Bracket creep undermines tax cuts, research finds
Personal income tax indexation would end bracket creep, but it would also strip the government of its ability to make prized tax cut announcements.
Had personal income taxes been indexed – meaning pinned to prices or incomes – in place of stage 3 tax cuts, lower-income taxpayers would have been better off. The difference is that, beyond the initial reform, the market would have been given all the credit.
“Now is the time to again index the personal income tax rate scale to permanently remove the bracket creep effects going forward,” wrote Paul Tilley, visiting fellow at ANU’s Tax and Transfer Policy Institute in a recent policy brief.
Over the seven years of the stage three tax cuts program (from 2018 to 2025), personal income taxes are expected to remain largely steady as a share of overall Commonwealth tax revenue, said Tilley.
This is due to bracket creep. Despite the cuts, taxes will hold as a share of government tax revenue in line with rising personal incomes.
Bracket creep occurs when income growth forces taxpayers into a higher tax bracket. Over time, this means tax revenue growth outpaces personal incomes.
Similarly, this means personal income taxes begin to make up a larger share of overall tax revenues and GDP, an effect referred to as fiscal drag.
“Over time, incomes can typically be expected to increase more than prices,” he wrote, adding “this has not been the case recently, though, with real wages going backwards at times.”
The 2018 budget included a ‘Personal Income Tax Plan’, which provided for income tax cuts over three stages, across seven years. Earlier this year, the Albanese government revised the cuts, delivering greater benefits for low-to-middle-income taxpayers.
Had personal income taxes been indexed to prices or incomes, instead of the revised stage 3 tax reforms, lower-income taxpayers would have paid less tax while higher-income earners would have paid roughly the same. Mid-high-income taxpayers (earning $100,000 to $200,000 per year) would have paid more.
Compared with the initially proposed stage three tax cuts, indexation would have delivered lower taxes for low-income earners, while higher-income earners would have paid more. Middle earners would have been largely unaffected.
In the late 1970s, the Fraser government indexed personal income taxes to price increases. This came off the back of an inquiry chaired by ANU academic Russell Matthews into the impact of inflation on the country’s tax system.
The inquiry report found that bracket creep had resulted in a different distribution of taxes from “that which was intended by the legislation.”
As such, indexation by prices was seen as the best way forward, despite acknowledging that increases in real income would continue to increase tax rates.
Their reign was short-lived, however, being walked back only a few years later. Challenges to the indexation as a component of a broader, allegedly unaffordable tax package, posed throughout Fraser’s 1977 election campaign proved existential and indexation has not been put in place since.
According to Tilley, bracket creep is not the core issue with the country’s tax system but solving it will open the floor to discussion of those deeper challenges.
“The more important tax policy issues at stake relate not to bracket creep and minor variations in the overall weight of personal income tax in the Australian tax system,” he said.
Instead, they relate to “the design issues of the income tax base, such as the inconsistent and inequitable approaches to the taxation of savings and the interactions with entity structures such as companies and trusts."
Tackling bracket creep would allow “a greater focus on these more fundamental tax base issues.”
What is needed, he said, is a comprehensive tax review.
