Taxation of Family Income
By Lucy Sullivan

The Lost Concept of Horizontal Equity

We have come some way from the traditional righteous resistance of the English people to taxation, which variously resulted in the deposition and beheading of a king (Charles I) and a revolution of independence by a colony (the USA). Taxation has always needed justification. While we now clearly see its need, we are obviously still concerned with its justice. Central to this concern is the question of who should pay tax and in what proportions.

An early principle was that tax should be paid by those who benefit from government. Hobbes, for example, argued in the seventeenth century that tax should be paid by property owners because government was chiefly concerned with law and war, of which they were the prime beneficiaries. For several centuries tax was levied on the basis of property and luxury goods, in the form of land tax and customs duties, thus targeting this section of the community.

But in the course of the last century, government has taken on large community service responsibilities from which everybody benefits, and often the poor more so than the wealthy, and correspondingly a new principle came to the fore – the principle that taxation should reflect ability to pay. This of course still means that the rich should pay most, and so this principle did not at first result in changes to the tax system – rather, it provided a new justification for the old system of taxation of property and luxury goods.

Income tax existed in only a minor way, in both Britain and Australia, until the middle of this century, and only the very wealthy were subject to it – for example, income taxes introduced by the Commonwealth and States in the 1920s had thresholds for payment at four to six times the adult male basic wage – $120,000 to $180,000 per annum in today's terms. During the Second World War, income tax was taken over entirely by the Commonwealth and was brought down to comparatively low income levels for the first time – being payable at less than double the basic wage in 1943, and at below minimum adult male full-time earnings by 1950.

The old taxes were proportional, with tax levied at the same rate regardless of individual wealth, but income tax in Australia from the first was highly 'progressive,' using the graduated scale we are still familiar with (now in a modest form). Proportional tax takes more from the wealthy simply because there is more income to be taxed – a 10% tax takes $1,000 from an income of $10,000, but $5,000 from an income of $50,000. But with progressive tax, increasingly higher proportions of income are taken in tax as income rises. Income tax in 1950 was highly progressive, with over a dozen marginal rates, and the top rate of over 60% coming in at about 15 times average weekly earnings.

By the 1940s, it had become clear that industry could not sustain minimum wages sufficient to support an average sized family, and taxation of low incomes would make them even more inadequate for a family, although still comfortable for a single earner. To provide for family income needs, a 'Child Endowment' payment to families was introduced in conjunction with the new system of income tax. In the 1950s, as tax bit further into incomes at all levels, a universal system of deductions for family expenses was introduced. Deductions from taxable income were allowed for a dependent wife (or housekeeper) and each child, and for educational and medical expenses, for home and water rates, and various other expenses. The principle of ability to pay lay behind this system, as it did behind that of rising marginal rates. There is clearly less ability to pay tax from a given income which supports several people than from the same income enjoyed by only one.

These two instruments of the principle of ability to pay – rising marginal rates and deductions (or rebates) for dependants – represent 'vertical equity' and 'horizontal equity,' respectively. The former addresses the factor of differences in gross income, and the latter that of differences in income per head in the economic unit of the family. Both are clearly of moment in any consideration of equity.

In the 1980s, the principle directing taxation policy changed from ability to pay to 'social justice.' Taxation became part of a more general 'incomes policy,' which sought to integrate welfare with taxation policy. Under the Hawke 'Accord', wages were to be stabilised, and low incomes raised where needed, using welfare payments rather than tax relief. Together with this development, both components of the 'ability to pay' principle in taxation – vertical and horizontal equity – were eviscerated. Marginal rates, in the 1980s and 1990s, were reduced to only 2 to 4 levels, and, with the help of galloping inflation, high rates became applicable at increasingly moderate levels of income. In 1997, the top rate came in at only 1á4 times average weekly earnings (AWE), compared with 15 times in 1950. Thus a largely proportional, in place of a progressive, tax system was created, and vertical equity was diminished.

The array of family deductions of the previous three decades was completely withdrawn in the early 1980s. The vestigial Child Endowment and per child deductions had been replaced in 1976 by a Family Allowance, a flat rate per child payment, which was realistic at first but rapidly lost value with inflation. Initially it was universal, but in the course of the 1980s an upper income threshold at about twice AWE was introduced. Thus horizontal equity, too, was largely eliminated. The combination of large tax calls on average incomes as a result of the new proportional taxation, and loss of recompense for the cost of dependants, immediately plunged many families into real poverty. This created a large field for welfare payments to restore livable incomes to families which were formerly self-supporting.

