Without any change in personal income tax rates or thresholds, the tax burden will increase substantially and many more taxpayers will face high marginal rates over the next few years.
The adverse economic impact of personal income tax is already high and is set to rise further if these trends go unchecked.
Increasing the thresholds for some or all marginal tax rates to match past growth in average earnings would alleviate the effects of bracket creep. While this has been the typical policy response in the past, it is a band-aid rather than a reform.
Genuine reform would include cuts in marginal rates – including the top rate — and automatic indexation of thresholds to prevent future bracket creep. This approach would provide a long-run supply-side boost to economic growth. A good long-term goal should be a maximum marginal rate of 35%.
Concerns about the ‘fairness’ of such an approach are misplaced. The trend has been for personal income tax to become more, not less, redistributive notwithstanding tax cuts since the 1990s. It is not clear why the system needs to be made more progressive, but that is the implicit judgment behind much recent commentary on tax issues. Indeed, reforms that make the system less progressive should be considered if there is a clear economic pay-off.
Cuts in marginal rates must be reconciled with budget repair. While cuts in marginal rates would help finance themselves in time by providing a boost to economic growth, the initial cost to revenue would be large. Even a medium size tax cut faces this dilemma. It is best resolved by more disciplined management of public expenditure.