Stage three tax cuts haven’t blunted the impact of bracket creep

Two months after announcing their Stage 3 income tax cuts backflip, and a month after it breezed through parliament, Labor are probably feeling satisfied with what they have pulled off — especially since it appears to have been politically popular. 

But if they think they have resolved the basic issues around personal income tax policy, they are mistaken. 

Anything the July 1 tax cuts do to relieve the tax burden will be short-lived, because on July 2 bracket creep will start increasing it again. 

Bracket creep lifts average tax rates even when nominal incomes are rising no faster than inflation — and real income is therefore unchanged. 

Under a progressive tax scale, an increasing proportion of income is taxed at one’s highest marginal rate. This happens whether or not income growth puts taxable income into a higher marginal rate bracket. 

Historically, governments of both stripes have allowed this mechanism to keep going until average rates — and marginal rates at average incomes — became so high that the burden became politically intolerable. This is when we finally get tax cuts. 

One important test of such cuts is how much they do to offset past bracket creep. 

On this issue, various claims were made about the Coalition government’s three-stage personal income tax plan that began in 2018-19 and was to be completed this July. 

The focus has always been on Stage 3; how it delivered a $9,000 gain to high income earners and allegedly over-compensated them for bracket creep. 

This was despite Stage 1 concentrating tax cuts on lower incomes, and high incomes not receiving significant relief from bracket creep since 2010-11. 

Simple comparisons of average tax rates in 2024-25 with those in 2017-18 — just before the tax cut plan started — did reveal a reduction in average rates from around $90,000 compared with seven years ago. 

However, such calculations fail to take into account the extra tax paid in each of those years as a result of bracket creep. Indeed, this failure of measurement applies at all income levels. 

Using a more comprehensive methodology, CIS research has recalculated the cumulative effect of bracket creep and discretionary tax cuts over those seven years and found that even under the Coalition’s original plan, the main beneficiaries of tax policy since 2017-18 have been those on incomes between $50,000 and $224,000. 

Far from ‘$9,000 gifts to the rich’, those with incomes above $224,000 are slightly worse off over the period — and that’s if they had received the original Stage 3 tax cuts in full. 

The Albanese government’s re-design of Stage 3 lowers the range of incomes that have been over-compensated for bracket creep to around $48,500–$214,000, and also delivers a cut to those on $34,000–$39,700 they would not otherwise have received. 

However, if we look back further to 2010-11 — the year the last major tranche of tax cuts were fully implemented — the results are dramatically different. 

The Coalition’s three-stage plan undercompensates everyone above $35,000; while Labor’s revision increases the extent of under-compensation above about $146,000 and slightly reduces it below that level. 

The conclusion is that while any government is free to shape the distribution of a tax cut as it sees fit, relief from bracket creep is one important criterion, which provides no justification for the Albanese government’s Stage 3 renovations. 

As a result, the bottoms of the 37% and 45% brackets ($135,000 and $190,000) will become pressure points sooner than otherwise. 

Second, to the extent some taxpayers are being over-compensated for past bracket creep, future bracket creep will eventually devour that benefit. 

The government’s Stage 3 tinkering might buy those taxpayers who benefit some more time … but not much. 

Third, if thresholds were indexed to inflation annually, relatively small reductions to tax would be made each year thereby avoiding the accumulation of revenue to fund larger but illusory ‘tax cuts’ every several years. 

Discretionary tax cuts under indexed tax brackets are genuine tax cuts — not merely the return of the additional money the government had taken in previous years. 

And fourth, if indexation is not adopted in future (and there is no sign that it will be) there has to be a better understanding that under the practice of widely spaced discretionary tax cuts, larger absolute dollar cuts at higher incomes are necessary unless average tax rates are to increase inexorably above a certain income level. 

Over time, that ‘certain’ level will become lower in real terms, capturing an increasing number of taxpayers; with all that implies for the effect of the tax system on incentive and aspiration. 

Matthew Taylor is Director of the Centre for Independent Studies Intergenerational program. Robert Carling is a Senior Fellow in the Economics program.