Australia's Future Tax System

Final Report: Detailed Analysis

Chapter A: Personal taxation

A1. Personal income tax

Annex A1: Concessional offsets in detail

This attachment outlines the concessional offsets that are available in the existing system and the proposed approach to reforming, removing or retaining them.

Dependency tax offsets — Dependent spouse tax offset

Taxpayers are eligible to claim a dependent spouse tax offset if they maintain a spouse on either a married or a de facto basis, and neither the taxpayer claiming the offset nor the spouse is entitled to Family Tax Benefit Part B. The offset subsidises the costs of maintaining a spouse who is not in the full-time workforce, and cuts out when the income of the spouse reaches $8,917 (2008–09) or when income of the taxpayer reaches $150,000. In 2006–07, around 354,000 taxpayers claimed the offset at a cost to the Government of approximately $465 million.

The dependent spouse tax offset should be removed where it impacts on participation incentives and should be limited to circumstances were there is less concern about the impact on workforce participation of the secondary earner — for example, for dependants unable to work due to invalidity or for those over Age Pension age.

The dependency offsets should be combined into a single offset to provide a tax concession where the taxpayer is supporting either a dependant who is unable to work due to disability or carer responsibility or where the taxpayer or dependant has reached Age Pension age.

Dependency tax offsets — Invalid relative tax offset

The invalid relative tax offset is available to taxpayers who maintain an invalid brother, sister or child who has been certified by a medical practitioner as unable to work. In 2006–07, around 29,000 taxpayers claimed the invalid relative and parent/parent-in-law tax offset at a cost of $43 million.

The means test applied to the invalid relative (which has an income cut-out point of $3,448 in 2008–09) makes taxpayers ineligible where the invalid relative receives Disability Support Pension or an alternative income support payment.

Support to families maintaining invalid relatives is essential. It is best delivered through the transfer system via the non-means tested Carer Allowance supplementary payment and the means tested Carer Payment. The transfer system is well equipped to deal with these circumstances and is a timely and effective way of delivering assistance to those in need.

The tax system can play an additional role in providing an offset for invalid dependent relatives, although this requires a parallel system for assessing invalidity. The tax system should provide a tax offset for taxpayers who maintain and provide daily care and attention for a disabled relative where the dependant does not receive an income support payment. This should form a component of the new dependency offset.

Dependency tax offsets — Housekeeper tax offset

The housekeeper tax offset is a subsidy to taxpayers who engage a full-time housekeeper for their house. The housekeeper must care for a child under 21 years of age, invalid relative or spouse of the taxpayer who is receiving a Disability Support Pension. In 2006–07, almost 11,000 taxpayers claimed the housekeeper tax offset at a cost of approximately $16 million. The housekeeper tax offset should be replaced with the single dependency offset for those situations where the dependant or taxpayer is unable to work or is of Age Pension age.

Dependency tax offsets — Child-housekeeper tax offset

The child-housekeeper tax offset subsidises taxpayers where their child, adopted child or stepchild keeps house for the taxpayer full-time and has some responsibility for the general running of the household. The child-housekeeper does not have to care for a dependant. Around 2,500 taxpayers claim the child-housekeeper tax offset each year at a cost of around $10 million.

The child-housekeeper tax offset should be removed, to encourage active engagement in study, training and work on the part of older dependent children. There are transfer programs that assist with the costs of undertaking work search, or full-time study or training.

Dependency tax offsets — Parent/parent-in-law tax offset

Taxpayers who maintain their parent or their spouse's parent may be eligible for the parent/parent-in-law tax offset. The means test applied to the parent or parent-in-law (which has a separate net income cut-out point of $6,614 in 2008–09) makes taxpayers ineligible for the offset where the parent receives the Age Pension or some other form of income support. Assistance for taxpayers with dependent parents or parents-in-law is better provided through the transfer system. The tax system can play an additional role in providing an offset for dependent parents and parents-in-law aged over 65 who are ineligible for the Age Pension.

Mature age worker tax offset

The mature age worker tax offset (MAWTO) is a non-refundable offset with a complicated design. While it is intended to increase work incentives for older Australians, it is unclear whether it has achieved this goal. It is delivered at the end of the year (not through withholding tax arrangements). While it reduces effective rates of tax on earned income over one range of income, it increases them over another.

