Australia's Future Tax System

Final Report: Detailed Analysis

Chapter F: The transfer system

F2. Means testing

F2–1 Designing equitable means tests to reduce impacts on work and saving

The tax system and the transfer systems often use different concepts of means to determine a person's tax liability and their eligibility for income support. Under a progressive tax system the more income a person has the higher is their tax liability. Under a means tested transfer system, the level of income support decreases as the means a person has at their disposal increase. Another difference between the systems is that the transfer system includes all means available to a person, including those of their spouse or partner, while the tax system only considers the means belonging to the individual.

Both the tax system and the transfer system include employment income as means, although the transfer system does not generally reduce a person's income by their work expenses when determining their level of means. Apart from the treatment of the means of a partner, another difference between the two systems in calculating a person's means is the treatment of assets.

The tax system includes only the income generated from assets, such as rent, dividends and interest. A change in the value of assets does not have an immediate effect in the tax system. Changes in asset values only affect a person's income when there is a disposal or other realisation event in relation to the asset.

The transfer system, however, looks beyond whether an asset actually generates an income to consider the amount of assets at a person's disposal. It assumes that a person can use their assets to generate an income to support themselves. This includes their non- or low-income earning assets. Changes in means, such as increases in assets values, are the refore tested more frequently in the transfer system.

The different treatment of assets in the transfer system is a reflection that targeting on the basis of need requires a broader view of a person's ability to maintain themselves than that which is implied by testing income only. Without an effective assessment of assets, income support would enable greater transfer of assets to younger generations through bequests, rather than targeting assistance to people in need.

Means testing can be an effective mechanism for targeting assistance to people in need. Australia relies more on means tested payments than many other countries, with the result that its transfer system is more progressive than those of other OECD countries. Chart F2-1 shows the ratio of benefits received by the poorest 20 per cent of people to the benefits received by the richest 20 per cent of people in OECD countries (Whiteford 2009). Whiteford finds that within the OECD, Australia has the most progressive distribution of disability benefits and unemployment benefits, ranks second in the distribution of Age Pension benefits and ranks fifth in the distribution of family benefits.

Chart F2-1: Progressivity of cash benefits

Ratio of benefits received by households in the poorest to the richest quintiles,
total population 2005

Ratio of benefits received by households in the poorest to the richest quintiles,total population 2005

Source: Whiteford 2009.

The targeted nature of Australia's income support system has a number of benefits. It contributes substantially to the progressive effect of the tax and transfer systems on income distribution. Means testing is important to the sustainability of the income support system. By focusing spending on a smaller group, the level of benefits provided to those most in need can be kept higher.

While means tests and taxes have a different conceptual basis, they can have a similar economic impact. Empirical research shows that means testing affects decisions to work as strongly as tax does (Meghir & Philips 2009). Means testing raise effective tax rates which reduce the return people get from work and saving. For example, a person who earns an additional $100 of income may not only pay tax on that amount but also lose some of their income support.

It is therefore essential to limit means testing to the core transfer payments, in particular income support and family payments. Payments and supplements should be withdrawn so that the cumulative effective tax is not excessive.

The existence of multiple separately means tested payments results in overlapping withdrawal rates, which raise effective rates of tax. This can be particularly problematic where services and concessions are linked to payments and create 'sudden-death' loss of assistance once a particular income level is crossed.

The level of efficiency of taxes and means tests as ways of raising revenue (or limiting outlays) has been a crucial question in the Review's deliberations. Although means tests reduce the returns from work or saving, they can be designed in ways that reduce this impact. Indeed, some features of means tests may make them a more efficient instrument than direct taxes. For some working-age transfer payments, means tests are accompanied by activity-testing that directly requires recipients to look for, or undertake, employment.

Principles

The transfer system should have a broader assessment of means than the tax system. The concept of means for income support payments should include not only income but also the ability of a person to generate an income from their assets.

Means test arrangements should ensure that people on the same type of payment with similar means, including their income and their assets, receive an equivalent level of income support or other assistance.

The settings for a means test should pay attention to its impact on a person's decision to work and save as well as its primary objective of targeting government payments.

Means testing should be limited to essential payments, in particular income support and family assistance payments, to avoid an unnecessarily high effective rate of tax created by the cumulative nature of means test and tax.

While the targeted nature of Australia's income support system is on balance a strength of the system, there are areas where means testing could be improved. In particular, people who are receiving the same type of payment and have similar means should be treated consistently. It is also important to maintain incentives to work and save.