sometimes claimed that families get considerable benefit from having one spouse available for housework, home improvements, and the like, and that these benefits should be measured and included in the taxable income of the household.  Certainly, as we have seen, inequities arise if we tax cash income while taking no account of the number of people who put their time into earning it.  And if family size and consequent needs are to be taken into consideration because they lower family living standards then it seems only fair that whatever raises family living standards must also be counted in the tax equation.

Domestic production is difficult to measure not just for practical reasons but conceptually.  It is tempting to treat homemaking as an average job and to settle upon a figure around the average earnings of female workers.  But this fails to distinguish between work done for children and work done for their parents.  It makes a very great difference whether or not the time, money and effort parents put into children is regarded as a form of production.  The amount of domestic production achievable for the benefit of the parents by a homemaker with children, especially small children, is really rather limited.  Should domestic production include the time and cost of raising children?  There are a number of arguments against this view.  It implies children are a purely private good, a form of investment in one's future security perhaps.  In our society children are not such an investment.  We cater for our financial needs in old age through the taxation and superannuation systems.  If we think of the family as a welfare institution, as this book has advocated, then the costs of children will be seen as neutral in the tax equation.

Further, the leisure of family life, such as there is, is a rather different thing from other leisure.  It is an essential condition of family life.  Much of that leisure is socially productive.  Is it leisure to read a story-book to a child?  If it is then why do we deem it virtually compulsory for children to attend public buildings five days a week to have the same activity performed -- perhaps less well -- by a stranger who is paid a salary out of the taxes of the child's parents?  But if reading to children is not leisure, is talking with them?  We know that conversation between children and their parents is crucial to the child's development.  But if this is not leisure is it leisure to provide a setting where children can play safely and happily?  As Montaigne observed long ago, "Children's playings are not sports and should be deemed their most important actions".  Spontaneous interaction with adults, especially within their family, is the main way they become civilised.

In any case, as most parents will attest, there is not much leisure left at the end of a normal day of looking after small children.  And there is no obvious reason why we should count only the work performed by parents during normal working hours.  There is much still to be done by parents for their children at the end of the day, and much carries through into the remainder of the week.  Of course, it is difficult to distinguish here between work and leisure, and it is characteristic of parenthood that this distinction is not made.  It is a labour of love, sometimes more love than labour, and sometimes the reverse.  The outcome of this discussion seems to be that imputed income from domestic production is in principle quite properly included in the calculation of taxable income if a distinction is drawn between the production performed for the parents' benefit and that performed for the children;  but that when the effort expended by parents on their children is excluded from the total calculation of domestic production the remaining imputed income will probably be small.  In fact, inclusion of the imputed value of domestic production in taxable income would affect single-earner couples without children far more than it would families with children.

To be consistent, we have to allow for part-time workers by scaling the imputed value appropriately.  It would not be very difficult to include a statement of hours worked on group certificates.  Alternatively, and very crudely, the second worker's income could be used as a surrogate for hours worked, as in a sense occurs at present when one partner's dependent spouse rebate is reduced in line with the other partner's income when this is too small to be taxable in its own right.

HORIZONTAL EQUITY

A second extrinsic virtue of family unit taxation (apart from alleviating poverty traps) is that it tends to reduce one of the most obvious inequities in the present personal income taxation system, that between PAYE tax-paying families and non-PAYE self-employed couples.  As O'Donohue observes, "Currently married couples may seek to use a business partnership as a way of minimising tax by splitting the income of the household head among family members in a partnership formed to conduct the family business ...". ⁽²³⁾  The parties may share the income of the partnership without both being income-earning active members of it.  Curiously little is said about this discrepancy either in public debate or in the technical tax literature, as if it were a natural and permanent feature of the taxation landscape.  The case is all the more surprising given that PAYE voters far outnumber self-employed voters.  No political party seems to regard the issue as requiring corrrective action.  The discrepancy may perhaps be ironed out by more stringent Tax Office scrutiny.  Whether this can be done is partly a technical and partly a political question.  If it can not then the inequity provides another reason for supporting family unit taxation.

One point to note here is that the inequity cannot be removed by a system of child rebates, even if those rebates are equivalent monetarily to the effect of full family unit taxation.  Rebates would be available to self-employed tax minimisers as much as to PAYE taxpayers.

