Australia's Future Tax System

Architecture of Australia's tax and transfer system

7.2 How individuals interact with the personal tax‑transfer system

The components of the personal tax—transfer system affect a household's disposable income and impact on incentives to work, save and develop skills. Marginal tax rates and means test tapers affect the financial return from additional work and the return from savings and investments. Transfers, tax exemptions for some forms of income, and tax offsets add to disposable income and can reduce incentives to work. Superannuation is facilitated through a mixture of compulsory saving and tax concessions which are designed to improve retirement income.

Chart 7.3 shows the elements of the personal tax‑transfer system and how it interacts with an individual or family unit. Other effects outside the Australian Government tax‑transfer system, such as the state tax‑transfer systems, also impact on the individual or family unit but are not included in this chart.

Chart 7.3: Personal tax‑transfer system

Chart 7.3: Personal tax-transfer system

Individuals interact with different agencies depending on whether they pay tax or they are eligible for transfers (the left and right sections respectively of Chart 7.3). The type of interactions can also differ between the agencies. This can lead to increased compliance costs for individuals depending on how many agencies they must deal with during a year.

The tax and transfer systems have different objectives which influence how the agencies administer their part of the system. Differences between the tax and transfer systems include: the financial basis of assessment (income versus income and assets); the income unit (individual versus family); and frequency (annual assessment versus fortnightly assessment) as outlined in Box 7.1.

The measurement of income is a particular area of difference (Table 7.1). Income support (pensions and allowances) are assessed on a social security definition of income, while only taxable income is used to assess the senior Australians tax offset and the low income phase‑in of the Medicare levy. Differences in what is assessed can also relate to the calculation period — fortnightly for income support and annually for tax assessment and family assistance. Another way in which income definitions vary is whether they are applied to an individual or a couple.

Box 7.1: Different characteristics of the personal tax‑transfer system

Individual versus family

The individual is generally the unit of assessment for the taxation system. However, there are exceptions where income tested programs are applied to individuals taking into account their spouse's income and/or family circumstances, such as the senior Australians tax offset and the Medicare levy surcharge.

The unit of assessment in the transfer system is the couple or family, based on the principle that the provision of targeted support should take into account other sources of financial support, including from close family members (spouse, parents of dependent children). The type of household also determines eligibility for assistance.

Income and assets tests

The income definitions used to assess the appropriate level of taxation and transfers differ within and between the two systems (see Table 7.1). 'Taxable income' in the tax system permits a range of deductions, while 'ordinary income' used for income support payments is a far more comprehensive definition of income.

Eligibility for most transfers is subject to means tests that target assistance based on an assessment of need. Income support payments are subject to both income and assets testing, with more generous assets test limits for those who do not own a home. Family assistance and the Commonwealth Seniors Health Card are tested on income but not assets.

Assessment periods

Tax is assessed on annual financial year income1, though amounts are withheld and remitted to the ATO on a regular basis through the pay as you go (PAYG) withholding arrangements.2 The effect of these arrangements is to remove employees from the majority of transactions occurring in the tax system. Income support payments are assessed and paid on a fortnightly basis, to provide timely support to recipients. Income support means tests are therefore highly responsive to short—term changes to an individual's or family's circumstances. Family assistance is provided to the majority of recipients on a fortnightly basis, with the income test based on annual income.

Agency assessment versus self‑assessment

The personal taxation system is generally based on self‑assessment — particularly in relation to deductions and non‑salary income sources. The transfer system is based on self‑identification — an individual needs to apply for most payments and allowances. Eligibility is assessed by an agency based on information provided by the individual.


  1. Primary producers, artists and composers can average their income over a number of years.
  2. Some people pay quarterly instalments, such as sole traders and people with investment and business income.

Table 7.1: Selected definitions of income in the tax‑transfer system

  Income base   Key components of the income base
      Employer fringe benefits Salary sacrifice‑superannuation contributions(a) Net losses
(rental property and financial)(b)
Tax exempt income
(including superannuation, foreign, defence income)
Pensions Ordinary income   Non‑grossed fringe benefits included Not included, except when over age pension age Losses cannot reduce other assessable income Some forms included
Allowances Ordinary income   Non‑grossed fringe benefits included Not included, except when over age pension age Losses cannot reduce other assessable income Some forms included
Family Assistance Adjusted taxable income   Non‑grossed reportable fringe benefits included Not included Net rental property losses added back Some forms included
Commonwealth Seniors Health Card Taxable income with adjustments   Assessable fringe benefits included Not included Net rental property losses added back Some forms included
Child support Taxable income with adjustments   Grossed‑up reportable fringe benefits included Not included Net rental property losses added back Some forms included
Superannuation co‑contribution Assessable income with adjustments   Grossed‑up reportable fringe benefits included Not included Losses not deducted from assessable income Not included
Personal income tax Taxable income   Not included Not included Losses included in taxable income Not included
Higher Education Loan Program Taxable income with adjustments   Grossed‑up reportable fringe benefits included Not included Net rental property losses added back Some forms included
Medicare levy surcharge Taxable income with adjustments   Grossed‑up reportable fringe benefits included Not included Losses included in taxable income Not included
Senior Australians tax offset Taxable income   Not included(c) Not included Losses included in taxable income Not included
  1. To be included in most programs from 1 July 2009.
  2. To be included in some programs from 1 July 2009.
  3. To be included from 1 July 2009.

