I’m not going to lie. For as long as I’ve known about “bracket creep”, I’ve said we should get rid of it. Why should the government get to rake in more tax from us every year – and then make out like they’re so generous when they give us a tax cut to make up for it?
As you may know, “bracket creep” refers to when your income rises (often somewhat in line with inflation), pushing you into a higher tax bracket.
Now, if your salary increases, it might seem like it’s fair to pay a bit more tax on that extra amount you’re earning. But the problem is, if your pay packet is only rising at the same rate – or even below – the growth in prices, then you’re not really any better off: your higher income buys the same – or an even smaller – number of things than last year.
Yet, because the income tax brackets stay the same (unless the government decides to change them), you might find a bigger share of your income ends up in a higher tax bracket, increasing the average rate of tax you pay on your income.
Paying higher tax, and being no richer in “real” terms (that is, accounting for inflation)? That sounds like a stitch-up, doesn’t it?
And then, come election time, the politicians fighting for your vote can make it sound like they’re being ever so generous by promising a tax cut … which only really makes up for the fact that a lot of us might have been bumped up into a higher tax bracket.
So, when people like Opposition Leader Angus Taylor promise to lock income tax brackets to inflation (that is, making it so that the tax brackets rise every year in line with the growth of prices), it seems like a very sensible – even great – idea.
In fact, when former opposition leader Peter Dutton proposed the idea last year, I wrote that it was one of the best in what was a broadly uninspiring election campaign from both major parties.
But this week, I’ve softened my stance – and Richard Denniss, director of The Australia Institute, along with senior research fellow David Richardson, have given the explanation that made me stop in my tracks.
Here’s the thing: there are mechanisms called “automatic stabilisers” built into several of the systems we use to smooth over the economy as it goes through its ups and downs.
Unlike the Reserve Bank choosing the level of interest rates every six weeks, or the government choosing whether to cut spending on various areas in the budget every year, “automatic stabilisers” are changes that happen automatically to deal with changes in the economy – without anyone lifting a finger.
When the economy slows, for example, more people tend to lose their jobs, leading to higher unemployment. But when unemployment rises, the amount of unemployment benefits paid out rises, helping to keep people afloat – but also helping to smooth over the effect it might have on the economy as people earn and spend less.
That is: unemployment benefits are an “automatic stabiliser”, growing when the economy starts slowing, and shrinking as the economy grows, and more people get back into jobs.
“Bracket creep”, similarly, works to stabilise the economy automatically. When inflation is climbing rapidly, the fact that Australians have to pay a higher average rate of tax means that they have less to spend than they otherwise would.
Of course, when the economy is growing slowly and inflation is low, bracket creep still leads to some people paying a higher average tax rate. But the extent of the bracket creep is smaller when inflation is lower.
The problem with indexing tax brackets – or tying them to inflation – is that it makes the task of getting inflation back under control more difficult. Why? Because it means that when inflation rears its head and prices surge, the tax brackets would also move higher, meaning some households, which otherwise might have found themselves paying higher average tax, would instead find themselves with more money in their pockets.
At least some of that additional money would be spent, lifting overall demand in the economy, which we know pushes prices up further – at a time when policymakers would be trying to get inflation down.
Essentially, indexing tax brackets, while arguably a “fair” thing to do to make sure Australians aren’t worse off when their wages rise but inflation eats away at their gains, would make the Reserve Bank’s job harder.
The bank would have to use its one main instrument – lifting interest rates further – to curb the additional spending that would occur during periods of high inflation. And because only about one third of Australians have a mortgage, the impact of those higher interest rates would be felt disproportionately by those with a home loan.
Bracket creep, while seemingly a way for governments to fatten up their tax coffers, actually gives governments the flexibility to change tax thresholds when it makes sense to do so from an economic perspective.
There is, of course, the argument that governments aren’t always capable or willing to take the actions that lead to the best outcomes for the economy. For example, if an election was on the horizon, the government might decide to lift tax thresholds or make an income tax cut even if it worsened inflation.
Or, a government might – instead of banking up the money it took out of the economy through bracket creep – end up spending it. In that case, there would still be an inflationary effect on the economy because itwould be pumping money back into the economy – potentially at a time when inflation is already high.
As AMP chief economist Shane Oliver puts it, stopping bracket creep is a way of keeping the government more honest. If our pollies wanted to splash more cash, for example, they couldn’t just rely on bracket creep topping up their coffers. They’d have to go to voters and explain why their taxes were rising and justify spending and tax changes more vigorously because voters would notice them.
That would promote more transparency when it comes to government spending and tax, and the government wouldn’t just be able to rely on people getting pushed into higher tax brackets to balance their books.
Then, there’s an argument that, while bracket creep works well when inflation is high and the economy is growing, it doesn’t work as effectively when times are bad. As Oliver puts it, bracket creep isn’t a “symmetrical” automatic stabiliser: when the economy is slowing and we might want people to pay less tax, for example, bracket creep doesn’t quite work to the same degree because wages don’t tend to fall very often.
But we also know that indexing income tax thresholds has been done before – and that the results weren’t quite as fantastic as we might have thought.
Richardson points out, for example, that the Fraser Coalition government tried to index personal income tax scales but ended up walking it back before abandoning it completely, largely because it was deemed too expensive for the government.
From a purely personal perspective, I’m a bit miffed at the prospect of paying higher average tax, especially if my wages fail to grow above inflation – although I’d be pretty happy to hit the next tax bracket any time soon.
While there are some solid arguments for eliminating bracket creep, it’s not a completely ridiculous tax setting to have in place. As a lesser-known automatic stabiliser, there are costs to getting rid of it completely, which are worth taking into account.
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Millie Muroi is the economics writer at The Sydney Morning Herald and The Age. She was formerly an economics correspondent based in Canberra’s Press Gallery and the banking writer based in Sydney.Connect via X or email.
