Australia should eliminate the problem of bracket creep by indexing marginal tax rates to average earnings.
The problem of bracket creep
Bracket creep is the fact that individuals will gradually face higher income tax over time, despite no increase in real income. It is caused by the combination of a progressive income tax and rising inflation, which slowly pushes individuals into higher tax brackets.
This significantly reduces the disposable income of Australian households. As the Centre for Independent Studies has shown, without legislative action, bracket creep would force 4.3 million taxpayers into higher marginal tax brackets over six years alone (beginning in 2012-13). This means that taxpayers will be paying $16.7 billion in additional taxes in 2018-19 than they paid in 2012-13, with a cumulative cost of $50.9 billion.
The government has recognized this problem, with the Turnbull government increasing the upper limit of the middle-income tax bracket from $80,000 to $87,000, from July this year. This means taxpayers will only have to pay 32.5 cents for every dollar earned between $37,001 and $87,000.
This is a positive decision, but it fails to address the underlying problem of bracket creep. It particularly fails to help the people bracket creep hurts the most — low income workers and those transitioning off welfare. The combined effect of marginal tax rates and welfare withdrawal generates Effective Marginal Tax Rates (EMTRs), where every dollar earned above a certain level can result in the loss of 21 to 34.5 cents per dollar to income tax, and 50 cents in every dollar of their welfare payments. This is clearly an incentive to reduce workforce participation.
This problem of bracket creep is expected to worsen in subsequent years. For these reasons, the Australian Taxpayers’ alliance proposes that personal income tax rates be indexed to average earnings.
Indexing marginal tax rates to average earnings
The best solution to the problem of bracket creep is to index the marginal tax rates to average earnings. Indexing marginal tax rates to average earnings would enable marginal tax rates to increase at the pace of inflation. It would increase workforce participation incentives and correct for the overall economic and social costs caused by bracket creep. It would also make Australia more competitive on an international scale.
Marginal tax rates can be indexed to things other than average earnings. But whatever the chosen index, it must not be subject at whim to adjustment or discretion, and must be published by an independent authority such as the Australian Bureau of Statistics.
Requires spending restraint
Resolving the problem of bracket creep will require the Australian government to restrain government spending. Currently, the Australian government’s underlying cash deficit is $37.1 billion. This is unsustainable.
The government is currently relying on the hidden tax increases of bracket creep to reduce this deficit. This is the wrong approach. As a Treasury ministerial brief has illustrated, reducing the budget deficit using bracket creep, rather than spending cuts, will cut gross domestic product (GDP) by 0.35 percent over the long term (despite an anticipated increase in Government spending of 0.2 percent of GDP). The reliance on bracket creep also reduces public accountability, by creating unrealistic expectations and obscuring the connection between tax and spending.
Solving the problem of bracket creep is necessary, but it will require the commonwealth government to rein in spending to more historically acceptable levels. The alternative is to increase other taxes, such as the GST. But this would result in increased prices, and unacceptable harm to low income workers.
Evidence shows that a spending restraint alone can cause a deficit reduction without further tax increases. This is the approach the government must take.
Bracket creep is a hidden tax increase that reduces disposable income for Australian households and reduces incentives to work — harming low income workers the most. The Australian government should resolve the problem of bracket creep by indexing marginal tax rates to average earnings. In order to do this without increasing the budget deficit, the government should also implement spending restraints.