When Garnaut met Henry: the carbon price and welfare reform

Posted 24/03/2011 by Michael Klapdor

Professor Ross Garnaut’s recent update paper no. 6 to the Garnaut Climate Change Review, released on 17 March 2011, found that ‘protecting the most vulnerable is critical to the success of the carbon price’. Professor Garnaut found that while reforms to income taxation would, for most taxpayers, assist in mitigating the effects of a rise in the price of consumer goods resulting from the introduction of a carbon price, those on little or no income could face hardship unless reforms are also made to the social security system.

Garnaut sees the introduction of carbon price as an opportunity for reform, holding that significant benefits to productivity, participation and income could be secured by a ‘judicious use of the revenue from the carbon price’. He points to the Henry Review of Australia’s Future Tax System as a blueprint for possible changes to the tax and transfer system that will enhance economic and social outcomes, help households dealing with the negative effects of a carbon price and possibly assist in efforts to reduce Australia’s carbon emissions by encouraging households to switch away from emissions-intensive goods.

The recommendations for reform of social security by the Henry Review are not examined in any detail by the Garnaut paper. They seek an overhaul of the structure and operation of the system, including:

  • Basing the income support system around three categories of payment: a pension category for those who are not expected to support themselves through work (because of age or disability), a participation category for those who are expected to support themselves at work (paid at a lower rate to pensions but a basic level of adequacy), and a student assistance category for those in full-time study. The effect of this would be to simplify the current system consisting of a multitude of different payments to one where the particular needs of certain groups within these categories, such as carers or parents, could be met through supplements rather than separate payments.
  • Increasing the payment rates for income support recipients in the proposed participation and student assistance categories (current Newstart and Youth Allowance recipients). The Henry Review found significant inconsistencies in the relative payment rates for singles and couples within the different payment categories. It noted that, according to OECD measurements of poverty, those receiving the Newstart and Youth Allowances are in poverty and receive the equivalent of 31 per cent of net median income.
  • Indexing payments and income tests consistently to maintain the relativities between different payment types. The current differences in indexation between pensions and allowances (see below) have seen a large and widening gap emerge between payment types, significantly affecting the equity and efficiency of the social security system. According to projections by the Henry Review, if the current indexation arrangements were to remain in place, it is likely that by 2040 a single pensioner would be paid twice as much as an unemployed person.
  • Replacing the two-part income and assets test with a comprehensive means test that determines access to all income support payments and which takes account of the ability of a person to generate income from their assets. Currently, different income and assets tests apply to different payment categories with different assets being taken into account by the different tests. This results in people receiving different amounts of payment despite having the same means or level of wealth.
  • Replacing multiple family payments with one single payment designed to reflect the additional costs of raising children as they age. The payment should be means tested in accordance with family taxable income so as to minimise workforce disincentives (i.e. high effective marginal tax rates when parents return to work–see below).
The recommendations to increase fairness across the welfare system in terms of rates of payment would be costly to introduce but could be very effective in addressing disadvantage amongst particular sections of the community. The Henry Review envisaged that the expense of improving the equity of the transfer system would be offset by increased participation (and thus less people on welfare) as a result of inbuilt incentives for those of workforce age to take up employment. Closing the gap between the participation and pension category payment rates would reduce the incentive for individuals to find a way into the higher payment category rather than seeking work.

Garnaut does not take up the Henry Review’s recommendations for reform of the social security system. Rather, in suggesting how best to assist low-income households following the introduction of carbon price, he looks to measures used following the introduction of the Goods and Services Tax (GST): bringing forward indexation and introducing a pension supplement.

Indexation of payments (at least in line with the Consumer Price Index (CPI)) can insulate welfare recipients from price rises following the introduction of a carbon price. However, Garnaut admits that the current CPI measure and timing of indexations are not perfect. The CPI does not accurately reflect the different goods purchased by different income groups and the indexation of payments can occur months after households are affected by price increases. The paper suggests that indexation could be brought forward to correspond to the introduction of a carbon price, as happened when the GST was introduced, but care would need to be taken to ensure that price rises faced by low-income households are not overstated and that existing high marginal effective tax rates are not made worse. Effective marginal tax rates—the percentage of an income increase lost to tax and income tests on welfare payments—can act as disincentives to entering the workforce or to increasing workforce participation. Garnaut warns that increasing social security payments through indexation, if not done carefully, can contribute to this disincentive. Too high an increase would mean that less income is effectively gained by taking up employment.

The indexation of pension payments (such as Age Pension and Disability Support Pension) is calculated differently from other social security payments. Pensions are indexed twice a year according to the higher of two different indexes: the CPI and the Pensioner and Beneficiary Living Cost Index. Pensions are also benchmarked to 25 per cent of male average weekly earnings (the single base rate cannot fall below 25 per cent of male total average weekly earnings–MTAWE). The MTAWE benchmark was introduced in 1997 and has driven the increase in pensions since then. The Harmer Review of pensions found that wage growth has increased the real value of pension rates by around 20 per cent since 1997 while, in the same period, Newstart and Youth Allowance have remained unchanged in real terms. The introduction of a carbon price could see prices rise more than wages in which case pension increases would be driven by the greater of the two different indexes.

The Garnaut paper suggests that a supplement (indexed to prices) be introduced for pensions. This would provide greater assistance to this particularly vulnerable group of income support recipients following the introduction of a carbon price and would preserve their real income over time. A similar supplement was introduced following the introduction of the GST with the purpose of offering a real increase to pension payments beyond what indexation would offer. Providing pensioners and not other income support recipients with an income supplement would, however, exacerbate the widening gap between payments rates for pension and allowance recipients.

While Garnaut promotes the introduction of a carbon price as an opportunity for reform, and offers the Henry Review as a blueprint for such reform of the tax and transfer system, he chooses to focus on short term measures for assisting low-income earners during the transition period. However the virtues of the Henry reforms are also recognised by Garnaut as a means of effecting growth in wages and increased workforce participation; helping to offset any short-term negative effects on productivity growth and incomes following on from the introduction of a carbon price. It remains to be seen whether the Government will focus on short-term measures or whether it will undertake the kind of tax and transfer system reforms that the Henry Review proposed.

(Image sourced from http://www.taxreview.treasury.gov.au)

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