Budget Forum 2018: This is not a Genuine or Equitable Way to Simplify the Personal Income Tax System

Scott Morrison has made much of his proposed tax changes, claiming that in the short term they will benefit low and middle income earners, and in the long term they will simplify the system and largely remove bracket creep. But much of this is sleight of hand, extending the misrepresentation of the tax scale that has bedevilled sensible discussion now for decades; and the apparent focus on low income earners will have disappeared by the time the longer-term proposals would be in place, when the biggest gains undoubtedly would be for high income earners.

Labor’s proposals can hardly be described as ‘reforms’ either, complicating the existing tax scale even more and failing to address bracket creep at all.

Complexity in tax offsets

The misrepresentation that has long existed comes from the way the tax threshold is presented. The following table shows how the current tax scale is most often publicly presented, and what I believe it really looks like if we take into account the low income tax offset (LITO)[1]:

2017-18 Personal Income Tax Scale

As publicly presented		As actually applies
Income range ($)	Marginal rate (%)	Income range ($)	Marginal rate (%)
0-18,200	0	0-20,542	0
18,200-37,000	19	20,542-37.000	19
37,000-87,000	32.5	37,000-66,667	34
87,000-180,000	37	666,667-87,000	32.5
Over 180,000	45	87,000-180,000	37
With LITO		Over 180,000	45

 

The actual scale above reflects the way the low income tax offset phases in, increasing the real tax threshold, and phases out above $37,000. (The real scale is even more complicated than shown here because of the Medicare Levy and, for seniors and pensioners, the Seniors and Pensioners Tax Offset (SAPTO) which raises their tax threshold to above the level of the pension).

The proposed 2018-19 scale will be much more complicated because of the new ‘low and middle income tax offset’ (LMITO). The following table shows what, to the best of my understanding from the limited information available, it will really look like compared to the official material in the budget papers:

Proposed 2018-19 Personal Income Tax Scale

As publicly presented		As would actually apply
Income range ($)	Marginal rate (%)	Income range ($)	Marginal rate (%)
0-18,200	0	0-21,594	0
18,200-37,000	19	21,594-37,000	19
37,000-90,000	32.5	37,000-48,000	31
90,000-180,000	37	48,000-66,667	34
Over 180,000	45	66,667-90,000	32.5
		90,000-120,000	38.5
With LITO and LMITO		120,000-180,000	37
		Over 180,000	45

 

This complex picture is because the new low and middle income tax offset is phased in from $37,000 and phased out from $90,000, while the existing low income tax offset still operates as now. Moreover, of course, the tax cut effected will only be available after the end of the financial year, as a lump sum rebate. The proposals deliver the cuts the political spin doctors want, but there is no genuine reform and certainly no simplification.

Labor’s scale for 2019-20 would arguably be even more complicated with its bigger low and middle income tax offset and the proposed sharper phasing out arrangements (raising the marginal rate further between $48,000 and $66,667). It might deliver tax cuts to those Labor wants to court, but at the expense of a complicated and opaque system with no clear policy merit. The proposals contrast with the reforms under Gillard and Swan when the low income tax offset was radically reduced and the real threshold made more transparent (the claimed increase in the threshold from $6,000 to $18,000 was almost entirely explained by the reduction in the low income tax offset, the actual increase being from just under $18,000 to just over $20,000).

The Government’s proposed 2024-25 scale would sensibly replace the new low and middle income tax offset with adjustments to the basic scale, but it also involves increasing the low income tax offset with new complex phasing out rules, and so is still much more complex than claimed:

Proposed 2024-25 Personal Income Tax Scale

As publicly presented		As would actually apply
Income range ($)	Marginal rate (%)	Income range ($)	Marginal rate (%)
0-18,200	0	0-21,594	0
18,200-41,000	19	21,594-37,000	19
41,000-200,000	32.5	37,000-40,000	25.5
Over 200,000	45	40,000-41,000	20.5
		41,000-63,000	34
With increased LITO		63,000-200,000	32.5
		Over 200,000	45

 

The scale would address bracket creep in part by modest adjustments to the tax points at $37,000 and $180,000. More importantly, it would remove entirely the 37% step now applying between $87,000 and $180,000, exceeding for many on higher incomes the adjustment needed for bracket creep. The claim that this represents radical reform is exaggerated, however, by decidedly odd steps that would actually apply between the tax threshold and $63,000 as shown above. It is far from the more standard rate of tax being claimed.

