Income tax plan not last word on reform

In selling its personal income tax cuts to voters, the Morrison government stressed that their plan – once fully implemented in 2024 – would result in 94 per cent of taxpayers facing a marginal tax rate of no more than 30 per cent.

Similar claims have been made for tax cuts in the past. Announcing the 1998 New Tax System package of reforms that included both the GST and large personal tax cuts, then treasurer Peter Costello foreshadowed that the cuts would result in 81 per cent of taxpayers facing a marginal rate of no more than 30 per cent.

Neither claim was strictly true, as the highlighted marginal rate of 30 per cent did not include the Medicare levy (then 1.5 per cent, now 2 per cent). Leaving aside that quibble, there was no reason to doubt Costello in 1998 or Frydenberg in 2019. But by last year, Costello’s 81 per cent had shrunk to 22 per cent and was projected to dwindle further to 16 per cent by 2024 without any tax cuts.

Treasurer Josh Frydenberg is hoping shoppers use their tax refunds to funnel their cash back into the economy. Alex Ellinghausen

The personal income tax system has been going around in circles, fighting the same battles and reclaiming the same ground over and over.

How did this happen, and is the Morrison/Frydenberg plan destined for the same fate – even assuming it survives the next five years unscathed by the exigencies of politics? Does income tax reform simply go around in circles, fighting the same battles and reclaiming the same ground over and over?

There has been a great deal of change in personal income tax over the past 30 years or so, including a reduction in the top rate in steps from 61 per cent to the current 47 per cent (Medicare levy included). No government did more than Howard/Costello to lower personal income tax. Some of this was structural change that remains in place today.

But to an important degree the personal income tax system has indeed been going around in circles, fighting the same battles and reclaiming the same ground over and over.

The most important reason Costello’s 81 per cent became 22 per cent was that a successor Labor government under treasurer Wayne Swan lifted the 30 per cent rate to 32.5 per cent in 2012.

That was a complicated manoeuvre, designed to offset – for higher income earners – a large increase in the tax-free threshold, which in turn compensated for the carbon tax. The carbon tax was then ditched, but the income tax tweak remained. But however it came about, the fact remains that 30 per cent became 32.5 per cent.

No matter how many voices warn of the damage from increasing marginal rates, there is no way Frydenberg’s (distant) future 30 per cent rate can be insulated from such reversals. Labor seems reluctant to stick to it.

But even if 30 per cent holds, the proportion of taxpayers subject to it (or less) will start to dwindle from day one – thanks to bracket creep.

Those moving from the 19 per cent bracket to the 30 per cent bracket will not erode Frydenberg’s 94 per cent, but those moving from 30 per cent to 45 per cent will.

One way to stop Frydenberg’s 94 per cent being frittered away is to institute automatic annual indexation of the new income tax thresholds

There are two ways to stop this from happening. The most dramatic is to put everyone on a top marginal rate of 30 per cent. The current legislated tax plan will eliminate the 37 per cent bracket, leaving one more bracket above it – 45 per cent from $200,000 – elimination of which would deliver a truly low, flat marginal rate structure. It would also align the top personal rate with the top company tax rate.

Such a reform was once seriously discussed, but has gone out of fashion in this era of heightened political sensitivity to inequality. Nobody currently in government would be willing to carry the flag for a 30 per cent top rate, but the future is another matter. After all, who would ever have thought in the 1970s that a Labor government would soon take the first and biggest step in cutting the absurdly high 61 per cent rate?

Such ideas need to be planted early in preparation for more favourable conditions. In the meantime, at least a reduction in the top marginal rate should be on the agenda, and it was pleasing to hear Bill Kelty – the former union leader and facilitator of the 1980s reforms – this week advocating just that.

The second way to stop Frydenberg’s 94 per cent being frittered away is to institute automatic annual indexation of the new income tax thresholds once they are in place – and preferably to average wages and not just the CPI. This would be a modest step – particularly in an era of low inflation –and is already practised in a number of other countries.

Our governments have, however, been reluctant to revisit it after a brief experiment by the Fraser government in the 1970s – preferring the flexibility to announce tax cuts out of the proceeds of accumulated bracket creep.

The Morrison government’s phased changes represent a major improvement, but are by no means the last word on income tax reform. Cutting the top marginal rate and indexing thresholds are just two elements of a reform agenda that needs to be pushed forward over the years ahead.

Robert Carling is a Senior Fellow at the Centre for Independent Studies.