Another round of tax cuts; another round of politicians saying tricky things about bracket creep. Whether they’re giving some of it back or letting it rip, our pollies on both sides hope bracket creep remains, as it has long been, their dirty little secret.
The latest is the claim that Anthony Albanese’s changes to the legislated stage 3 tax cuts will, over the next 10 years, cause income tax collections to be $28 billion higher than they would have been.
Anthony Albanese’s tax cut rejig will make them fairer. But we’ll have more bracket creep under Labor than we would had under Scott Morrison.
This figure is from Treasury’s published advice to Treasurer Jim Chalmers. What Treasury hasn’t been honest enough to do, however, is to warn us that its projection is based on a quite unrealistic assumption.
So let me tell you how bracket creep works, in a way the pollies never would.
First, understand that the income tax scale assumes there’s no such thing as inflation. It assumes that every pay rise you get results from a promotion or from moving to a better-paid job.
In which case, it would be fair enough to make you pay a higher proportion of your income in tax. It ignores that most of the pay rises we get merely cover the rise in consumer prices, leaving us no better off in “real” terms.
This would be true even if all of us paid the same flat tax rate of, say, 30 per cent. But it’s even more the case because the tax scale is “progressive”: our income is taxed in slices, with the tax rate on each slice getting progressively higher.
That is, the proportion of our total income paid in tax – our overall average rate of tax – increases as our income increases, for whatever reason.
The justification for having a progressive tax scale is to ensure that those who can afford to cover a higher share of the cost of government pay a lot more than those who can’t. Fair enough.
It’s easy to see how a rise in our income that pushed the last part of that income into a higher tax bracket would increase our average rate of tax. That’s how this phenomenon got the name “bracket creep”.
What’s harder to see is that, though moving to what economists call a higher marginal tax rate is the fastest way to increase your average rate of tax, the mere fact that every pay rise means a greater proportion of your total income is taxed at your (higher) marginal rate will still drag up your average rate. That’s even if you’re not pushed into a higher bracket – say, because you’re already on the top marginal rate.
What all this means is that, for as long as the pollies sit back and do nothing, the presence of any degree of inflation means everyone’s average tax rate keeps rising forever.
The dirty secret is, all pollies like bracket creep because it’s a way of increasing taxes without having to announce it, meaning many people don’t notice.
But obviously, the pollies know they can’t get away with that forever. The standard solution to bracket creep – practised by the US, Canada, Denmark, Sweden and other European countries – is to automatically index all the tax brackets each year, raising them by the rate of inflation.
The Fraser government did this for a couple of years in the 1970s before deciding it wasn’t worth it politically. Because the annual tax cuts it produced were small and automatic, the media and the taxpayers took too little notice of them.
So Malcolm Fraser decided it was smarter politics to delay having tax cuts until you could afford to have a big one. Say, every three years or so. And what about having it before an election – or maybe just after an election?
And, what’s more, why give everyone the same percentage cut in taxes when you could play favourites by cutting tax rates on some slices more that on others?
Why not cut the rates for higher brackets by more than you cut them for lower brackets? This would make the tax scale less progressive, which the better-off would love.
This is the way both sides have played the tax-cut game until then-treasurer Scott Morrison came along in the 2018 budget with his tricky plan to cut tax in three stages over seven years.
Note that having tax cuts only every three years or so means the taxman gets to keep a lot of the proceeds of bracket creep. Your eventual tax cut gives back only some of the extra that bracket creep has taken.
What a tax cut does is lower your average tax rate to somewhere closer to what it was at the time of the previous tax cut. And, of course, the day after your latest tax cut, the bracket-creep machine starts pushing your average tax rate back up again.
Note too, that if, rather than raising each of the tax brackets by the same percentage, the pollies start fiddling with the size of the rates applying to some of the brackets, there’s no guarantee that the bracket creep you lost is related to what you get back.
And the truth is, bracket creep doesn’t hit taxpayers towards the top of the scale proportionately to those towards the bottom. Average tax rates towards the bottom rise more than those at or near the top.
That’s because the brackets are closer together – the tax slices are thinner – near the bottom than they are near the top. And, of course, someone already on the top marginal tax rate can’t ever move to a higher rate.
Got all that? Now we can look at the strange design of the three-stage tax cut treasurer Morrison announced in the budget of May 2018, and at Albanese’s broken promise last week not to change stage 3 of the cuts.
As I’ve written several times, stage 1 – the low- and middle-income tax offset – was terminated, without announcement, in the Morrison government’s last budget before the 2022 election. Labor could have made sure everyone knew this, but chose to stay silent.
The stage 2 tax cuts were small and did little for taxpayers in the bottom half. The stage 3 tax cuts, long planned to start this July, centred on moving to put everyone earning between $45,000 a year and $200,000 a year – about 94 per cent of taxpayers – on a marginal tax rate of 30¢ in the dollar.
This, we were assured, would end bracket creep for good and all. Not true – because, as I’ve explained, there’s more to bracket creep than moving into a higher tax bracket. What is true, however, is that this move would have greatly reduced the extent of bracket creep in future.
Trouble is, moving to this radically less progressive tax scale involved no tax cuts for people at the bottom, and only modest cuts for those in the middle, but massive cuts for people on $180,000 a year and above.
Get it? The bottom half, who have contributed most to the bracket creep now being returned, would get precious little of it back, while the top half would clean up. As we know, Albanese’s rejig will make the tax cuts much less unfair.
However, the drawback is that, in future, we’ll have more bracket creep under Labor’s plan than we would have under Morrison’s. That’s the main reason Treasury projects that, over the next 10 years, the taxman will now collect about $28 billion more than he would have without the latest changes.
Just one problem with this arithmetic. It assumes that future governments could get away with letting bracket creep rip for a whole decade without ever having a tax cut to give some of it back. Yeah, sure.
