Budget 2018: Income tax brackets and how the Government’s plan really works
For something considered as certain as death, confusion reigns when it comes to income tax.
The Government is selling its personal income tax plan by arguing that “94 per cent of Australian taxpayers will pay no more than 32.5 cents in the dollar”, compared to 63 per cent if the current system is left unchanged.
At the same time, analysis by various think tanks, experts and media outlets shows that the substantial majority of savings from the tax cuts will go to higher income earners.
How do these numbers tally?
It all comes down to tax brackets and marginal tax rates, essential features of a “progressive” tax system.
In this context, “progressive” means that you pay a higher rate of tax as your income goes up.
This is as opposed to a “flat tax” system, where everyone pays the same rate on all their income.
Many people appear confused about this distinction, including former treasurer Joe Hockey, who once said on talkback radio:
“When Australians spend the first six months of the year working for the Government, with tax rates nearly 50 cents in the dollar, it is a disincentive.”
This is a complete confusion of tax rates with the rate of tax paid.
Few people on the top tax rate, even when it was almost 50 cents in the dollar, spent anywhere near six months “working for the Government”.
That’s because that is their “marginal tax rate” — that is the tax rate they pay on every dollar they earn above the top income threshold, currently $180,000.
Even these very high income earners pay zero tax on the first $18,200 they earn due to the first tax bracket, the tax-free threshold.
Adopting Mr Hockey’s analogy, someone who earns $200,000 annually actually spends the first five weeks of the year bludging off government services without paying any income tax.
For personal income, Australia currently has five tax brackets.
|Taxable income||Tax on this income|
|0 – $18,200||Nil|
|$18,201 – $37,000||19c for each $1 over $18,200|
|$37,001 – $87,000||$3,572 plus 32.5c for each $1 over $37,000|
|$87,001 – $180,000||$19,822 plus 37c for each $1 over $87,000|
|$180,001 and over||$54,232 plus 45c for each $1 over $180,000|
Not including 2 per cent Medicare levy.
Once you’re clear on the difference between marginal tax rates and the rate of tax paid it’s much easier to understand how the Turnbull Government’s full seven-year tax plan favours high income earners.
The fundamental nature of this system is that a change in the threshold or rates at the bottom also benefits those in the middle and at the top.
Phase one skewed towards middle and low earners
As widely acknowledged, phase one in July 2018 is directed at low-middle income earners, by introducing a four-year Low and Middle Income Tax Offset (LMITO) that affected taxpayers receive at the end of the year as part of their refund.
Because this is a targeted refund, it doesn’t feed through to high-income earners.
The only bracket change is a $3,000 increase in the threshold for the 37 per cent threshold to $90,000.
The combination of the two means individuals earning $90,000 a year are the biggest beneficiaries in dollar terms, at $665 a year.
But, even in phase one, higher income earners would benefit from this small change to the tune of $135 a year.
That’s because $3,000 of their income that was taxed at 37 per cent will instead be taxed at 32.5 per cent.
Phase two mainly benefits upper-middle and high earners
In phase two, starting from July 2022, the threshold for tipping into the 32.5 per cent tax bracket will be lifted from $37,000 to $41,000 and the threshold for the 37 per cent bracket will go from $90,000 to $120,000.
This doesn’t help low income earners, with those earning up to $35,000 still only getting the $200 a year in benefits they started off with in July 2018.
Likewise, middle-income workers earning between $50,000-$90,000, who lose the benefit of the LMITO, will only get an extra $10 a year benefit from this phase.
It is upper-middle and high-income earners who will see the biggest rewards flow through, with everyone earning from $120,000 a year upwards keeping an extra $2,025 of their pay from the taxman.
This highlights how a change in the lower tax thresholds benefit higher earners more — they receive tax cuts on their income between $37,000-$41,000 as well as their income that falls into the $90,000-$120,000 bracket.
Phase three only benefits upper-middle and high earners
Phase three, which would kick in on July 1, 2014, is the centrepiece of the plan and the biggest change to the current system.
