A cut in company income tax in next month’s budget would be welcome and long overdue, but it should not come at the expense of personal income tax reform, even if budget constraints mean the government has to make a modest start to both.
The political imperatives are well known, but there are also strong economic reasons for reform. There is plenty of research pointing to an important role for lower personal tax rates in an economic growth agenda.
The government’s tax reform priorities appear to be driven by Treasury modelling that concludes cuts in company income tax will do much more to boost the economy than cuts in personal tax. However, for technical reasons the personal tax Treasury has modelled is a flat rate tax on labour income. It is hardly surprising an income tax in that form is found to have an economic cost similar to the GST.
The real world personal income tax is far more complex, with features such as graduated rates, various offsets, and uneven treatment of savings income. It imposes high economic costs through its effects on people’s decisions regarding work, saving, investment in human capital and small businesses, tax avoidance effort, and Australia’s competitiveness in the global market for skilled labour. While company income tax may well impose greater economic costs, personal tax is not as far behind as is often suggested.
Moreover, unlike company income tax, the burden of personal income tax grows automatically through bracket creep. On the Treasury’s own projections, the average tax rate (net tax paid as a proportion of taxable income) will rise over the next five years to its highest level ever. It will be 11% above where it stands now and 18% above the long-term average.
Underlying this trend are high marginal rates and bracket thresholds that are declining in real terms and as multiples of average earnings. Cuts in marginal rates since 1999 have been largely reversed by explicit rate increases (including the Medicare levy). With the exception of the second highest rate, marginal rates have hardly budged. Meanwhile, increases in thresholds since 1999 — although large — are being eroded by bracket creep.
Within the next few years, for most taxpayers it will be as if the tax cuts of 2000-2012 never happened. More than 70% of taxpayers — including practically all full-time employees — will face a marginal rate of 34.5% or higher. Just fiddling with thresholds would be a band-aid rather than a reform. What is needed are cuts in marginal rates, which are what drive the economic behavioural response to income tax. Adjusting thresholds is not a substitute.
An ambitious reform agenda would cut the marginal rate for the bulk of full-time workers to no more than 30% and the top rate to no more than 35%. It would make sense at the same time to reset the levels at which these marginal rates cut in. For example, a top rate as low as 35% should start at a lower threshold than $180,000. Once thresholds are reset, they should be automatically indexed to average earnings so bracket creep cannot recur.
There will be objections that cutting the top rate is ‘unfair’, but before anyone rushes to that judgement they should study the distribution of the personal tax burden and how it has evolved over time. Personal tax (and the tax/transfer system more broadly) is highly progressive and the trend has been for the top 20% to bear an increasing share. Arguably, this process has gone too far.
Given current budget conditions, a large tax cut is a pipe dream. But putting personal tax reform in the ‘too hard’ basket is not an option either. If it is not addressed in this budget, it will have to be addressed in the next parliament. Whoever is in government will need to find a way through the fiscal constraints to achieve real reform within a reasonable timeframe.
The Turnbull government should start with the current system by announcing its medium-term reform goals in this budget and commencing implementation not later than July 2017. It should consider radical options, such as abolishing the tax-free threshold (which necessitates higher marginal rates than would otherwise be required) and replacing it with a targeted low income tax offset. Beyond that, the key to personal tax reform is much stronger restraint of government expenditure than we have seen for many years.
Robert Carling is a Senior Fellow at the Centre for Independent Studies and author of the research report Taming the Monster: reforming personal income tax
Home > Commentary > Opinion > Turnbull government must not delay personal income tax cut
Turnbull government must not delay personal income tax cut
The political imperatives are well known, but there are also strong economic reasons for reform. There is plenty of research pointing to an important role for lower personal tax rates in an economic growth agenda.
The government’s tax reform priorities appear to be driven by Treasury modelling that concludes cuts in company income tax will do much more to boost the economy than cuts in personal tax. However, for technical reasons the personal tax Treasury has modelled is a flat rate tax on labour income. It is hardly surprising an income tax in that form is found to have an economic cost similar to the GST.
The real world personal income tax is far more complex, with features such as graduated rates, various offsets, and uneven treatment of savings income. It imposes high economic costs through its effects on people’s decisions regarding work, saving, investment in human capital and small businesses, tax avoidance effort, and Australia’s competitiveness in the global market for skilled labour. While company income tax may well impose greater economic costs, personal tax is not as far behind as is often suggested.
Moreover, unlike company income tax, the burden of personal income tax grows automatically through bracket creep. On the Treasury’s own projections, the average tax rate (net tax paid as a proportion of taxable income) will rise over the next five years to its highest level ever. It will be 11% above where it stands now and 18% above the long-term average.
Underlying this trend are high marginal rates and bracket thresholds that are declining in real terms and as multiples of average earnings. Cuts in marginal rates since 1999 have been largely reversed by explicit rate increases (including the Medicare levy). With the exception of the second highest rate, marginal rates have hardly budged. Meanwhile, increases in thresholds since 1999 — although large — are being eroded by bracket creep.
Within the next few years, for most taxpayers it will be as if the tax cuts of 2000-2012 never happened. More than 70% of taxpayers — including practically all full-time employees — will face a marginal rate of 34.5% or higher. Just fiddling with thresholds would be a band-aid rather than a reform. What is needed are cuts in marginal rates, which are what drive the economic behavioural response to income tax. Adjusting thresholds is not a substitute.
An ambitious reform agenda would cut the marginal rate for the bulk of full-time workers to no more than 30% and the top rate to no more than 35%. It would make sense at the same time to reset the levels at which these marginal rates cut in. For example, a top rate as low as 35% should start at a lower threshold than $180,000. Once thresholds are reset, they should be automatically indexed to average earnings so bracket creep cannot recur.
There will be objections that cutting the top rate is ‘unfair’, but before anyone rushes to that judgement they should study the distribution of the personal tax burden and how it has evolved over time. Personal tax (and the tax/transfer system more broadly) is highly progressive and the trend has been for the top 20% to bear an increasing share. Arguably, this process has gone too far.
Given current budget conditions, a large tax cut is a pipe dream. But putting personal tax reform in the ‘too hard’ basket is not an option either. If it is not addressed in this budget, it will have to be addressed in the next parliament. Whoever is in government will need to find a way through the fiscal constraints to achieve real reform within a reasonable timeframe.
The Turnbull government should start with the current system by announcing its medium-term reform goals in this budget and commencing implementation not later than July 2017. It should consider radical options, such as abolishing the tax-free threshold (which necessitates higher marginal rates than would otherwise be required) and replacing it with a targeted low income tax offset. Beyond that, the key to personal tax reform is much stronger restraint of government expenditure than we have seen for many years.
Robert Carling is a Senior Fellow at the Centre for Independent Studies and author of the research report Taming the Monster: reforming personal income tax
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