Major tax reform needed to overcome bracket creep

Major tax reform needed to overcome bracket creep.

The Albanese government’s backflip over the shape of tax cuts taking effect on July 1 have put a strong spotlight on the refusal to address the continuing bracket creep problem.

The creep is a product of graduated income tax scales (currently 19, 32.5 37 and 45% marginal rates plus 2% Medicare levy) when the thresholds for each rate apply are not indexed for inflation. Even if your income only increases in line with inflation, your average tax rate (tax as a percentage of pre-tax income) will increase because an increasing proportion of your income is taxed at your highest marginal rate.

This happens whether or not your income growth pushes you into a higher marginal rate band. The faster nominal incomes grow, the more potently bracket creep lifts average tax rates and slugs workers. This is what has happened in the past couple of years as average wage growth has picked up pace.

The Coalition government’s Stage 3 tax cuts would not have abolished bracket creep but they were designed to weaken it by eliminating the 37% rate, which Albanese’s revamp retains. Some 1.8 million individual taxpayers will be worse off from 1 July compared with the Coalition’s Stage 3 — and this number will increase over time because of bracket creep.

By coincidence, the government also announced last week the automatic six-monthly increases in excise duties on fuel, beer, spirits and tobacco resulting from the policy of indexation to the consumer price index. For example, excise on petrol has gone up by 1.9 cents per litre since this time last year, or 2.1 cents after the GST is added on. This may not seem much, but there is an increase every six months, which becomes permanently built in to the base around which petrol prices fluctuate.

This is a very convenient policy for tax revenue because it maintains the real value of excise duties without the government having to legislate. It stands in stark contrast to the refusal of successive governments to do the same for the income tax thresholds.

This inconsistency creates a “heads Canberra wins, tails we lose” situation; each policy disadvantages the taxpayer and benefits the government’s tax revenue. People are unlikely to march in the streets about this, but they are entitled to demand better.

The government says its tax cuts are offsetting bracket creep. That is true to some extent, but it is not true for all taxpayers and it can never remain true indefinitely — because without indexation, the wheels of bracket creep will keep turning and undo the relief provided by this tax cut.

This is how it has always been. There have been many tax cuts over the past 50 or so years, yet the burden of income tax has not gone down and stayed down because bracket creep continues.

The process is fundamentally dishonest. The government rakes in the revenue from bracket creep over a number of years and then gives some of it back by increasing various thresholds and fiddling with marginal rates — then gives it a PR spin to call it a big tax cut.

There is a way out of the dishonesty and that is to do to income tax thresholds what is already done to excise duties: index them to the consumer price index, or better still to average wages. Then any tax cuts from the indexed base are genuine tax cuts.

This is what happens in several other countries and it happened in Australia for a few years under the Fraser government in the 1970s and early 80s, until it became politically more lucrative and attractive to let bracket creep run and then declare big tax cuts.

Bracket creep is called the stealth tax because it turbo-charges the growth of tax revenue and the government doesn’t have to do anything to achieve that outcome. That is the political attraction. It is lazy budget management.

Australia’s heavy reliance on personal income tax has repeatedly been identified as a key weakness of our tax system, yet unrestrained bracket creep will keep increasing it.

The longer bracket creep is allowed to go unchecked, the higher everyone’s average tax rate will go. The overall average tax rate is projected to reach a record high level early in the next decade.

We need this or a future government to end the cynical politics and end the charade of tax cuts offsetting bracket creep by announcing automatic annual indexation of bracket thresholds. That would be a reform worthy of the name. But don’t hold your breath waiting for it.

Robert Carling is a Senior Fellow at the Centre for Independent Studies and a former IMF, World Bank and federal and state Treasury economist.

Photo by Nicola Barts.