If You’d ask an economist about improving GDP and common welfare, he would probably discuss many different aspects of economic policy. One of them is keeping the tax rate on low level. Most of us expect tax-reduce to improve GDP growth rate. Unfortunately, income diversification continue to grow according to personal income tax-reduce. But there is one method of tax reduction, that helps the poor, increases GDP and reduces the income diverse. It’s non-taxed income tax threshold/personal allowance.
What is Income tax threshold?
Income tax threshold has different names in national tax systems. E.g. it is called personal allowance, basic allowance, tax-free amount or just income tax threshold. The rules of income subtraction are different too. How does it work? Basically, we can call income tax threshold an amount which not exceeded allows the taxer to pay no tax at all. If annual income amount is higher than income tax threshold, the only payed taxed part of the income is surplus above personal allowance.
Income tax threshold and linear income tax model
Income tax threshold reduces every personal income tax, but it is mostly perceptible for the lower and middle classes, because their percentage tax reduction is much higher than percentage tax reduction of a millionaire, although absolute number of millionaire reduction will be for sure equal or higher. Let me show You the relationship between the total income amount, income tax threshold and effective tax rate for 20% high linear income tax and three different personal allowance (5k, 10k, 20k):
Relationship between the total income amount, income tax threshold and effective tax rate for 20% high linear income tax and three different personal allowance (5k, 10k, 20k)
As we can see, the tax reduction affects every personal income tax-payer, but the strength of the affect is different for different income levels and income tax threshold. The lower is income, the higher is percentage tax reduction. Effective tax rate for 20k income is 15%, 10% or 20% high (depending on personal allowance), for 50k income 18%, 16%, 12% and for 100k income 19%, 18%, 16%. The highest income, the highest effective tax rate (going to 20% limes). Millionaire would save 0,1%, 0,2% and 0,4%. The tax reduction amount is equal for every of three examples and is 10k high.
Income tax threshold and progressive income tax model
Now we will analyze the progressive tax system example. In our case the basic tax rate is still 20% high, but income above 50k will be taxed with 40% high tax. The tax-change level depends on personal allowance too, it will be increased by amount equal to personal allowance, so that in every 20% taxed income amount will be equal: 50k.
Relationship between the total income amount, income tax threshold and effective tax rate for 20%, 40% high progressive income tax and three different personal allowance (5k, 10k, 20k)
Till the incomes rich new tax rate levels which I marked with red points (55k, 60k, 70k), the curves are equal to linear tax graph. The important changes come when incomes exceed those levels. As we see, the growth of effective tax rate speeds up when the resident pay 40% tax rate too. The limes of effective tax rate is 40% high. For 20k and 50k the percentage tax reduction is the same as in a linear tax model, so we will compare 50k, 75k and 100k income for every analyzed personal allowance. 50k income resident saves 2%, 4% and 8% for 5k, 10k and 20k high allowance, 75k income resident saves 2,7%, 5,7% and 10,7%, 100k income residents save 2%, 4%, 8%. Millionaire would save 0,2%, 0,4%, 0,8%.
Income tax threshold increases GDP and improves prosperity
Increasing tax-free amount is probably the only one tax-reduce, that is so profitable for the poor and the middle-class. Any other reduces decrease mainly the richest residents taxes. Targeting the benefits to the lower-class increases consumption, what has got at least two important consequences. First is growing welfare and prosperity of a average resident and decreasing income diversification. Second is much more stable GDP growth. As history and experience show, consumer spending is more stable in recession time. The richest residents can easy decrease their consumption and – first of all – investments (investments are the most unstable and depend on GDP growth part of total GDP). The poor cannot decrease their consumption as easily as the richest can, because it is much more difficult to give up basic consumer spending (food, clothes etc.) than to give up buying a new yacht or going on holiday to Bahamas.
Income tax threshold in the world
The personal allowance in United Kingdom is 9440 pounds, in Germany 8130 euro, in United States sum of standard deduction (6100 $ for single) and personal exemption (3950 $), in Luxembourg 11 265 euro, in Netherlands 2103 euro, in Spain 17 707 euro, in Poland 3091 zloty (equal to 736 euro), in Croatia 26 400 kuna (equal to 3450 euro).
