How inflation gives you a hidden tax hike – and Govt pockets the proceeds

Dr Eric Crampton
10 May, 2022

Those on the economic right sometimes wish for flat taxes. If inflation continues to run at 7 percent and the country’s tax thresholds do not change, we will eventually wind up with one. Inflation will inexorably push everyone into higher and higher tax brackets, until most people are paying the top rate.

Perhaps someone made the mistake of making their wish for a flat-tax using one of those cursed monkey-paws that always grants your wish in a horrible way. I will have to ask some of the usual suspects to find out who among them is to blame.

But more seriously – it really shouldn’t be like this. The political benefits for National and Labour are obvious, but the political economy is a disaster. Labour gets substantial increases in tax revenue without having to legislate a tax increase, and National gets to pretend that it is providing ‘hard-working Kiwis’ with a tax cut when they are mainly providing an inflation-adjustment.

When inflation is running around 7%, an offer of a 5% pay increase is a real pay cut, and a 7% increase only treads water.

But some who would see through an employer’s offer of a 5% wage hike when inflation is 7% often seem to miss the problems in tax thresholds that remain sticky when inflation runs high.

I don’t think many workers would be impressed if their employer said nobody was getting an inflation-adjustment to salaries this year because it would give more nominal dollars to workers at the top. Nevertheless, Grant Robertson seems to be able to use that as an argument against adjusting the tax thresholds.

It is pretty easy to illustrate the effects over time.

Inland Revenue publishes data on the number of people falling into different wage and salary earnings bands going back to the early 2000s. Their data only includes wage and salary earnings, so superannuation, benefits, and student allowances are not included. Neither are investment earnings.

The data lets you see where any level of wage and salary earnings sits within the distribution of wage and salary earnings. The simplest way of making these comparisons over time is by checking percentile. If you earn more than 20% of other wage and salary earners, and less than 80%, you are at the 20th percentile. Someone who earns more than 90% of other wage and salary earners, but below the remaining 10%, is at the 90th percentile.

I moved to New Zealand in November of 2003.

At the time, the top 39% tax bracket kicked in at $60,000 and the middle 33% tax rate applied from $38,000 to $60,000.

The IRD data shows that roughly speaking, the top 10% of wage and salary earners faced the 39% tax rate on their last dollar earned; the bottom 70% faced the 19.5% rate, and those between the bottom 70% and the top 10% paid the 33% tax rate.

The same tax rates applied through the 2007/08 tax year, but inflation in the mid-2000s ran high. By 2007/08, workers at the 64th percentile were hitting the 33% tax rate, and the 39% rate kicked in around the 85th percentile.

Whether you think that the top tax rate should hit the top 2%, the top 10% or the top 15% is something of an aesthetic question. The 39% rate does not raise a lot of money for the government.

But whatever moral argument there is for greater or lesser progressivity in the tax system, where the thresholds wind up hitting does not seem the kind of thing that should be determined by what inflation has been like.

It seems hard to argue that it was either morally or economically right that someone at the 66th percentile in earnings, the spot where one-third of workers earn more and two-thirds earn less, should drift from the lowest tax rate in 2003/4 into the 33% tax rate in 2007/08 simply because of inflation.  

National reset the tax thresholds through a series of adjustments from 2008/09 through 2010/11, packaged as a tax cut as well as a shift from income to consumption taxes – the increase in GST. The new rates applied fully from 2011/12.

After the changes, the bottom 28% of wages and salary earners, earning up to $14,000, faced a 10.5% tax rate.

On earnings from $14,000 to $48,000, the 17.5% rate applied. This rate covered everyone from the 28th percentile of wage and salary earners up to the 68th percentile.

From the 68th percentile to the 85th percentile, or $48,000 to $70,000, the 30% rate applied. And earnings in the top 15%, over $70,000, drew the new top rate of 33%.

But then a decade of inflation worked its magic.

By 2020/21, you only needed to earn more than 19% of all of wage and salary earnings to hit the 17.5% tax rate, rather than needing to hit the 28th percentile. The 30% tax started hitting from the 50th percentile – the median – of wage and salary earnings rather than from the 68th percentile. Triggering the 33% tax required earning more than 73% of other workers, rather than 85%.

And those in the top 2%, from $180,000, face the renewed 39% rate – a policy decision rather than bracket creep.

Simply restoring the tax brackets to the wage and earnings percentiles that they represented in 2017/18, when Labour took office, would make for a large adjustment.

It is one thing for Parliament to decide that workers at different parts of the income distribution should face different tax rates. That is Parliament’s job.

But should inflation continue to be able to ratchet people into higher tax brackets while providing the opposition the opportunity to sell inflation adjustments as tax cuts? A suspicious person might even worry that, if the government can earn a lot of money by letting the Reserve Bank ignore inflation, it might not be too vigilant about whether the Bank is fulfilling the terms of its Remit.

A better approach could automatically index the tax thresholds. Whenever bracket creep would warrant at least a $1,000 change to a tax bracket, the tax brackets could change automatically, every 1 April, announced in advance to provide the accountants with plenty of time.

When wage and salary earnings right at the median of the wage and salary earnings distribution is enough to put a worker onto the 30% tax rate, something is going to have to give – before inflation gives us a very high flat tax.

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