How much stick to give jobless

Just one of the major elements of the Henry tax review that Kevin Rudd brushed aside in his rush for a quick political fix was reform of the "transfer system". Huh?

In the jargon of economics, a transfer is a cash payment from the government to an individual, which isn't made in return for the receipt of goods and services.

So transfers include pensions, the dole and family benefits. You may think social security payments have nothing to do with taxation, but economists see the two as closely related. Taxes are cash going from us to the government; transfers are cash going from the government to us. For every dollar the federal government gets in, more than 25 goes out in transfers.

Indeed, the review's terms of reference required it to consider improvements to the "tax and transfer payments system" - note the implication: two components of a single system. Dr Ken Henry and his panel note that our transfer system is different from those in most developed countries. Its primary purpose is to provide a minimum adequate standard of living - meaning its goal is to alleviate poverty rather than help people maintain the incomes they enjoyed when they were working.

This emphasis just on avoiding poverty is the reason our system provides people with a flat rate of benefit (rather than a proportion of their former income) that's subject to a means test to ensure assistance goes only to the needy. This makes our transfer system the cheapest among the rich countries (which does much to explain why our level of taxation is lower than most of theirs). But it also means our system is the most "progressive" - it benefits the poor disproportionately to the rich.

A lot of people imagine progressivity comes from the choice of taxes you levy - lots of income tax and not much indirect tax. But you can also make the total system more progressive by biasing government spending in favour of low-income earners - which is just what we do.

Henry makes the further point that (contrary to the nonsense we keep hearing from the libertarian think tanks) means testing greatly reduces the degree of "churning" - taking money from people, then giving it back to them. Our system tends to take from the well-off and give it to the less well-off (which is what the well-off libertarians hate about it).

Now, it's clear from all the references to the "tax and transfer system" that one of the major goals of the review was to fully integrate the two systems - make them fit together better. That the two systems don't fit well can be seen from our frequent wrestling with the problem of high "effective marginal tax rates". Say a mother working full-time is considering moving to a tougher, higher-paying job. On each extra dollar she earns she would lose 31.5 in income tax. But she may also lose 30 in family benefit. If so, her marginal tax rate is, effectively, 61.5 in the dollar - well above the top tax rate of 46.5 and quite a disincentive.

It's clear the hope in getting the Henry review to look at the tax and transfer system was for it to find a comprehensive fix to the effective marginal tax problem.

But here's the scoop: it couldn't do it. After much effort it decided the two systems just couldn't be integrated. The problem is created by our love of means-testing, but is compounded because income tax is levied on the individual, whereas eligibility for transfer payments is based on the joint income of couples.

Its best suggestion was that the separate means tests for part A and part B of the family benefit be combined, with a single "withdrawal rate" of only 15 to 20 for each extra dollar of income earned.

The review turned to the range of transfer payments, saying their adequacy, structure and incentive effects could be improved. It says income-support payments should be divided into three categories reflecting society's expectations about the individual's ability to work.

Particularly with an ageing population, we want to encourage as many people to work as possible. The benefits of work are social as well as economic. It doesn't just provide you with an income, it makes you feel good to be part of the action. The first category is "pensions" - for the aged and the seriously disabled - where there's no expectation of work. Next is the "participation" category for those who are expected to work now or in the near future. This would include the unemployed and sole parents. The last category is "students", for young people undertaking full-time study.

The review notes that successive governments have allowed big gaps to emerge between the levels of benefits in the three categories with, for instance, the single-adult dole falling $108 a week below the single pension of $336 a week. "These differences produce very different outcomes for people with similar capacity to work," the review says. "They can create disincentives to work" or incentives to move on to payments (such as the disability support pension) that don't require you to look for a job.

It says these gaps should be reduced, and then each category's payment should be indexed on the same basis to prevent them widening again. But the gaps shouldn't be eliminated, with people in the participation category getting less than those on pensions, and students getting less again.

Why the differences? The dole should be lower than the pension to increase the incentive to find work and because it's assumed periods on the dole will be short. Students should get less because they can save by living at home or in groups and because they can work part-time.

Sorry, but this doesn't make sense to me. At present the single dole is only about 45 per cent of the minimum wage. People of working age face more costs than the elderly, not fewer. How much stick do the unemployed need to make them work? Hardly that much.

Maintaining a gap between the pension and the dole will continue to present a disincentive for sole parents to risk looking for work, lest all they find is a lower rate of benefit. But if you don't like what the review has proposed, don't worry.

It will be a long time before the government puts reforming the transfer system on its to-do list. It's happy to live with all the present deficiencies.