Do Australians pay too much income tax or not enough?

It is an open question depending on your idea of how many services you are keen on the Federal Government to provide and whether you prefer a small government or a larger one.

At the moment, Australia sits at around the Organisation for Economic Cooperation and Development (OECD) average for taxes as a percentage of gross domestic product (GDP) if you include compulsory superannuation, although such comparative calculations are difficult and complex.

What is clear is that we are in the group of “middle tax” countries but still far lower than some of the Scandanavian and other European countries that have much higher tax collections and more extensive government services.

The perceived wisdom at the moment seems to be that our income tax burden is a bit on the low side, given the large amount of gross government debt which is approaching $1 trillion and we are stuck with a structural Budget deficit well into the future.

That brings a sharp focus on the controversial stage three tax cuts that are due to start from the middle of 2024 and are set to cost the Budget $250 billion.

Tax brackets set to fall

Even though Labor voted in favour of these cuts while in opposition – cuts that will abolish the 37% tax bracket and cut the existing 32.5% rate to 30% while increasing the threshold for the 45% rate to $200,000 – they have come under increasing pressure to abandon them.

That is understandable as government debt rapidly closes in on $1 trillion and amid plenty of calls for extra funding for areas from the health system to welfare payments, the National Disability Insurance Scheme (NDIS), defence, and everything in between.

However, some recent analysis by the Parliamentary Budget Office showed that perhaps we should not be too hasty in getting rid of the planned tax changes – or at the very least, they should be tilted more towards those on lower incomes.

Bracket creep and fiscal drag raising the tax take

That analysis showed the magnitude of the most insidious of all tax increases – bracket creep and fiscal drag – which governments of all flavours have studiously avoided tinkering with because it painlessly delivers them increases in tax without any effort on their part.

Simply put, bracket creep and fiscal drag refer to the process of gradually rising wages putting people into higher average tax rates, even though they have not got any richer in inflation-adjusted income terms.

This process works overall and not just when you move into a higher tax bracket because more of your income is earned above the existing threshold rate that is your maximum.

Politicians return excess tax when it suits them

The normal political reaction to this is to allow the process to happen over time and then – usually when an election is on the way – to magnanimously hand back some of this extra tax revenue in the form of tax cuts or through other targeted tax measures and allowances.

A good recent example of this is the famous “lamington” extra tax break offered by the former Morrison Government – which is actually called the low- and middle-income tax offset (LMITO) – which was first offered as a temporary measure in 2018 before being extended.

It gave low- and middle-income earners a tax break of between $255 and $1,080 a year and benefitted those whose taxable income was between $37,001 and $126,000.

That may not sound like a lot of money for each individual but it came at a Budget cost of $7.2 billion a year, which demonstrates how sensitive the Budget is to tax changes.

It also shows why the stage three tax cuts are so expensive at $250 billion but that in itself is not a reason not to go ahead with them – particularly as the aim was to make up for past bracket creep and fiscal drag and flatten the tax rates.

Big cuts still don’t make up for bracket creep

Under the cuts, a person earning more than $200,000 will gain $9,000 a year once the tax cuts are introduced. Someone earning $70,000 will gain $625.

The amazing thing about these tax cuts is that analysis from the Parliamentary Budget Office shows they still do not go far enough in compensating for the effects of bracket creep and fiscal drag.

The recent analysis showed that it would take another $60 billion of tax cuts to achieve that aim, which would still just leave individuals in the same financial position.

Another thing the analysis showed clearly is that reversing bracket creep is an ongoing task, with people continuing to lose more of their pay in the form of tax as soon as the new tax scales come into existence.

Cuts need to keep coming to keep the tax burden steady

“The legislated stage three tax cuts in 2024-25, which cost around $250 billion over the period to 2032-33, offset some of the impact of bracket creep, but do not eliminate it completely – bracket creep will still continue even after taxes are cut,” the report found.

So, without continuing tax reform or further tax cuts, ordinary workers will bear the brunt of repairing the Budget.

This will particularly be the case as the large Baby Boomer cohort continues to retire, leaving fewer employed workers to pay tax.

The Budget office found that the tax burden borne by the top 10% of income earners is expected to fall over the rest of the decade, with or without the stage three tax cuts.

It also noted that while bracket creep was one way to continue to repair the Budget, much of that burden would fall on low- and middle-income taxpayers.