Definitions

'Ordinary income' for social security purposes includes salary, wages, net business income, rent and deemed income on financial investments. It also includes certain periodic payments such as some gifts and allowances, and payments to employees for particular purposes such as relocation or travel, where the employee has the discretion whether to spend the money on that purpose. Exceptions to ordinary income include emergency or like assistance, payments by States or Territories to assist a person to purchase or build their own home, payments made to a person for a dependent child, or insurance or compensation payments made for the loss or damage to buildings, plant or personal effects.

'Adjusted taxable income' is taxable income, adjusted fringe benefits, target foreign income, net rental property losses, tax free pensions or benefits, less any deductible child support paid.

'Assessable income' is ordinary income plus statutory income (provided it is neither exempt nor non‑assessable non‑exempt).

Interactions within the year

As people's circumstances change, their interactions with the personal tax‑transfer system also change. In some cases only the tax system will affect income, while in others it is the transfer system. There will also be times when people are paying tax as well as receiving transfers or paying tax on a transfer. This is referred to as 'churning', as the total payments received offset part or all of the tax they pay.

Analysis of churning is highly sensitive to the time period in question. Income support payments are targeted on the basis of an immediate current need, such as unemployment, and are mostly assessed fortnightly. In such cases, the transfer system is responsive to an immediate set of circumstances for which people typically cannot cover their costs. The tax system has an annual basis, with some expectation that individuals can manage variations in income over the period. As an individual's or couple's earnings increase, transfers are recouped through payment withdrawal. Tax liabilities also increase.

While churning is a consequence of a targeted redistributive system, it can be costly. One set of costs relates to the separate administration of the tax‑transfer system, to the extent that a similar outcome could be achieved with less churn. Another set of costs relates to the compliance costs on individuals, who are subject to different information and compliance requirements from the combined effects of the two systems.

At an aggregate level, Australia has a low level of churn by international standards, as the personal tax‑transfer system is tightly targeted, highly progressive and substantially redistributive. OECD estimates (Whiteford 2005) indicate that Australia has the lowest level of churn of any OECD country, on the basis of direct taxes and transfers. Widening the assessment to include indirect taxes and non‑cash benefits does not significantly change this analysis (Harding et al, 2006).

Individuals experience churn in two main ways. Many families who receive family assistance (Family Tax Benefit (FTB) or child care assistance) also pay income tax. Families can choose whether to receive FTB after their taxable income has been assessed at the end of the year. However, fewer than 10 per cent of families choose this option, instead preferring fortnightly payments despite the associated churn. Historically, redistribution of family assistance from breadwinners to primary carers within couples has been an important reason why governments have supported direct payments rather than delivery of assistance for children through the tax system.

Individuals and families also experience churn when they receive income support and have low to moderate levels of private income. For example, a person on a part—rate Newstart Allowance with an ongoing part‑time job is in both systems at the same time. If they move off Newstart into full‑time work, they would still be in both the tax and transfer systems over the course of the income year. Similarly, older Australians with savings may also receive the Age Pension and still pay tax even after the operation of the low income tax offset (LITO) and the senior Australians tax offset. Churning of income support recipients with private income has increased since the 1980s, as income support payments have risen from below the tax free threshold to well above it. While a relatively low tax free threshold increases this form of churn, a higher tax free threshold would have the disadvantage of increasing opportunities for tax planning.

Interactions over time

Charts 7.4 and 7.5 show how the personal tax‑transfer system interacts to determine an individual's disposable income for two single income family types — one with no children and one with a partner and two children aged three and eight. Point A shows the effect of the tax‑transfer system at an income of $10,000. Point B shows the effect where the level of earned income is $45,000. They also show the extent of 'churn' which can occur in the system.

Chart 7.4: Transfers and taxes, by level of income

Single income no children (2008‑09)

Chart 7.4: Transfers and taxes, by level of income - Single income no children (2008-09)

Source: Australian Treasury estimates.

