Tax could be the reason your budget isn’t working

Do you ever feel that the weekly budget just isn’t stretching as far as it used to?

Most of us do but the reason may not be the usual culprits such as higher gas and electricity prices or higher petrol and grocery prices.

It could be the amount of tax you are paying – despite those “tax cuts’’ that you thought you may have been getting.

The dirty little secret of tax – bracket creep – works very efficiently to increase the average tax rates of most workers, even if their wages have only risen to keep up with the aforementioned cost pressures.

So that squeeze on your budget isn’t just your imagination or over-spending, it may well be tax automatically grabbing a higher share of your income over time.

Middle income earners are feeling the squeeze

The Parliamentary Budget Office analysis of the final budget outcome for 2018-19 and the April Budget makes it clear that the current balanced Federal Budget is set to bounce back to surplus this year and remain strongly in surplus for many years to come – assuming there are no spending changes and Treasury’s medium range forecasts stand the test of time.

The interesting part of the analysis is that actual income tax collections per person will keep rising, even with the legislated decade of tax cuts that are now in place.

In short and brutal terms, unless you are a very high-income earner, your average income tax rate will keep gently rising over time because the tax cuts only partly compensate for bracket creep – plus the more efficient collection of tax overall.

Substantial tax rises to come

Some of those rises are quite substantial too – for the middle fifth of earners their current average tax rate of 14.9% of income will rise to 18.8% over the next decade.

Of course, that 3.9% rise would have been much greater without the legislated tax cuts – a whopping 6.3% – but it is a little bit dubious for any government to claim too much credit for tax cuts that really only reduce the rate of income tax rises.

It is a similar story for most other income levels, with average tax paid on the bottom fifth quintile rising from a minimal 0.6% to 1.2%.

The second lowest quintile will move from an average income tax rate of 5.3% to 9.9%, a significant rise.

The second highest fifth move from paying 22% to 23.4% while the highest earners, who are above $90,000 a year, see their average tax rate actually fall slightly.

Average tax rates tell the story

There are a couple of things to notice about these average tax rates, which are a much more helpful way of looking at tax than simply comparing marginal tax rates.

The first is that those on higher incomes might pay the great bulk of tax in dollar terms but they are also treated the best by the tax cuts.

That may be appropriate given the need to keep incentive in the tax scales as more workers climb through the scales and increase their average tax rates.

The second thing to note is that it is middle income earners who are bearing the brunt of the average tax rises because their tax cut compensation is lower than their level of bracket creep.

That – combined with fairly tight control on government spending – is one of the secrets behind the projection of budget surpluses well into the future.

Of course, with the Australian economy spluttering and slowing and much of the country hit by drought, there will be a lot of pressure on the Morrison Government to increase spending to stimulate the economy and help the struggling agricultural sector.

Forecasts can be faulty

That slowing economy is also a very good reason not to take this sort of forward projection too seriously.

In typical Treasury fashion, its predictions are for economic growth to snap back and speed up to a greater than usual pace.

That may not be an impossible scenario but it looks increasingly unlikely as the Reserve Bank cuts interest rates to stimulate growth and much of the world is stuck in a slower than usual growth pattern.

The one projection you probably can take to the bank is that average income tax rates will creep upwards over time as workers keep rising through the income tax rates.