CONCLUSION

The sad fact seems to be that in the past fifteen years the debate about family assistance has only gone around in a circle.  When in 1976 family tax rebates were converted to Family Allowances the rationale was two-fold:  to help low-income families who paid little tax anyway, and to help improve the economic position of women within the family.  Much the same rationale applied to the introduction of benefits for single mothers.  Now it appears that in doing this we merely abolished the economic advantages of being self-supporting and created poverty traps instead.  To begin to remedy this we will need a radical, but fair, family tax system, one which goes back beyond 1976 to the sort of tax advantages for families, particularly low-income families, which existed thirty years ago.  This will not disadvantage women, for many of them now work and many are sole parents who could work.  Feminists now sometimes recognise that the Family Allowance Supplement does provide a work disincentive for second income-earners.  It is equally obvious that the single-parent poverty trap discourages women who would otherwise take a job.

Estimating the net economic effect of family unit taxation is a matter of balancing the efficiency losses of the necessarily higher tax rates on individuals without dependants against the efficiency gains which would flow from removing the poverty traps affecting low-income families.  This estimation cannot be attempted here.  But if it turns out that family unit taxation is not economically less efficient than the present system then the equity merits of the argument are the crucial determinant.  The equity case requires a debate about whether or not children are taxpayers, a debate which has never been undertaken, at least not in Australia.

In the previous chapter it was suggested that an assistance scheme for families with children is both justifiable in itself, because of the financial strain experienced by (particularly low-income) families, and also -- a point to be developed in Chapter Eight -- the best way to produce an equitable relation between two-parent and single-parent families.  In this chapter it has been contended that the application in the tax system of the generally-accepted principle of horizontal equity to children is both a requirement of justice and also necessary to eliminate or alleviate the adverse effects of poverty traps, economically inefficient and socially undesirable disincentives operating on families in the welfare system.  If the argument of this chapter is correct then, merely because they are children, over four million Australians are annually denied elementary taxation justice, without a murmur of objection from the rest of us.  We now need to see how the arguments in these two chapters are related.  There are four goals here:  financial assistance for two-parent families;  equalisation of assistance for all family types;  taxation justice for children and their parents;  and the elimination of poverty traps.  All four seem reasonable in themselves and consistent with each other;  all four involve greater assistance to ordinary two-parent working families.  All the arguments that favour general family allowance-type welfare assistance for families with children carry through to the case for tax assistance, but tax relief must take priority over welfare assistance if we are to avoid counter-productive "churning" and reduce poverty traps.

Whether such support would help to reduce family breakdown is a separate question, about which little is known.  At least we can say that it might be helpful in this way.  But the general topic is one which now requires an extended examination.

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ENDNOTES

1.  Common Treasury, 2, 217.

2.  Ibid. 234;  Feldstein, "On the Theory of Tax Reform".

3.  See Figure 2.1 above.

4.  See e.g. Taxes and Growth:  the London Conference.

5.  Warren, Papers on Taxation and Tax Incidence, 30 and Figure 4.

6.  See Freebairn, Porter & Walsh, Spending and Taxing and Spending and Taxing II, and Cole, "A Tax System for the 'Nineties".

7.  Jordan, Common Treasury, 2, 217.

8.  EPAC, Working Papers to Council Paper 35, 23, 32.

9.  Ibid. 34.

10.  EPAC Council Paper 35, 65f.

11.  Ibid. 36;  Working Papers, 17-22.

12.  Cass, Income Support for the Unemployed in Australia:  Towards a More Active System, 57ff.

13.  Trethewey, "What Do Our Futures Hold?", 10.

14.  Pink and Brown People, 59.

15.  Jordan. Common Treasury, 223.

16.  Burns, "Why Do Women Continue to Marry?", 226;  Whiteford, Issues in Assistance for Families, 41.

17.  Edwards, The Income Unit in the Australian Tax and Social Security Systems, 136f, 139.

18.  Edwards, "The Australian Taxation Unit:  An Evaluation".

19.  The Income Unit ..., 139.

20.  O'Donohue, An Examination of Taxation Arrangements for Couples with Children, 25.

21.  Edwards, The Income Unit ..., 147, Table 7.9, and 149.

22.  This point answers the main objection to income splitting raised by Patricia Apps and Elizabeth Savage in a number of papers.

23.  An Examination of Taxation Arrangements for Couples with Children, 24.