The 1980s, through to the present, saw a constant accumulation and reshuffling of welfare payments for families, now in need as not before – family allowance, family income supplement, tertiary education assistance scheme, family allowance supplement, Austudy, rental assistance, basic family payment, additional family payment, and so on. These payments to a large degree merely return to lower income families money which was initially taken from them as a result of a tax system which no longer recognises the need for horizontal equity for families. And most families were (and are) not eligible for these payments in full measure, or at all. Payments are tapered to upper income thresholds so as to bring the lowest and all intermediate income families up to the income level of the lowest equivalent family income which receives no assistance. This can be seen as achieving 'income equity,' or rather, income equality, for a substantial proportion of Australian families.

Earlier approaches to family income had supported the ideal that a family should be able to live on the single earnings of the father, allowing the mother to care for the children and the home. Thus the 'basic wage' determination of 1907 was for an adult male wage sufficient to support a couple and three children in frugal comfort. The horizontal equity of the deductions system, which costed in each family member and their major expenses, continued this ideal. Feminist activists, on the other hand, from the 1970s. demanded that women with children remain in the workforce, and that government support for the family should only be in the form of provision of childcare for working mothers. Nevertheless, the large majority of Australians still believe that pre-school children should have the full-time care of their mothers, and part-time work only is preferred for and by mothers of older children.

The loss of horizontal equity in the tax system, and the selective targeting of welfare at unemployed and low-income families, meant that to rise much above the welfare level of income, mothers were forced to join the workforce, and if the father's income was merely average, even substantial part-time work would not raise the family income above the $45,000 needed if the family was to actually gain much financially from its extra efforts.

As demonstrated in the following graphs, the change from a tax system based on the principle of ability to pay (using both vertical equity and horizontal equity), to one based on notions of social justice, has in practice meant considerably greater income inequality in general combined with absolute income equality at poverty levels for average families.

The graphs present data for a single-income family with three teenage children and for a single earner (which includes both members of a two-income couple without dependent children), at a variety of income levels, standardised as a percentage of average weekly earnings (AWE) for a particular year. The graphs show income up to 200% AWE, which takes in 95% of earners. The lowest income represented in the early years is 75% AWE, about the level of the basic wage. In later years, 50% AWE is shown, although for most mature male earners this would today also represent only part-time work. The nature of the system is such that similar patterns would appear if families of different compositions were employed.

The first set of graphs (Figure 1) shows tax paid in 1950 and 1960, when progressive vertical equity (VE) and horizontal equity (HE) were accomplished in taxation, and in 1990 and 1997, when welfare had become the major tool of incomes policy. A comparison of the two pairs of graphs shows the eradication of both VE (in the sense of progressivity) and HE from the tax system between the 1950s and the 1990s.

For both family and single earners, in 1950 and 1960, the gradient in tax paid accelerates as income rises, demonstrating the progressive impact of rising marginal rates spread across the income range. In 1990 and 1997, by contrast, the gradient approximates to a straight line across the income range, with little acceleration for higher incomes. This is the result of a low tax threshold and few marginal rates all impinging low in the income range (the top rate of 47 cents came in at $50,000 per annum in 1997). Vertical equity is today diminished, and the loss is far greater at higher income levels than those shown.

The effectiveness of tax deductions in achieving HE also shows clearly in the early years. As families ascended the income scale, the gap between their taxation and that of single earners persisted. This is important in socioeconomic terms, as horizontal equity is conceived as a means of allowing a family to maintain the social and income status which is a normal corollary of its income-earner's level and quality of employment.

In 1950, families on 75% AWE and on AWE paid no tax, and in 1960 exemption was extended until income approached 150% AWE. In 1950, single earners at 200% AWE paid nearly three times (300%) the tax of equivalent family earners. In 1990 and 1997, by contrast, families paid substantial tax even at the lowest levels of full-time earnings, and the difference in tax paid by the family of five and the single earner is minuscule across the range of earnings. In 1997, at 200% AWE single earners paid only 2.5% more tax than equivalent family earners.

Thus taxation today disregards differences in ability to pay determined by the number of persons an income supports. It has been estimated that each additional adult in a household costs 0.6, and each child 0.3, of the household expenditure for the first adult. This means that our family with three teenagers requires 280% of the income of a single earner to live in equivalent comfort. When AWE was $33,000 (1995), the Institute of Family Studies calculated that a family with three children required an income of $73,000 to enjoy the same standard of living as a single person on AWE.

