Don’t believe the income tax fairytale

Which Christmas story should we choose when it comes to income tax?

The first happy story, told by NATSEM, says that income taxes are lower today than if personal tax thresholds had been indexed since 2005. This is the story that could come from “It’s a Wonderful Life” (if you can imagine the Hollywood classic dealing with personal tax thresholds). The second sad story, by CIS, is a bit of a Grinch tale: income taxes are higher today than if tax thresholds had been indexed since 2013.

So which story is true: the Wonderful Life story or the Grinch? In fact, both are true. This shows the difficulties with conducting and interpreting economic modelling: you can end up with completely different results depending on your assumptions.

First, let us look at the happy Christmas story as told by NATSEM. They estimate personal tax revenue is about $31 billion lower today than if tax thresholds had been indexed to inflation since 2004–05, or $20 billion lower than if thresholds had been indexed to average wages growth. In other words, discretionary tax cuts have delivered lower taxes than indexation. The NATSEM results have been interpreted as stating that taxpayers are better off despite bracket creep: essentially claiming the effects of bracket creep have been more than erased by income tax cuts over the past decade.

Next, what about the sad Christmas story from CIS modelling? This finds we are paying more tax because of bracket creep since 2012–13: an extra $6 billion this year, rising to an extra $16.7 billion in three years’ time. The average cost per taxpayer is $450 today and is forecast to be $1,181 in three years. More details, including an estimate of the impact for each income level, are in an article I wrote in Business Spectator last week. The clear conclusion is that bracket creep is making Australian taxpayers worse off.

These results are consistent, despite appearances. Tax is indeed higher today than if thresholds had been indexed since 2013, and lower today than if thresholds had been indexed since 2005 (I have been able to replicate NATSEM’s results quite closely). This shows the importance of the starting year. We chose 2013 as the starting year because this is when the last change to tax thresholds occurred. The tax changes in 2013 reflected what Parliament considered to be the appropriate tax system in that year; since then this intent has been subverted by bracket creep since then.

The use of 2005 as a starting year is less convincing. The choice is 10 years ago, which is a round figure. However, there were a number of major tax changes in the years before and after 2005: the tax system wasn’t particularly stable in that period. In addition, bracket creep had already increased taxes before 2005, so this artificially inflates the tax take in that year.

There were substantial tax cuts in the following years of 2006 and 2007. These cuts not only returned bracket creep, but also addressed the political problem the Howard government faced that it was a high taxing government — the tax to GDP ratio was reaching all-time highs. The Howard government realised this wasn’t tenable, which is why they implemented large tax cuts in the following years. If we choose 2005 as a starting point for an analysis of bracket creep, it implies that the historically high tax rates in 2005 should continue into the future. This is because bracket creep doesn’t reduce the tax to GDP ratio: it just limits the increase in this ratio.

When we argued in our paper ¾ Exposing the Stealth Tax: the bracket creep rip-off ¾ that tax thresholds should be indexed, we weren’t ruling out other tax changes. In an indexed tax system, governments and Parliaments can still adjust tax thresholds. It would have been better in 2005 (or even earlier) for thresholds to be indexed, and there be additional personal tax cuts to ensure the tax to GDP ratio was reduced from historically high levels.

There are good reasons, therefore, to prefer an analysis of bracket creep that starts with the year 2013 rather than 2005. While both the sad and happy Christmas story are true — and we’re sure most people would prefer a happy ending — the sad story is the more believable one. Isn’t it always the way?

Michael Potter is Research Fellow in the Economics Program at the Centre for Independent Studies. He is co-author (with Robert Carling) of the report Exposing the Stealth Tax: the bracket creep rip-off.