Income splitting and marginal tax rates [updated]

NZ Herald:

A new tax scheme with the potential to save couples with children as much as $9000 a year will be announced on Monday by Revenue Minister Peter Dunne.

Called income-splitting, it allows partners to combine their income and split it down the middle for tax purposes.

That can put each partners' income into a lower tax bracket.

It would also apply when there is one income earner in a family. When that income is split in two, savings could be significant.

Mr Dunne, the leader of the United Future Party, has wanted to bring in income-splitting for years and made it part of his support agreement with the Government after the 2008 election.

"We've promised income-splitting for a long time," he told NZPA tonight.

"It's for parents with dependent children up to age 18 and the definition of parents will be exactly the same as that used for Working for Families and other benefits - married couples, civil union couples, de facto couples."

Ok. From 1 October, marginal PAYE tax rates will be:

• $0-$14K: 10.5%
• $14K-$48K: 17.5%
• $48K-$70K: 30%
• $70K and up: 33%

Currently, everyone files as an individual. Moving to income splitting will reduce marginal tax rates on single income families, and by most for those earning between $48K-$96K as they would drop from the 30% or 33% marginal rate down to 17.5%. But it will substantially increase the marginal tax rate facing second earners, and especially those whose working partners earn $96K and up. The first dollar earned by the second earner in that case is taxed at the 30% rate; we might expect some labour supply response.

By way of example, consider a single income couple where the partner is considering returning to the work force. The first earner is on $100K and currently pays $23,920 PAYE. The second earner could earn $30K and would pay $4,270 PAYE, facing a marginal tax rate of 17.5%. If the second worker enters the workforce, the family is more than $25K better off. Now, switch to an income-splitting regime. The first earner now pays only $16,040 PAYE - the family is rather better off. But if the second earner enters the workforce, the family's total tax bill increases by $9,000, leaving them only $21K better off with the second earner's return to work. The gain to the second earner's entering the workforce is more than $4,000 lower under the income-splitting regime. This isn't because overall taxes are higher with income splitting - the family pays about $3K less in overall taxes. But the gains from income splitting, in this case, are inframarginal. Similarly, the losses from a second earner's exiting the workforce are lower than they otherwise would be.

It'll be interesting to see what happens to the labour force participation rates among second earners in higher income families should Dunne's policy be implemented.

Update: Nolan comments, noting usefully that the policy effectively increases taxes on non-preferred groups (folks without kids). If it's fiscally neutral, we either increase taxes elsewhere or we cut spending; if we cut spending, we could have used that cut to fund a broader-based cut to marginal tax rates rather than cuts that reduce average rates without doing much to marginal rates.