The MAWTO was introduced in the 2004–05 tax year for eligible Australian residents aged 55 or over who remain in the workforce. It offers a rebate of up to $500 based on the amount of net income generated from working during the year. The amount of the rebate is not indexed. It is phased in at five cents per dollar of assessable labour income less related deductions, reaches the maximum amount when net income from working reaches $10,000, and phases out completely when this type of income reaches $63,000. As with other offsets, the benefit is received when tax is assessed.

The MAWTO should be removed. Removal of this and other offsets would facilitate lower tax rates and a higher tax-free threshold, which is a more effective way of encouraging workforce participation than offsets like the MAWTO.

Private health insurance tax offset

To encourage the take up of private health insurance the Australian government currently subsidises premiums based on a person's age (see Table A1–9). It does this through direct premium reductions or by providing individuals with assistance through the tax or transfer system.

Table A1–9: Amount of private health insurance subsidy, by age

Age of the oldest person covered by the policy(a) Amount of the subsidy
Less than 65 years 30% of the amount of premium paid
65 years to under 70 years 35% of the amount of premium paid
70 years or over 40% of the amount of premium paid
  1. If the oldest person moves into the next age group during the year, the rebate is based on the number of days that person was in each group.

Source: ATO.

As a general principle, it is administratively costly to provide the same benefit through multiple mechanisms. This also makes it more complicated for people to decide how to claim the subsidy. Providing assistance as a direct premium reduction is more efficient than through a tax offset because a premium reduction provides timely assistance, particularly for those who are least able to afford the cost of insurance at the time it is purchased. It is also the most common method of claiming assistance.

Means testing subsidy entitlements risks inaccurate assessments of annual income and consequent debts. If government wishes to increase the fairness and sustainability of private health insurance subsidies, it could consider other ways of limiting the cost of the subsidy, such as limiting the type of eligible policies or capping the value of subsidies paid. If used as an alternative to means testing, these approaches could also facilitate the use of direct premium reductions as the sole method of subsidising private health insurance. This would simplify the system, increase transparency and make it easier for people to make decisions about their insurance cover.

Medical expenses tax offset

The Australian government assists people with very high unreimbursed medical expenses through the medical expenses tax offset. This provides a 20 per cent tax offset to taxpayers who have unreimbursed family medical expenses above $1,500 in an income year.

Unreimbursed medical expenses include medical expenses which have been paid in full minus any refunds — for example, from Medicare or a private health insurer — that have been received, or that could have been received. Medical expenses that qualify for the offset include payments to doctors, dentists and optometrists. Other expenses, such as ambulance charges, do not qualify, while some expenses that are not covered by Medicare are covered by the offset. This can make it difficult for people to understand their entitlements. In 2008-09 this offset provided individuals with approximately $440 million in assistance.

The offset does not provide assistance when the expense is incurred, as it can only be claimed at the end of the income year. A family that incurs significant medical expenses early in the financial year will have to wait some time to recoup part of the cost through the offset.

The offset must be claimed by an individual but is assessed on a family basis. This can make it difficult for people to decide which family member should make a claim for assistance. The design of the offset is also inequitable for single people as the amount of unreimbursed medical expenses they must incur before they can receive assistance is the same as for families. In addition, some low-income individuals and families with high medical expenses cannot claim the full value of the offset because they have an insufficient tax liability and the offset is not refundable.

For these reasons, the medical expenses tax offset should be removed and an alternative method for delivering safety net arrangements for individuals with very high medical expenses should be developed using (for example, Medicare safety net arrangements). In light of this, the Review supports the NHHRC's recommendation that the scope and structure of safety net arrangements be reviewed. The purpose of the review would be 'to create a simpler, more family-centred approach that protects people from unaffordably high' health care costs (National Health and Hospitals Reform Commission 2009).

Education tax refund

The education tax refund (ETR) was introduced for the 2008–09 tax year as a refundable offset to assist parents and independent students with certain prescribed education expenses (including computers) related to primary and secondary schooling. To be eligible, parents must meet the means test for Family Tax Benefit Part A (FTB A), and independent students must be in receipt of Youth Allowance, ABSTUDY or a like payment. An offset of 50 per cent of expenses up to an indexed maximum refund of $375 for primary students and $750 for secondary students is available.

As the refund is paid through the tax system, there is a time lag between when the expense is incurred and when the refund is received. More generally, payments such as the ETR, which are linked to receipt of other payments (in this case FTB A), effectively create 'sudden death' cut outs and result in very high (over 100 per cent) effective rates of tax at the point at which the main payment (FTB A) is extinguished.