A simpler, more equitable tax system

The idea of a more standard marginal tax rate is not new; it could have merit not only in simplifying the tax system but in limiting the marginal tax rate most people face. It was not only advocated by the Henry Report but was in fact enacted in 1978 by the Fraser Government. But in both cases, it was associated with a very hefty increase in the tax threshold, which is by far the most important contributor to the income tax scale’s progressivity; such an increase could ensure an equitable distribution of any tax cuts.

Updating these two scales to 2018-19 would approximately lead to the following arrangements:

Henry and Fraser Scales updated to 2018-19 (approximates)

Henry Report scale		Fraser scale
Income range ($)	Marginal rate (%)*	Income range ($)	Marginal rate (%)
0-30,000	0	0-30,000	0
30,000-220,000	35	30,000-120,000	32
Over 220,000	45	120,000-240,000	46
		Over 240,000	60

*Includes the Medicare levy

The Henry and Fraser scales were explicitly designed to ensure the tax threshold was above the level of the pension, ensuring few if any maximum-rate pensioners paid income tax, and that those not on social security but with similar low incomes were similarly protected from paying income tax. The Fraser scale was also designed so that those on incomes up to and slightly over average earnings faced only the standard marginal tax rate if they worked extra hours; the Henry scale would achieve this for those on incomes over twice the average.

The Treasurer, however, proposes a very modest increase in the effective tax threshold in 2018-19, and no further increase over the following six years. There is a case for a standard marginal rate for the vast majority of taxpayers, but only if the tax threshold is increased a lot further. With a much bigger threshold, the need for a first marginal step of 19% would be questionable. Whether a standard rate should apply on incomes as high as $200,000 and above is arguable, however, notwithstanding Henry’s recommendation; a more modest increase in that step might lead to a fairer distribution of tax cuts.

Genuine reform would replace the low income tax offset (and not introduce a low and middle income tax offset), and it would involve instead a clear articulation of the real tax threshold and marginal tax rates, with an increase in the threshold and an extension of the 32.5% step in particular. Better still, the high threshold recommended by Henry and applying under Fraser would mean that there was no need for a Seniors and Pensioners Tax Offset either, as the basic threshold would be above the level of the pension. This would offer a much more coherent alignment of the tax and transfers system, not all that different to the one advocates of guaranteed minimum incomes look for, that might deliver appropriate progressivity across the tax and transfers system while retaining sensible incentives to work and save.

[1] The scale is also complicated by the Medicare Levy but merging this into the scale, as recommended by Henry, raises significant additional issues particularly concerning the impact of the Levy Surcharge on private health insurance membership.

 

More from our Budget Forum 2018 series:

Budget Forum 2018: A Missed Opportunity for Enhancing Australia’s Budget Transparency on Distributional Information by Teck Chi Wong

Budget Forum 2018: Targeting the Black Economy by Joel Emery

Budget Forum 2018: Tax Caps and Tax Cuts: Good for Australia? by Miranda Stewart

Budget Forum 2018: Risks Greater Than I Can Recall in My Working Life by John Hewson

Budget Forum 2018: Should Australia Produce a Citizen’s Climate Budget? by Usman W Chohan

Budget Forum 2018: The Future of Corporate Taxation by David Ingles

Budget Forum 2018: Cuts to Personal Income Tax – A Mixed Bag by Robert Breunig

Budget Forum 2018: A Political Budget Unlikely to Work Politically by John Hewson

Budget Forum 2018: The Government Could Be Boosting the Budget Bottom Line with a Change to How It Taxes Gas by Diane Kraal