Many researchers and commentators have called for childcare costs to be made tax-deductible, as an alternative to the current means-tested subsidy. Such a policy may be superficially attractive because for many people, childcare is a cost borne because they are working. But making childcare tax-deductible would be a backward step. Most families, and especially low-income families, would be worse off than under the subsidy. And work disincentives would be even worse than they are now.
Most families would be worse off
A tax deduction will inevitably give more to high earners than to low and middle earners – the very opposite of the means-tested subsidy. So it’s no surprise that a switch from the subsidy to tax-deductibility would leave all but a handful of high-earning families worse off.
Take a family with two parents working full-time, each earning $40,000 a year, and two children in childcare. Their total childcare cost is currently about $57,000 a year, and they can claim about $46,000 a year in childcare subsidy. Under the tax-deductible option, this would be replaced with a tax deduction of only $4,500, leaving the family $42,000 worse off.
Even a family with much higher income would be worse off under tax-deductibility. A family with two parents working full-time, each earning $90,000 a year, and two children in childcare, can currently claim about $29,000 a year in childcare subsidy. Under the tax-deductible option, this would be replaced with a tax deduction of $19,000, leaving the family $10,000 worse off.
Barriers to work would be higher for low and middle earners
A move to tax-deductibility would also be bad news in terms of work incentives. Grattan Institute research has shown that second earners (most often women) with young children face very large disincentives to increasing their work hours, especially if they are considering taking on a fourth or fifth day. A move to tax deductibility would exacerbate some of the worst disincentives.
The chart below shows the ‘workforce disincentive rate’ – the proportion of income from an extra day’s work lost through higher taxes, reduced family payments, and child-care costs – for second earners. Under tax-deductibility, the workforce disincentive rate would be more than 100 per cent for women earning $60,000 or less. That is, they would be paying for the privilege of working. Surely few would bother.
Cashflow would be a serious problem
The timing of receiving a tax deduction would also create huge cashflow problems for families. Under the Child Care Subsidy, an estimated subsidy is paid upfront to providers, and parents need only pay the ‘gap’. Under the tax-deductibility policy, parents would presumably need to pay the full amount upfront, and receive their deduction and rebate at tax time. Given the full cost of childcare is so large (about $29,000 per year per child for full-time care), this would create a cashflow squeeze for all but the most well-off families. Many households simply could not bear this cost upfront and would drop out of childcare and work.
An opt-in system would be too complex
Some proponents of tax-deductible childcare suggest a hybrid system where parents can choose to ‘opt in’ to tax-deductibility or continue to use the subsidy as per the current system. But an ‘opt-in’ system would be very confusing for parents, who would need to understand two different payment systems, and have a very good idea of their expected earnings for the coming year, to properly choose between a deduction and a subsidy. And this additional complexity would do very little to improve childcare affordability, since only a small number of high-earning families would be better off opting in to the deduction.
An increased subsidy would make childcare more affordable and reduce work disincentives
Reforming the Child Care Subsidy should be should be central to the Federal Government’s plans for lifting Australia out of the COVID-19 recession. An increased subsidy of 95 per cent for low-income households, gradually tapering for families with incomes above $68,000, would reduce disincentives to work, supporting higher workforce participation and boosting GDP by about $11 billion a year.
By contrast, switching to tax-deductibility would increase pressure on low and middle-income families and force parents, mainly mothers, out of the workforce by making childcare less affordable, further reducing the financial return from work. Not the result I think any of its proponents would be hoping for.