Chart 7.5: Transfers and taxes, by level of income

Single income family, two children aged 3 and 8 (2008‑09)

Chart 7.5: Transfers and taxes, by level of income - Single income family, two children aged 3 and 8 (2008-09)

Source: Australian Treasury estimates.

The amounts above zero show the components of the personal tax‑transfer system which have a positive effect on disposable income. These are Newstart Allowance, Parenting Payment (Partnered), LITO and Family Tax Benefit A and B. The items below zero reflect the individual's tax and Medicare levy liability. As the individual earns more income they start to lose their payments and offsets and pay more tax. The effect on disposable income is shown in Tables 7.2 and 7.3.

Table 7.2: Disposable income based on family type — $10,000 earned income (2008‑09)

  Individual —
no children
Single income couple — children 3 and 8
Earned income $10,000 $10,000
Newstart $6,946 $5,825
Parenting Payment (Partnered) $10,369
Gross income $16,946 $26,194
Gross tax (Medicare levy threshold not reached) $1,642 $2,129
‑ less beneficiary tax offsets $142 $655
‑ less LITO $1,200 $1,200
Net tax payable $300 $274
Family Tax Benefit Part A + B (tax exempt income) $11,789
Total disposable income $16,646 $37,709

Table 7.3: Disposable income based on family type — $45,000 earned income (2008‑09)

  Individual —
no children
Single income couple — children 3 and 8
Earned income $45,000 $45,000
Gross taxable income $45,000 $45,000
Gross tax on gross income (including Medicare levy) $8,175 $8,175
‑ less LITO $600 $600
Net tax payable $7,575 $7,575
Family Tax Benefit Part A + B (tax exempt income) $12,469
Total disposable income $37,425 $49,894

The interactions between the components of the personal tax‑transfer system mean that some individuals and families will not become net taxpayers until their private income is well above the tax—free threshold of $6,000. This point is sometimes called the 'net tax threshold' and represents the point where cash transfers equal tax paid. After this point the individual or family will become net taxpayers. As shown in Table 7.4, the net tax threshold differs for different family types.

Table 7.4: Net tax threshold for different family types (2008‑09)

Family types Net tax threshold
Single person, no children $19,448
Single income couple, no children $33,864
Dual income couple (75‑25 split), no children $35,579
Sole parent, two children aged 3 and 8 $53,819
Single income couple, two children aged 3 and 8 $53,819
Dual income couple (75‑25 split), two children aged 3 and 8 $59,367

Over a lifecycle, people receive greater subsidies at times of higher need, such as when they have young children and in old age, and pay higher levels of tax at times when they can better afford to do so, such as in later working years when their children have left home. In this way, the tax‑transfer system 'smooths' income through more difficult periods and bears some of the risks associated with unemployment, illness and other life contingencies.

Inflation and the personal tax‑transfer system

The personal income tax settings affect a person's real disposable income (income adjusted for changes in inflation). Where a progressive tax scale is not adjusted over time, wage increases can result in an individual paying a higher average tax rate on the same level of real income. This can reduce the progressivity of the tax system and is known as bracket creep or fiscal drag.

Australia has returned fiscal drag through regular (though unscheduled) tax cuts in the form of changes to rates, thresholds and adjustments to LITO. Compared to 1985, successive tax cuts have meant that taxpayers at all income levels pay less tax than they would have if the thresholds had been indexed to the consumer price index (CPI) or even to wages growth.

Table 7.5 shows the effect on average tax rates of the return of fiscal drag since 1985 for a single person earning half average weekly earnings (AWE), AWE, and twice AWE. For example, if the tax thresholds had only been indexed to CPI or wages, an individual earning AWE would have an average tax rate today of 22.8 per cent and 21.4 per cent, respectively. The changes to personal tax thresholds since 1985 have meant that this individual has an average tax rate of 18.1 per cent.

Table 7.5: Fiscal drag has been more than returned since 1985

    Average tax rate in 2008‑09 if the 1985‑86 personal tax thresholds
had been indexed to:
Earnings Actual average tax rate in 2008‑09 Inflation Wage growth
Half AWE ($24,070) 7.8 14.7 13.5
AWE ($48,140) 18.1 22.8 21.4
Twice AWE ($96,280) 27.0 37.2 34.8

Assumes CPI/AWE indexation applies to personal tax thresholds, LITO amount and threshold, and the Medicare low‑income threshold.

Source: Australian Treasury estimates.

Inflation can also affect the purchasing power of transfers through the effects on payment rates and thresholds. The combination of the indexation to CPI and benchmarking of Age and Service Pensions to male total average weekly earnings (MTAWE) has resulted in increased purchasing power over time, while the indexation of allowances to CPI has sought to ensure that the value of these payments is not eroded by changes in consumer prices. The indexation of income support payments is discussed in more detail in the next section.