Australia's Future Tax System

Architecture of Australia's tax and transfer system

7.4 Workforce participation

Taxes on earned income are a significant source of government revenue. An increasing dependency ratio will affect the ability of the working age population to support government programs. This gap can be filled by increased participation of people in the workforce and increased productivity.

The personal tax‑transfer system can affect workforce participation decisions by altering the financial rewards of working — that is, disposable incomes. Where transfers are high enough to meet an individual's needs, their incentives to work longer hours are reduced. Tax, together with reductions in transfers as people earn more income, reduces the financial rewards from work, making it less attractive. Policy settings thus need to consider participation goals alongside other concerns such as adequacy and affordability.

Workforce participation is an important driver of economic growth and has benefits for broader social inclusion. While the proportion of the population in paid work is currently at an all time high, the increased prevalence of part‑time work and employment of female workers have increased the importance of personal tax‑transfer settings that encourage participation. These groups seem more responsive to incentives than are males working full‑time hours, as they tend to have more flexible patterns of participation and are more affected by interactions with the personal tax‑transfer system.

Another reason incentives are becoming more important is population ageing, which will drive down the participation rate in the future.

Financial incentives, however, are only part of the story. An individual's responsiveness to them will depend on the role played by other factors that influence participation. There are also non‑financial incentives such as activity tests for certain income support payments which can play a significant role for some. Individuals take into account many other considerations, such as: meeting basic financial needs; their work ethic; caring responsibilities; their health and disability status; level of wealth; social expectations; the availability of child care; working conditions; and the benefits of remaining attached to the labour market as it affects career prospects and expected future earnings.

One way of assessing financial incentives to work is to measure the amount by which an individual's gross pay is reduced by the personal tax‑transfer system. The proportion of an individual's gross pay that is taken as tax or is offset by a reduction in payments is called their effective tax rate (ETR). There are various types of ETRs. An individual who moves into the workforce will keep only part of their gross pay after tax is taken out and transfers are reduced. These are often called participation tax rates. If an individual takes on some extra work, they will only keep a proportion of their extra gross pay. These are called effective marginal tax rates for an additional dollar earned and effective average tax rates for a larger increase in earnings (for example, another day's work). If ETRs are too high, some people may decide it is not worth their while to take a job, or work extra hours. Other people in certain circumstances might decide to increase hours of work to ensure their ongoing commitments are met. See Section 3.5 for a discussion of participation tax rates and ETRs.

Chart 7.11 provides an example of the ETRs faced by a secondary earner with two school‑aged children. The chart considers ETRs when moving into work, and also when earning an additional dollar. It is important to consider ETRs on a range of different increases in income, as people generally can only increase (or decrease) their hours in blocks.

Chart 7.11: Effective tax rates faced by a secondary earner

With a partner earning average weekly earnings with children aged 6 and 7

Chart 7.11: Effective tax rates faced by a secondary earner - With a partner earning average weekly earnings with children aged 6 and 7

  1. for 2008‑09. Children are aged 6 and 7, partner is earning $57,900.

Source: Australian Treasury estimates.

A secondary earner who enters the workforce in a job paying $280 a week (about three days at the Federal Minimum Wage) loses 30 per cent of their pay (the light blue line). Once they are in the workforce the impact of the tax‑transfer system on an additional dollar of earnings can be significant. For example, if they move from gross earnings of $900 a week to $901 a week, the tax‑transfer system takes 65.5 cents of this increase.

Some households face high ETRs on earning an additional dollar of private income. Research for AMP (AMP.NATSEM 2006) found that over the decade to 2006‑07 there had been a reduction in the number of working age Australians facing very high ETRs of over 80 per cent. However, it found there had been a pronounced increase in the overall number of people facing ETRs of greater than 50 per cent (from 4.8 to 7.1 per cent). Almost two‑thirds of these people were members of couples with dependent children. This was due to the extension of eligibility for family assistance to a greater proportion of people.

Calculating rewards for working can be complex. They can be influenced by the cost of getting to work, purchasing appropriate clothing and equipment and the costs of child care. While elements of the personal tax‑transfer system assist with the cost of child care, child care tends to be relatively 'lumpy' — it is generally purchased in blocks of days per week, rather than in amounts corresponding to additional hours worked. Similarly, people can lose various concessions as their earnings increase. These have different values to different people depending upon their circumstances and consumption patterns.

There are also questions about the importance of financial incentives that do not have an immediate effect on an individual's disposable income. For example, the net return from working is reduced by the withdrawal of LITO. However, half of this withdrawal is not calculated until the end of the year when the individual submits their tax return. As the full effect of the withdrawal is not seen in an individual's regular pay packets it may play less of a role in affecting their decision to do additional work.

A targeted social security system, which reduces payments as incomes increase, necessarily reduces financial incentives. Lower taper rates can be used to improve incentives by reducing the amount of a payment that is lost for a given increase in income. However, this means that access to some of the payment is provided to people on higher incomes as the taper range will be longer. This can then affect the new recipients' incentives, as additional work will reduce the payments they would receive under the lower tax rate. Attempts to increase participation at certain incomes can therefore adversely affect the incentives of other income earners.

Chart 7.12 shows how lower taper rates have affected payment cut‑outs over time. For example, in 1978 an unemployment benefit recipient would lose all their payment working only 18 hours a week at the minimum wage. In 2008 they can work 29 hours a week before losing their payment. The cut‑out point for pensions has increased even more dramatically.

Chart 7.12: Pension and allowance cut‑out points as a percentage
of the minimum wage(a)

Chart 7.12: Pension and allowance cut-out points as a percentageof the minimum wage(a)

  1. Excludes supplementary payments such as Rent Assistance.

Source: DEEWR estimates.

The position of ETRs along the income scale is also important. High ETRs lower down the income scale can act as a disincentive to move into paid work. High ETRs further up the income scale can make it less attractive to take on full‑time or better paid work or invest in education. Disincentives at certain income levels, such as around the Federal Minimum Wage, are of particular interest since they may impact on people whose decision to participate in the workforce is sensitive to the financial return.

While participation is important, some parts of the personal tax‑transfer system are designed to enable people to stay out of the paid workforce. The provision of Age, Carer and Disability Support pensions and Carer Payment reflects a community decision that certain people should not or cannot be expected to rely on paid work for income. There are also measures to support people taking time out of paid work for shorter periods, such as students or carers of young children. In recognition of the longer term value of these activities, the community bears some of the short term costs.