Do flat taxes make sense? Depends on your goal.

Stuff's Susan Edmunds got in touch asking whether flat taxes work. I was pretty long-winded, so only some of my comments could possibly be used. Here's what I'd sent through. Enjoy!

People’s views on flat taxes will depend on their views of the desirable overall size and scope of government. It is difficult to finance a large redistributive state on a 17.5% flat tax – the Crown gets a very large proportion of its revenue from income tax payments from high income earners. The flat tax is consistent with ACT’s desire for a more constrained and smaller government, and can be efficient within that setup. Lower effective marginal tax rates can increase labour supply, but we should be cautious not to overstate effects here. Most studies conclude that primary earners are not that responsive to tax rates, or at least not in the shorter term in deciding how many hours to work. The overall tax burden can be important for bigger on/off kinds of decisions though, like whether to migrate to New Zealand in the first place, or whether to shift abroad if you currently live here.

So a flat tax can be consistent with a shift toward a smaller overall government.

ACT proposes funding the reduction in the overall tax take by abolishing the Provincial Growth Fund, raising the age of NZ Super, removing fees-free study, cancelling winter energy payments, capping Working for Families, and ending government contributions to Kiwisaver.

Abolishing the Provincial Growth Fund seems sensible enough, but we should note that that fund will end at the end of the current government. A tax system change is long lasting. So future governments would be constrained against putting in big expensive regional spending programmes to buy the support of whichever party might make that a condition of coalition support.

Raising the age of Super entitlement, so long as it’s done with enough lead-time for people to prepare properly for retirement, is also a generally good idea – whether you want to use the savings then to give more money to younger poorer people, or to fund a reduced overall tax bill. It would be difficult to do this in the short term.

Removing fees-free study makes the overall package less regressive than it might otherwise seem as the benefits of the programme disproportionately accrue to higher-earning families. While many poorer families also benefit from fees-free study, the bulk of the benefit goes to higher earning families who would have gone to further study anyway. That’s one reason that we had opposed fees-free in the first place, and had suggested reinstating interest on student loans while using the savings to boost scholarships for low-income students and to improve preparation for tertiary study at high school.

Winter energy payments are incredibly badly targeted and an ineffective way of supporting those on lower incomes. But the combination of reducing this payment while also increasing income tax paid at the bottom might argue for an offsetting boost to benefits. Similarly, capping Working for Families to two children will be attractive to those on higher incomes who have had fewer children and who might wonder about very large family sizes among those on lower incomes, it would likely have negative effects on material deprivation among those poorer larger families.

Finally, abolishing Crown contributions to Kiwisaver also seems rather sensible. Series of papers produced by Grant Scobie and various co-authors showed that Kiwisaver has had no effect on overall savings rates. The policy then mostly rewards people for savings that they would have undertaken anyway.

Caveat on all of this: I have not double-checked the numbers and am taking them all as given on ACT’s website.

Aligning the flat tax rate with the company tax rate will mostly have effect on companies’ ability to attract foreign capital, and a bit of a reduction in taxes paid by nonresidents. Under the imputation regime, the company tax rate is a bit irrelevant if the company is solely held by Kiwis: the owners of the firm get an imputation tax credit along with any dividend payment, so if the company tax rate were higher than the top marginal tax rate, then IRD would just be writing that off against their income tax due anyway. Where it would have effect is on dividend distributions to foreign owners who aren’t eligible for imputation credits and who would consequently see a tax reduction – and also consequently be more willing to invest in New Zealand. Since New Zealand is generally shallow when it comes to capital and could use a lot more investment, on balance that part seems rather desirable.

I think some of the reporting around the proposed flat tax has been a bit lazy, but some of the problem is that we just don’t have data here that’s available in other places. For example, there’s been a lot of reporting that many earners would see an increase in total taxes paid under a 17.5% flat tax because the higher tax on earnings under $14,000 would outweigh the reduced taxes paid on earnings over $48,000. But many earners that are in that group will be secondary earners in households where a primary earner will enjoy a more substantial tax cut. So if we then consider a household where one person is on >$100k and the second person is on $40k, there would be an increase in the tax paid by the second person but it would be dominated by the tax cut enjoyed by the first person. And, the tax increase on the second person would be ‘inframarginal’ – in other words, the marginal tax rate doesn’t change for that person, but the tax collected on earlier earnings does. So it should not have any effect on the second person’s hours worked (conditional on that person still finding it worthwhile to be in work), but will have some likely minor effect on the higher-earning partner’s labour supply. And if we think about migration decisions as being about how the household as a whole fares, it could have effects on decisions by families with a higher skilled worker to move to New Zealand.

So, I suppose, a few bottom lines:
• If your ideal government includes a lot of redistribution, including programmes like fees-free study that are very poorly targeted if you think redistribution should mostly help poor people, then you shouldn’t be a fan of flat taxes. They simply cannot raise the amount of money necessary for a large redistributive state.

• If you think that government should on the whole be smaller, then financing it via a flat tax can work well. Don’t be overoptimistic about huge consequent growth effects coming out of increased labour supply from the highly skilled who are already here, as the literature suggests primary earners’ wages are not all that responsive to tax rates. But you could see a bump via greater labour supply from high skilled secondary earners, and through changes in migration.

You can’t really say whether a flat tax works without specifying what the goal is. It doesn’t work if you want to have a large and redistributive state as you cannot finance that kind of government on a flat tax. But it does work if you don’t want that kind of government. 

The quoted bits have me more firmly on the pro side. I'd be happy enough with a smaller overall size of government, but figure it's worth laying out the tradeoffs.