The government recently increased the pension by up to $65 per fortnight, but the pressure for ever higher welfare benefits continues. The Greens asked for $200 per fortnight, while the Australia Institute is seeking a $100 per fortnight increase in the dole.

The unfortunate reality is that, even without these increases, the current welfare system is unsustainable.

The welfare budget in Australia – including health, education and other welfare – is more than $250 billion per year. As the Intergenerational Report explains, our ageing population and ever-growing demand for health services means the Australian welfare system will require fundamental welfare reform by the middle of this century.

While real reform is always politically difficult, there is a reform possibility that could lead to $80 billion worth of tax cuts, matched with $80 billion worth of spending cuts, and would not make anybody worse off. Though a dramatic claim, this is achievable by cutting tax-welfare churn.

Half of our $250 billion welfare budget is redistribution from the rich to the poor. The other half is pointless ‘churn,’ where the same family both pays taxes and receives welfare benefits. The biggest cause of this churn is ‘services churn’ where middle- and high-income earners pay tax and then receive government subsidised health and schooling services.

It is largely this middle-class welfare that makes our welfare system unsustainable. With ever-rising health and pension costs, the government cannot afford to continue picking up the bill for richer Australians.

One way to reduce this costly welfare is to ‘swap’ benefits for a tax cut for those on middle- and high-incomes. Redistribution would remain unchanged, while the swap could save the government around $80 billion in unnecessary spending.

To qualify for the tax cut, individuals would be means-tested. Recent welfare reforms have introduced similar means-testing for the Baby Bonus, the Family Tax Benefit, and the Private Health Insurance Rebate.

Two obvious objections to means-testing of government benefits arise: that is it unfair to middle- and high-income earners, and it creates a disincentive to work. Both these problems can be solved by linking the means-test to exactly matching tax cuts.

For example, the current government health subsidy for a single person is about $3,000 per year. A low-income earner would continue to get this full subsidy and receive free health care. Because of the means-test, high-income earners would not receive the health subsidy. However, under the tax-welfare swap they would receive a tax cut of $3,000 per year, so they also would be no worse off. There would be the same amount of redistribution, universal health care, and similar incentives for work. But the benefits would be significant.

By targeting welfare at those who need help, the welfare state becomes sustainable. Further, by reducing churn we can save billions of dollars in administration, compliance and efficiency costs. And finally, removing churn will also encourage more individual responsibility, promote a more active civil society, and provide greater transparency in our tax-transfer system.

This policy has broad appeal. It provides tax cuts and smaller government, but also reduces middle-class welfare and creates a more sustainable welfare system.

Removing the tax-welfare churn for middle- and high-income families produces a more sustainable welfare system, while providing economic and social benefits, and leaving nobody worse off.

John Humphreys is a Research Fellow with the Economics Program at The Centre for Independent Studies.