The ETR should be removed from the personal tax system and replaced with automatic advance payments through the family payment system at the beginning of each school semester to those that meet the existing eligibility criteria. The Back to School Bonus would be an appropriate model.10 While eligibility for the rebate would no longer be contingent on the purchase of particular items, the proposed reform would reduce the compliance burden (substantiation requirements) for family payment recipients, provide more timely compensation and reduce complexity and administration costs in the tax system.

Entrepreneurs' tax offset

The entrepreneurs' tax offset (ETO) was introduced in 2005 to provide encouragement to entrepreneurs in the very early stages of business development. The ETO provides a 25 per cent tax offset on the annual income tax liability attributable to business income of very small businesses. Around 73 per cent of recipients of the ETO receive less than $600 (though the maximum rebate is $2,500). The ETO begins to phase out for businesses whose turnover exceeds $50,000, and businesses with a turnover of $75,000 cease to be eligible. Eligibility for the offset is also restricted through a means test on the claimant's other (non-small business) income.

Removing the ETO would reduce compliance and administration costs and provide a more equitable and neutral treatment between self-employment and employment income. The ETO is very complex to administer and provides problematic incentives related to business structure.

Overseas defence forces and civilian tax offsets

The overseas defence forces tax offset is available to members of the Australian Defence Force (ADF) serving in places where the nature of service is declared to be uncongenial and isolated. The overseas civilian offset is available to prescribed civilian personnel, such as Australian Federal Police (AFP) personnel, contributed by Australia to an armed force of the United Nations overseas.

For both offsets the annual amount is $338 plus 50 per cent of any dependency tax offsets for which the taxpayer is eligible.

The important contribution of Australians serving overseas is best recognised through direct salary and wages, rather than delayed payments delivered through the taxation system. The overseas defence forces tax offset and the overseas civilian tax offset should be replaced with additional remuneration. This would simplify the tax system, while still recognising the specific hardships that members face while serving in particular places.

Zone tax offset

The zone tax offset (ZTO) is available to residents of particular areas in Australia, designated Zone A, Zone B and special areas within each zone. While the special areas are defined by reference to remoteness, and can shift as concentrations of population shift, Zones A and B have not been changed for some time. Special areas include places that are more than 250 kilometres by the shortest practicable surface route from the nearest town with more than 2,500 people, as of 1981.

For special areas the offset is equal to $1,173 plus 50 per cent of the relevant rebate amount per year. For ordinary Zone A the offset is equal to $338 plus 50 per cent of the relevant rebate amount per year. For ordinary Zone B the offset is equal to $57 plus 20 per cent of the relevant rebate amount per year. The relevant rebate amount is the total of dependency offsets the taxpayer is eligible for, including notional offsets.

Data on the number of taxpayers claiming the ZTO is combined with the overseas forces offsets. In 2006–07 around 550,000 taxpayers claimed the ZTO or overseas forces offsets at a cost of $234 million.

While the Review has not examined the ZTO in detail, it is notable that the zones do not appear to be determined by any modern concept of remoteness. The zones were established in 1945 and the boundaries have remained broadly unchanged since 1956. Given changes in population and the distribution of industry and transport infrastructure since 1956, many areas in the zones are not disadvantaged or isolated. On the other hand some remote areas fall outside the zones. For example while Darwin is in Zone A and Townsville and Cairns are in Zone B, Ivanhoe, in western New South Wales, with a population of around 250 and more than 200 kilometres from the nearest town with over 2,500 people, lies outside the zones.

The zone tax offset should be reviewed, with a view to providing assistance based on contemporary measures of remoteness.

Notional tax offsets

In general there are three categories of notional dependant tax offsets: the sole parent offset, the dependent spouse with child offset, and the dependant child offset (where the amount of the offset depends on the number of children and whether the child is a student). Although these offsets have been abolished in their own right, they are still used to determine a taxpayer's eligibility for the zone, overseas forces and medical expenses tax offsets and for determining the amount of the Medicare levy family income threshold offsets.

For example, taxpayers who are living in a zone or are on eligible overseas service and who are sole parents or have a dependent spouse or child are eligible for an increased amount of ZTO or overseas forces offset as a result of the notional tax offsets. The notional dependent spouse with child tax offset of $2,508 allows a taxpayer who qualifies for the ZTO an additional offset of $1,254 if they are a resident of a special area or ordinary Zone A, or $502 if they are a resident of ordinary Zone B.

The notional tax offsets should be removed.

