Inflation must be in the tax review

Instead of thinking up new ways to extract more tax dollars from our pay packets, the Abbott government should turn its attention to stopping the dreaded bracket creep, which does the job by stealth.

The Howard-Costello era tax cuts dealt a blow to personal income tax bracket creep for a while, but the issue has now returned to the fiscal policy agenda like a disease that cannot be eradicated.

In reality, though, it can be eradicated in one fell swoop if the federal government institutionalises indexation of personal income tax thresholds for inflation. Indexation is not yet on the agenda but should be considered by the tax system review foreshadowed by the Abbott government.

Automatic indexation, which operates in several countries, could be implemented by legislating with indefinite effect to increase the thresholds for each marginal tax rate from July 1 each year by the annual increase in the consumer price index. This year, for example, the first and second thresholds would go up by $528 and $1073 respectively (to $18,728 and $38,073), resulting in a saving of about $300 a year to the average wage-earner.

Six dollars a week may appear trivial, and indexation may be thought of as a relic of a bygone era of high inflation, but the cumulative effects of bracket creep remain substantial and are best nipped in the bud each year rather than being allowed to build up.

It is these cumulative effects that led Treasury to project (in secretary Martin Parkinson’s speech on April 2) that 10 years of bracket creep would lift the average wage-earner’s effective average income tax rate from 23 per cent to 28 per cent — an increase of almost one-quarter without so much as a stroke of the legislative pen.

Without indexation, taxpayers’ average tax rates will increase even if their income goes up by no more than the inflation rate, as an increasing proportion of their income falls into higher tax brackets. Contrary to popular belief, this happens whether or not one’s income moves into a higher marginal-rate bracket.

Australia experienced a version of personal income tax indexation in the 1970s, but the experiment didn’t last long before there was a return to the old routine of raking in the proceeds of bracket creep, then giving some of it back through periodic discretionary “tax cuts’’. The Fraser government introduced indexation in 1976 as part of its initial attraction to the idea of small government, but soon diluted it by discounting and then arbitrarily halving the CPI for indexation purposes.

It was abandoned altogether after six years, during which time the cumulative indexation of thresholds was less than half the increase in the CPI.

The Fraser government, like others, found indexation inconvenient because it took away the budget flexibility that the extra revenue from bracket creep provides. Bracket creep builds automatic tax increases into the system, with no announcement and no legislation required. Looked at that way, its appeal to governments is not surprising.

It supercharges revenue growth and makes leviathans’ life easier. That’s why any government will be reluctant to institutionalise indexation and eradicate bracket creep unless it is put under pressure to do so by an independent review.

An indexation regime focuses discretionary policy more on where it should be, namely marginal tax rates, and less on thresholds. It is also more conducive to restraining the growth of government spending because there is less automatic revenue growth to be spent. It is likelier to force policymakers to consider discretionary tax increases to finance new spending and, therefore, make them think twice about it.

One of the myths to have stuck to the Howard-Costello tax cuts is that marginal rates were slashed — trimmed yes, but slashed no. Most of the action took the form of discretionary increases in the marginal-rate thresholds. Although very large, they have been the only threshold adjustments in more than 20 years, and as such have to be set against 20 years’ inflation. They are now being steadily eroded by inflation.

Personal income tax is not the only tax to be distorted by inflation. The budget proposal to reinstate the automatic indexation of fuel excise aims to correct one such distortion. Yet it is inconsistent to index excise duties but not income tax brackets — a combination that rigs the system in favour of more revenue.

The interaction between inflation and the tax system is a subject ripe for examination by the federal government’s forthcoming tax review.

Robert Carling is a senior fellow at The Centre for Independent Studies.