Thursday 7 August 2014

What is hourly averaging?

Hourly averaging is the primary idea presented in Rethinking Taxation, so it is probably a good idea to set out briefly what this means. Hourly averaging is a new way to work out what tax-rate people should pay. The best available basis on which to determine someone's tax rate is their lifetime average hourly income.

It therefore rivals proposals that calculate the tax rate based on the value of a particular transaction (such as most duties and consumption/sales/ excise taxes). The main rival, however, is the idea that the total amount that someone receives in a year is the appropriate determinant of someone’s tax rate (as with income tax). 

A year or longer?

Hourly averaging alters this annual taxation in two opposite directions. On the one hand the horizon of the tax is increased from a single year to the lifetime of the individual. So instead of treating each year’s income separately in calculating tax, all the taxpayers’ income is included. This is not a novel proposal: the idea of multiple year tax averaging and its logical extension of lifetime averaging are longstanding proposals.

There are several advantages to having a longer period. One is that it avoids an arbitrary point in the year around which people might organise their affairs for the sole aim of minimising their tax bill. Even more importantly, it gives a better idea of how economically fortunate the taxpayer is. Some people spent many years developing skills and then earn a lot for them later. Others might have very fluctuating income. A highly progressive tax system would tax these people a lot during their good years but not take account of the less good ones. 

Averaging by time or by hours worked?

The innovation comes in the other part of hourly averaging. Instead of dividing the income by the number of years that have passed, I propose to use hour credits as the denominator. People would receive hour credits for a number of reasons, but the archetypal source of an hour credit is that someone has performed an hour of work for their employer. The employer would inform the tax authority of the work done, and this would be included in their tax calculations from then on.

What are the benefits?

Calculating tax on a lifetime basis using hour credits allows for highly progressive tax rates. High rates can be applied to those with a high hourly average income. Furthermore, negative hourly tax rates can provide a powerful earning subsidy to those who have a low hourly average income. This means that a lot of revenue can be generated from the most economically fortunate (those who make use of their talents or position to earn economic rents) and shared to those who work hard but for low pay. No other proposal promises to do this.

Using hours in the calculation provides a strong incentive for people to work more that progressive taxes can otherwise remove. Everyone would want more hour credits. After all, this would reduce their tax-rate for any given amount of income. Hour credits would effectively represent additional income to their recipients; each person would know that they receive x amount of money whenever they get an additional hour credit. This means that people will have a strong incentive to work longer, counteracting the common complaint that taxing the fortunate and assisting the less fortunate discourages people from working.

Hourly averaging is a proposal that utilises the advantages of the market economy such as the incentives to produce and consume in the most efficient way. However, it counteracts the inequities that market economies perpetuate; that some do very well while others struggle.

You can find out more about hourly averaging from my book 'Rethinking Taxation' or by looking through more of my blogs. If you have any thoughts please leave a comment below or send me a direct message.


Tommy Hobbes said...

A couple of thoughts on this :
1) high earning put in a lot of hours too, in fact many high earning positions require longer hours. Therefore wouldn’t this result in less revenue being raised?
2) if people moved between tax jurisdictions this would be practically difficult to impose as would require harmonious tax laws. Also of rent earning assets were spread around different countries.

dougbamford said...

Thanks for the comment.

I think you are right on point two. The system requires a lot of international co-operation. I talk about this in the final chapter of my book, and I've discussed international taxation in a few papers I've written.

I'm not sure I understand your first point because I expect you are right that most people who earn large amounts do work very long hours. There will be some, of course, who earn a lot per hour but don't work full time, but they will be the minority. The current tax system will encourage part-time working.

Tommy Hobbes said...

For point (1), if I have understood your proposal correctly Doug, income tax collected by the IR will go down as working hours increase (income tax paid will obviously also go down). According to the current tax system, rates increase as income passes through certain thresholds. If we now introduce hours as the denominator, then the amount of tax paid will decrease.

This means a high earner (or anyone) who works long hours will pay less tax.

If they work shorter hours (for the same sum of $) she will pay more tax. Therefore there will be no incentive to work shorter hours.

So whilst this would indeed benefit anyone working long hours, it would not discriminate between high and low earners and could end up raising less revenue for the country.

So I guess this would discourage part-time work. May be I am missing an obvious point here.

Tommy Hobbes said...
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dougbamford said...

Thanks for the comment "Tommy"!

I think you are right but I'm not 100% sure I've understood you. There is certainly a strong tax incentive to work longer hours (at least up to any maximum claimable amount in the period). There is already the advantage of working longer hours if these increase gross wages, so this adds to that. The advantage of working fewer hours remains - having more free time.

Are you assuming that someone's income is going to be fixed but they can choose how many hours to take to earn it? One of the worries is that people might reduce their productivity (make less effort) because they would rather have lower taxes than more free time. This is a worry but on the other hand employers want to get their workers to be as effective and productive as possible for a given amount of expenditure.

Tommy Hobbes said...
This comment has been removed by the author.
Tommy Hobbes said...

Perhaps we are in agreement ... the current tax system will encourage part time working (or at least not encourage longer hours).

In terms of fixed income, this depends on the job.

Many "professional" jobs pay a fixed base amount regardless of hours and a year end performance bonus, there may be a relationship between number of hours worked and size of that bonus, but usually there is no direct correlation. So in this case given a fixed base, the amount of tax paid based on hourly averaging, would be less. (Unrelated - how would you prevent fraud in recording hours worked? Perhaps building access records? Login times? What about external meetings (eg four hour round of golf with business associates)? )

In the case of variable hourly pay - I would be concerned that people will work more given the incentive of less tax.

dougbamford said...

Thanks "Tommmy" - I agree those are major concerns.

My response to them is to apply a maximum amount of claimable hours. This would reduce the scope for fraud and mean that the tax incentive to work longer hours will cease beyond a certain point.

There is a downside to this maximum, which is that the benefits of applying the hourly calculation cease above that point. Some people who work very long hours may no longer do so and society might miss out, particularly if they are among the more productive people. On the other hand, I think people's productivity will decline if they work too many hours per week, and perhaps it would be better if these high responsibility jobs were shared out between more people.

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