It simply removes the 37 per cent tax bracket from the system, creating one giant middle tax bracket of 32.5 per cent for income between $41,000-$200,000.
That move doesn’t give any additional tax relief to anyone earning $120,000 a year or less, but gives a steadily increasing tax break for everyone above that level until it tops out at the new top tax threshold of $200,000 where the 45 per cent tax rate kicks in.
The biggest beneficiary of this is anyone earning $200,000 a year or more, who gets 4.5-cents-in-the-dollar tax relief on earnings between $120,001-$180,000 and a 12.5-cents-in-the-dollar tax cut on income between $180,001-$200,000, adding $7,225 a year to their take-home income.
Pros and cons of tax cut plan
Those are the facts, rather than the spin, of how the Government’s tax plan will change who pays what. But what will be the effects — the benefits and costs?
Even amongst experts, this is really a matter of opinion. So here are a few expert views.
Stephen Walters, chief economist, Australian Institute of Company Directors
- At the margin, reducing the tax burden may help support household spending, against a backdrop of record low wages growth.
- The system becomes simpler over time as the number of tax brackets shrinks from five to four.
- Full implementation takes too long — the final phase kicks in from 2024, at least two federal elections away.
- Abolishing the 37 per cent tax bracket means the personal tax system becomes less progressive over time.
Matt Grudnoff, senior economist, The Australia Institute
Pros: None given.
- The tax cuts will flow overwhelmingly to high-income earners with more than 60 per cent going to the top 20 per cent and 40 per cent going to the top 10 per cent of taxpayers. High-income earners will get an oversized tax cut, completely out of proportion to their incomes.
- This tax cut will drastically reduce the progressive nature of our income tax system, which will increase inequality. The World Bank, IMF and prominent economists around the world have shown that rising inequality reduces economic growth.
- The reality of “small government” is fewer services. Flat tax advocates, like the Tea Party in the US, also oppose universal access to government services like health and education.
- It is unfortunate that this tax plan is over seven years and not four. This means that three years of this tax plan are outside the scrutiny of the budget and we are unable to probably assess its cost. It is also problematic that the most expensive parts of the tax cut that go overwhelmingly to high- income earners start on the fifth year, just one year outside the budget forward estimates. This greatly reduces the transparency of these tax cuts.
The Australia Institute’s analysis of which income groups will benefit from the tax cut. (Supplied: TAI)
Matthew O’Donnell, senior economist, Centre for Independent Studies
- It is a fairer system in the sense that most taxpayers pay the same tax rate for each extra dollar they earn. Why should talented and hardworking individuals face increasing tax rates for providing their more valuable services to employers and consumers?
- It promotes economic growth as it provides the vast majority of middle-class Australians with the incentive to work more than previously.
- It reduces the impact of bracket creep. Increasing the size of the 32.5 per cent tax threshold means that the effect of rising inflation on the average tax rates faced by taxpayers is lessened. Fewer thresholds mean that each year there are fewer taxpayers whose incomes rise into a higher income tax rate threshold, which increases their average tax rates.
- Announcing tax changes four and six years in the future is largely meaningless, even if they are put into legislation now. The main changes are not due to take effect until after two more federal elections! Just imagine what could happen between now and then.
- If implemented the new income tax rates will be even more progressive as there is no change to the top tax rate. On the face of it this seems like a good thing, but it will increase the already increasing disconnect between those that pay net tax and those that don’t. The top 20 per cent of income tax payers currently pay about 61 per cent of all income tax, up from 53.9 per cent in 1996/97.
Australia has a high top marginal tax rate and low threshold compared to most countries. (Supplied: Saul Eslake)
Professor Robert Breunig, director, ANU Tax and Transfer Policy Institute
- We should welcome the move to give money back to taxpayers who have seen income tax increase as a percentage of their income over the past few years.
- Nothing has been done to address the problems with GST or the complexity of the system, or to reduce the number of taxes.
- Nothing has been done to address the many expensive exemptions and exceptions in the system, which are actually a bigger threat to fairness than the marginal rate structure.