Averaging tax offsets — Employment termination payment tax offset

Historically, payments made in respect of termination of employment have been taxed at a concessional rate. The employment termination payment tax offset limits the maximum rate of tax applied to taxed elements of employment termination payments.

The taxable component of an employment termination payment up to $145,000 (in 2008–09) is taxed at 15 per cent if the recipient is at or above preservation age, and at 30 per cent if they are under preservation age. Amounts received in excess of this threshold are taxed at the top marginal tax rate. The offset was introduced in 2007 as part of the Better Super changes to replace previous arrangements under which the concessional taxation treatment of employment termination payments was aligned with the taxation arrangements applying to superannuation benefits. A limit to the concessional treatment of these payments was introduced, because they could less clearly be characterised as retirement-related.

The existing arrangements are complex and the income threshold for the concession differs significantly from the marginal tax rate thresholds. In addition, the concession is provided for generous 'golden handshakes' as well as for unpaid salary.

Elements of employment termination payments, such as 'golden handshakes', should be treated as income and taxed at marginal rates. Over time, the remaining concessions in relation to these payments should be removed and the payments taxed as income.

Averaging tax offsets — Lump sum in arrears tax offset

The lump sum in arrears tax offset limits the tax payable on the arrears component of eligible lump sum income that accrued in earlier years, such as salary or wages that accrued during a period ending more than 12 months before the date on which they were paid. It reduces the tax liability to what it would have been if the income had been received in the year(s) in which it accrued. The offset enables smoothing of tax liabilities where taxpayers receive lump sum income. The offset ensures that a taxpayer who receives a lump sum is not penalised through a higher tax liability purely because of the timing of the payment which may be out of their control.

The lump sum in arrears tax offset should be retained.

Averaging tax offsets — Medicare levy surcharge lump sum payment in arrears tax offset

The Medicare levy surcharge lump sum payment in arrears tax offset provides an offset to taxpayers who have incurred a Medicare levy surcharge liability or an increased liability in the current year due to the receipt of an eligible lump sum payment in arrears. It ensures that any Medicare levy surcharge liability arising from receipt of an eligible lump sum payment in arrears, such as a workers compensation payment, is offset.

The Medicare levy surcharge lump sum payment in arrears tax offset should be retained if the Medicare levy surcharge is retained.

Other averaging offsets

A taxpayer with income from primary production may have their income from previous years averaged out over a period of up to five years. This is designed to ensure that a primary producer with a fluctuating income is taxed comparably to a person with a steady income stream. Where tax on the current year's income would exceed the tax on the average income amount, the taxpayer is eligible for an offset equal to the difference. Where tax on the current year's income would be less than the tax on the averaged income amount they incur an additional tax liability.

A taxpayer who is a 'special professional' — an author, inventor, performing artist, production associate or sportsperson — is also able to use an income averaging scheme under which the tax payable is calculated by applying to the total amount of 'above-average' special professional income the average rate of tax that one-fifth of that amount would have borne if it had been the top slice of the taxpayer's taxable income in the relevant income year. Averaging plays an important role in ensuring reasonable treatment for primary producers and special professionals.

The averaging arrangements for primary producers and special professionals should be retained.

Superannuation tax offsets — Spouse superannuation contributions offset

The spouse superannuation contributions tax offset should be removed. Under the proposed superannuation contribution rules, all contributions would be eligible for an offset. The spouse superannuation contribution tax offset would no longer be necessary.

Other offsets for individuals

There are a number of other smaller offsets that would need to be considered on a case-by-case basis if the number of offsets were to be reduced further. In general, tax offsets should not be used to provide assistance to groups or individuals. This should instead be done through direct government spending, including through the transfer system.

Unused annual leave tax offset

This offset applies to unused annual leave accrued before 18 August 1993 or made in connection with a payment that includes or consists of a genuine redundancy payment, payment from an approved early retirement scheme or a payment that consists of an invalidity segment. The offset limits the rate of tax on the unused annual leave payment to 30 per cent.

Unused long service leave offset

This offset applies to unused long service leave accrued before 18 August 1993 and to genuine redundancy payments, early retirement scheme payments and an invalidity segment of an employment termination payment or superannuation benefit post-18 August 1993. The offset limits the rate of tax on the unused long service leave payment to 30 per cent.

Payments for unused annual leave and long service leave should be treated as income and taxed at marginal tax rates.

10 The Back to School Bonus is part of the Nation Building and Jobs Plan announced on 3 February 2009. It was a one-off, upfront bonus of $950 paid to families eligible for FTB A for each eligible child of school age.