As welfare forms an important part of incomes policy in the 1990s, it is also necessary to compare final incomes today with those early in the half-century, that is, income when welfare has been added, as well as tax deducted. Figure 2 shows that in 1950 and 1960, the operation of vertical equity was similar for both family and single post-tax-and-welfare (PTW) incomes. As earnings rose, final income was increasingly depressed as a percentage of initial earnings, but both family and single PTW incomes nevertheless rose steadily across the income range.

In 1990 and 1997, single earner PTW incomes still rise with rising initial income, but there is a dramatic change where family incomes are concerned. There is virtually no increase in PTW family income between initial earnings of 50% and of 120% AWE. (This effect is more commonly expressed as representing 'high effective marginal tax rates' – in this case as high as 100% – over a given range of incomes. Withdrawal of welfare payments, in actual fact, is responsible for the effect.) In 1997, the family on 120% AWE retained only 13% more income than the family on 75% AWE, whereas the single earner on 120% AWE retained 58% more income than the single earner on 75% AWE. Only after family earnings pass 120% AWE does PTW income begin to rise in a manner comparable with that of single earners. The large gap between family and single incomes at 50% and 75% AWE (the result of welfare payments rather than taxation provisions) suggests the operation of horizontal equity, but in fact the principle of equity applies only in a limited range, for the gap diminishes as income rises, and is largely absent across most of the range of incomes.

It is difficult to conceptualise clearly what the principle of social justice really implies, in terms of its current tax/welfare application. If it is universal income equality across the board, then this goal has been pursued and achieved only selectively, targeting a subset of the population – namely, lower to middle income families. Neither single earners, of all income levels, nor families on higher incomes are drawn into the net of income equality which has been cast around lower and middle income families – in all other cases final income is free to rise with rise in earnings. But if uniformity of income is the goal of social justice, surely, in justice, all incomes should be reduced to the same level on a per capita basis, not just those of average income families. However, to date no moves have been made, or even proposed, for achieving this goal where incomes lie outside the welfare net. Indeed, as we have seen, changes have been in the opposite direction, towards greater inequality of incomes and diminished vertical equity.

The ability-to-pay principle has been doubly abandoned where average income families are concerned. The inability of middle-income families to pay tax at the same rate as middle income single earners, and at the same rate as both family and single higher income earners, has been ignored on both counts of HE and VE, resulting in a taxation-induced income crisis for the average family. In effect, the majority of families are kept close to the poverty line assigned as the minimum income requirement under welfare provisions.

Attempts to break out of this strangle-hold on family incomes, by both parents working or even taking multiple jobs, can bear little fruit until joint incomes pass $50,000 per annum, and this resort in itself constitutes a penalty on the family, as the work of raising children is substantial in itself. Often the result is that children are ill-cared for, and rising youth crime, drug abuse and suicide are partly attributable to this cause. Revenue which could have been left in the hands of parents is devoted to childcare subsidy and funding, a far more expensive method of caring for children, and unlike the other major family payments, this is not subject to an income threshold, so that tax from lower income families subsidises high double-income families.

Neither the recent Liberal nor Labor proposals for tax reform do other than fiddle with the current state of affairs as regards the family. It needs to be determined whether social justice in the field of taxation and welfare means a uniform income per head of population, such that everyone, working or unemployed, adult or child, receives, say, $12,000 per annum, or whether it means merely taxation which is in some way proportional to ability to pay. If the latter, this requires the re-introduction of horizontal equity into the tax system. Income justice for the family could be achieved by introducing a universal tax rebate per child, graduated for age, equivalent to the per child payment for a family on welfare – in the region of $3,500-5,000 per annum – and withdrawing all other family welfare.

Suggested Reading

Smith, J.P. 1993, Taxing Popularity: The Story of Taxation in Australia, Canberra: Federalism Research Centre, Australian National University.

Lucy Sullivan is a Research Fellow at the Centre for Independent Studies.  A more detailed version of this article was published under the title Tax Injustice: Keeping the Family Cap-in-Hand as CIS Issue Analysis No. 3 in July 1998.  Copies of Issue Analysis are available by contacting the CIS or by visiting the website at http://www.cis.org.au

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