Option: Index personal income tax thresholds to price inflation, but not to real wage growth
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 people’s pay rising over time through the combined effect of price inflation and real wage growth. As that happens, they move into higher tax brackets and accordingly pay more tax.
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 implicitly assume that this periodic adjustment happens.
New Zealand could introduce legislation that would automatically adjust income tax thresholds to compensate for price inflation (although not for real wage growth). The effect would be that on average over time governments would collect more tax revenue relative to a situation where they periodically adjust tax thresholds to compensate for both price inflation and real wage growth.
Fiscal implications
Figure 2 shows that if we index personal income tax thresholds to price inflation (and make no other adjustments), we could spend more and still maintain net government debt at 20% of GDP on average over time.
- Figure 2 Three government spending paths - the impact of inflation indexing tax thresholds
Broader living standards implications
Indexing personal income tax thresholds to price inflation but not adjusting for real wage growth might be seen by some as an acceptable change, as people would become liable to pay more tax only as they become richer.
There are equity considerations though, as this approach would make our system less progressive (relative to a system that adjusts for the effects of both price inflation and real wage growth). Also this approach would probably have negative economic growth impacts.
- Figure 3 The Treasury's Living Standards Pentagon
