G. Option: Government taxes more

In our "Resume Historic Cost Growth" scenario, we hold tax revenue constant at 29% of GDP, but this is not a prediction of the future size of the tax take. In fact, it is unlikely that all future governments will see 29% of GDP as the optimal amount they should collect in tax. Some governments will collect more than that, others less.

One reason for collecting more tax might be to fund spending increases in some areas. Options for raising more tax revenue include:

• introducing a new kind of tax
• increasing the existing tax rates
• extending the kinds of income that are subject to income tax, and
• making no adjustments to compensate for people moving into higher tax brackets as their wages rise through price inflation and real wage growth (sometimes called "fiscal drag" or "bracket creep").

This section gives more detail on two specific options: (1) only partially compensating for fiscal drag by indexing personal income tax thresholds to price inflation but not to real wage growth, and (2) increasing the GST rate to 17.5%.

Annex 1 discusses a broader range of options for raising more tax revenue.[66]

Could we boost tax revenue by indexing personal income tax thresholds to inflation only?

The projections in our "Resume Historic Cost Growth" scenario hold tax revenue constant at 29% of GDP. But holding tax revenue constant requires some assumptions about how governments will respond to the fact that people's pay rises over time, through the combined effect of price inflation and real wage increases through economic growth. As that happens, they move into higher tax brackets. We currently pay income tax of:

• 10.5% on income up to $14,000
• 17.5% on $14,001 to $48,000
• 30% on $48,001 to $70,000
• 33% above $70,000

As people move into higher personal tax brackets, governments collect more money. Since in New Zealand there is no automatic adjustment for this, governments must adjust tax thresholds periodically if they wish to compensate for this effect. Our projections that hold tax revenue constant at 29% of GDP assume that this periodic adjustment happens. Otherwise, we would expect to see tax revenue rising as a share of GDP.

Some other countries[67] do automatically adjust income tax thresholds to allow for price inflation (although usually not for real wage growth). So when people's wages rise owing to price inflation, they are not pushed into higher tax brackets. However, they are pushed into higher brackets if economic growth increases their wages in real terms.

New Zealand could introduce such legislation - and at the same time no longer make periodic adjustments. Legislation like this would mean that people would not find themselves paying more tax when all that has happened is that inflation has pushed their wages up. But it would also mean that governments would collect more tax revenue relative to a situation where they periodically adjust tax thresholds to compensate for both inflation and real wage growth. It would mean that over time, the government would collect more tax revenue as a share of GDP.

Figure 11 shows the difference such an adjustment would make to the government's fiscal position out to 2060. It shows three lines:

• Our standard orange "Spending path under 'Resume Historic Cost Growth' scenario" line, which tracks the average spending path we would see if expense areas grow at the rates we have seen historically, also taking into account current legislative settings and demographic changes.
• Our standard blue "Spending path that maintains 20% net debt with tax revenue at 29% of GDP" line, which tracks the average spending path that would allow us to maintain net government debt at an average of 20% of GDP from 2020, assuming our tax take remains constant at 29% of GDP (including the implicit assumption that governments will adjust tax thresholds to compensate for price inflation and real wage growth).
• The dashed blue "Spending path that maintains 20% net debt with inflation indexed thresholds" line, which shows how the spending path necessary to maintain net government debt at 20% of GDP changes if we index personal income tax thresholds to inflation.

Increasing the tax by indexing personal income tax thresholds to price inflation means that our spending can be higher and still allow us to have net government debt at 20% of GDP on average. The extra tax is represented by the difference between the solid blue and dashed blue lines.

As Figure 11 shows, the fiscal benefits of such indexing increase over time. As our gap grows, this approach continues to close about half of it.

Figure 11 Three government spending paths - the impact of inflation indexing tax thresholds

How would indexing personal income tax thresholds affect our living standards?

The change would mean that most people would eventually move into higher tax brackets. Currently around 10% of taxpayers pay the top tax rate of 33% on some of their income. Indexing personal income tax thresholds to price inflation (but not to real wage growth) could raise that to around 39% of people by 2060.[68] Eventually every full-time worker would be paying 33% tax on some of their income, although this would not happen until well after 2060.

Whether this impact is equitable depends on your point of view. On an individual basis, it seems reasonable: individuals will pay a higher share of their income in tax over time, but only if they actually earn more. The idea that people might move into higher income tax brackets as their incomes rise is one that people might be able to accept. However, on a population-wide basis, the impact of almost everyone moving into higher tax brackets is to make the tax system less progressive relative to a system where governments adjust thresholds to compensate for both price inflation and real wage growth (although the system would still be progressive overall).

We also need to consider the impacts that indexing personal income tax thresholds to inflation could have on economic growth. Essentially, this would be a personal tax increase so we might expect to see some dampening effect on economic growth via disincentives to work. This approach would raise the marginal tax rates faced by lower and middle income earners (although not top income earners whose income is already partially taxed at 33%), reducing incentives to work more or find better paying jobs. These disincentive impacts might be felt most acutely at the point where the tax and benefit systems interact. This approach would also raise the average tax rates that everyone pays, which could have implications for people's choices on whether to live and work in New Zealand.

However, this approach is likely to harm investment incentives less than an increase in all personal tax rates, as most saving and investment is made by higher income individuals who are already paying the highest tax rate of 33%.