Time to do away with this insidious tax hurting us all

We may at last be on the verge of seeing genuine tax reform, a mere 25 years since the introduction of the GST signalled the last big change to how we are taxed.

As part of a pre-election pitch to hold the balance of power, a number of independent MPs have called on the Treasurer to commit to ending (or at least severely curtailing) bracket creep.

Bracket creep is caused by the inflation and its interaction with our progressive tax system. As your income rises, an increasing percentage of it is taxed at higher marginal rates. Even if your salary only keeps up with inflation, the amount of tax you pay goes up — and your living standards go down.

It’s important to understand bracket creep is not limited to when you slide from one tax bracket to the next (though that does make it worse). Bracket creep affects every additional dollar you earn.

It is an insidious tax. It happens without legislation, and most people are unaware it is even happening. It’s also regressive, hammering those on lower incomes relatively more than those on higher incomes.

Worse still, its effect are cumulative and also increase over time. This means each year that bracket creep is left unchecked, its pain intensifies; especially in an environment of low real wage growth and high inflation (which we have experienced in recent years).

So in the first year, your taxes increase only a little bit. But after 10 years, not only have you paid more tax for a decade, your yearly tax bill has also increased a lot.

For example, as the CIS noted in our recent paper Bracket Creep Raiding Our Wallets, the Stage 3 tax cuts actually undercompensated taxpayers for accumulated bracket creep. Despite this, the cuts were still curtailed because they were wrongly seen as too generous.

Ironically, unlike other problems with the tax and transfer system, fixing bracket creep is easy. Automatically index the tax brackets each year (‘to what?’ is a question we will return to) and bracket creep will disappear.

It’s also relatively cheap in the near term, exactly because bracket creep usually starts small and accumulates over time.

So why has bracket creep been so hard to get rid of? The main reasons are political and, to be honest, may seem somewhat cynical.

The first is that bracket creep is useful in continuing to increase the government’s tax take over time. The argument is that the public punishes politicians for tax increases, so one that doesn’t have to be voted on is worth its weight in gold.

This situation would have more merit if bracket creep meaningfully contributed to establishing a sustainable budget balance over time. At least then you could argue the ends justified the means; but the opposite is true.

Instead, bracket creep facilitates the ever upwards ratcheting of government spending.

Those who believe the government should be much bigger love bracket creep, despite its regressivity, for just this reason.

However, the fact that people would not vote for tax increases is a terrible reason to impose them by stealth.

The second point, even more cynically, is that politicians get a sugar hit from delivering tax cuts to voters. Theoretically, politicians can deliver periodic tax cuts that would offset bracket creep (and allow them to manage the timing of the impact on the budget at the same time).

The biggest problem with this is that ‘across the board’ cuts have become increasingly difficult to implement, especially for those on above-average incomes. Note the response to the Stage 3 tax cuts pointed out above.

Nor does an unfair stealth tax become fair just because its impact is constrained to those who are earning higher incomes.

The Independents have done us a favour by putting tax reform back on the table, especially as this proposal would make almost all taxpayers better off.

The major parties, given how quick they are to back new spending during an election campaign, could easily add indexation to their platforms as well.

The real question that should be debated is not whether tax brackets should be indexed, but what is the appropriate measure to index them to.

There are three logical options, each with their own benefits or potential drawbacks depending on your perspective.

The option most advantageous to taxpayers, and therefore the best, would be to index tax brackets to movements in average wages.

Under this formulation, tax rates would automatically adjust for increasing in average living standards because of economic growth, not merely the year-to-year changes in prices.

This would completely offset the impact of inflation, and ensure tax brackets reflected longer-term changes in community living standards. It would mean tax rates were more representative of relative incomes over a longer period; ensuring, for example, that only those on relatively high incomes paid the top rate of tax.

Indexation against wages is not as radical as it sounds: both the Age Pension and the Disability Support Pension are benchmarked against a set percentage of wages, not just indexed to inflation — precisely to reflect changes in living standards over time.

No doubt this would be criticised as the most ‘costly’ option, if you can describe not taking additional, unearned money from taxpayers as a ‘cost’.

However, it would certainly impose much-needed discipline on government spending; requiring politicians to seek the approval of parliament if they wanted more revenue.

The other two options are very similar. These are to index the tax brackets by 2.5% each year (representing the RBA’s target for inflation) or to index them directly to movements in the CPI.

If the RBA is doing its job well, over time the difference between these two measures should be minimal. In recent years, the difference would have been substantial.

These policies would allow greater room for the government to introduce periodic tax cuts to align tax rates with community living standards. The cynics might be mollified if we keep some of the fun of promising tax cuts.

Regardless of which option is ultimately taken up, any indexation would be an enormous improvement on the situation as it currently stands.

With the public newly-aware of just how destructive inflation can be to living standards, the time is right to pluck this low-hanging tax fruit.

Simon Cowan is Research Director at the Centre for Independent Studies.