While the budget did not announce any much-needed tax reform, it does have two noteworthy aspects from a medium-term perspective. First, it introduces the re-designed version of the stage 3 tax cuts that was announced in January. Second, it continues a long pattern of fiscal stimulus. I discuss both of those aspects in turn.
Stage 3 personal income tax cuts
Table 1 compares three alternative tax scales for 2024-25 and beyond. Without any stage 3 tax cut, the tax scale for 2023-24 would have continued to operate (“No Stage 3”). The stage 3 tax cut was originally proposed and legislated in by the Turnbull Government (“Old Stage 3”). In January 2024, the Albanese Government proposed an amended stage 3 tax cut and included it in the 2024-25 budget (“New Stage 3”).
Table 1: Personal income tax scales
The new Stage 3 tax cut has a similar fiscal cost to the Old Stage 3 tax cut as they both return bracket creep. However, they return bracket creep in different ways. Compared to the Old Stage 3, the New Stage 3 gives a larger or smaller tax cut depending on whether your taxable income is under or over $146,482. Hence, the New Stage 3 tax scale is more redistributive than the Old Stage 3 tax scale. Figures 1 to 3 take a closer look at how the three alternative tax scales affect the tax burden, tax disincentive effects and income redistribution.
Figure 1 expresses the tax burden as the effective average tax rate. Comparing the three alternative tax scales, both the Old and New Stage 3 reduce the average tax rate to about 23% in 2024-25, the same as its historical average in the first two decades of this century. Effectively, this returns the proceeds of bracket creep. Without a “tax cut”, the average rate of tax would have reached 25% in 2024-25.
Looking ahead, bracket creep is projected to lift the average tax rate back to 25% by 2028-29 (Figure 1). Thus, without indexation of the tax brackets, a similar-sized “tax cut” would again be needed then to return the proceeds of bracket creep.
Figure 1: Personal income tax burden, effective average tax rate
Note: In Figures 1-3, the historical average is calculated over the period 2000-01 to 2019-20.
Figure 2 represents the tax disincentive effects of the personal income tax system using the effective marginal tax rate, calculated as an income-weighted average across taxpayers. The New Stage 3 reduces the effective marginal tax rate from 37% to its historical average of 35%. The Old Stage 3 reduced it by more to 34%, aiming to reduce tax disincentive effects.
Figure 2: Personal income tax disincentives, effective marginal tax rate
Note: the effective marginal tax rate is an income-weighted average across taxpayers.
Figure 3 represents the income redistribution effects of the personal income tax system using the Reynolds-Smolensky Index (RSI). The RSI is based on the Gini Index of income inequality. It is calculated as the Gini Index for pre-tax incomes less the Gini Index for after-tax incomes. In the first two decades of this century, the RSI has varied in a narrow range between 0.063 and 0.073 and has averaged 0.069.
In 2024-25, the New Stage 3 leaves the RSI almost unchanged from 2023-24, down from 0.065 to 0.064. Under the Old Stage 3, it would have fallen to a century-low of 0.058 (Figure 3), meaning the personal income tax system would have become significantly less redistributive.
Figure 3: Personal income tax redistribution of Income, Reynolds-Smolensky Index
Note: The RSI is calculated by applying the tax scale for each year to the 2020-21 distribution of pre-tax income, re-scaled for movements in average earnings. This is known as the fixed income method for calculating the RSI. It aims to capture the intrinsic redistributive capacities of the tax scale, free of the effects of year-to-year variations in the shape of the distribution of pre-tax incomes.
Overall, the New Stage 3 broadly keeps the characteristics of the personal income tax scale close to historical norms. The tax burden, the effective marginal tax rate and the extent of income re-distribution, in the ways measured in Figures 1-3, are all close to historical averages for the period 2000-01 to 2019-20.
The Old Stage 3 chose a different point in the trade-off between efficiency and equity. The effective marginal tax rate was reduced by more (Figure 2) but with less redistribution of income (Figure 3). This trade-off between efficiency and equity involves value judgments that are appropriately made by elected governments.
Interestingly, the redistributive effect of the personal income tax system has remained fairly stable over time (Figure 3). This has continued under the New Stage 3, whereas the Old Stage 3 would have represented a significant shift to less redistribution.
By lowering the effective marginal tax rate, the Old Stage 3 would have reduced disincentive effects on saving and the effective labour supply, improving economic efficiency but lowering equity.
In comparing the New Stage 3 with the Old Stage 3, Treasury includes a narrow discussion of efficiency effects. It considers the effects of the personal income tax scale on labour supply, but not on saving.
In considering the effects on labour supply, it discusses average tax rates, which matter at the extensive margin, but not marginal tax rates, which matter at the intensive margin (The extensive margin refers to the number of workers, whereas the intensive margin refers to how many hours that each works). Finally, in aggregating the effect on labour supply across workers, it does not take into account differences in output/wages per hour between workers. In a fuller analysis, it would find that the Old Stage 3 was better for efficiency than the New Stage 3.
We would also need to consider the role of social security payments alongside that of the personal income tax system. Taking both into account would show bigger redistribution effects as well as bigger economic inefficiencies. Again, the trade-off between efficiency and equity is for elected governments to decide.
Fiscal Policy
In the 2024-25 budget, fiscal policy continued its post-COVID pattern of being mildly expansionary.
Figure 2 shows the net cost to the budget (over the forward estimates) of policy measures announced in each calendar year from 2019. Following the massive COVID fiscal stimulus of $429 billion announced in 2020 and 2021, in each of the three post-COVID years there has been mild fiscal stimulus of under $50 billion. The figure for 2024 of $24 billion includes the 2024-25 budget, but not further measures that may be announced over the remainder of the calendar year.
Figure 4: Net cost of policy measures over forward estimates
Source: Budget Papers
Fiscal tightening would have been more appropriate in the post-COVID period. That would have supported monetary policy, thus reducing the extent of rises in interest rates and inflation.
Over the last six years, federal governments have implemented fiscal expansion when it is needed, but not fiscal tightening when it is needed. A continuation of that approach would mean that government debt ratches up until it becomes unsustainably high, and we experience higher interest rates and potentially higher inflation than other advanced economies.
This evident asymmetry in how federal governments are prepared to conduct fiscal policy should be taken into account in the advice they are given in the future. Ideally, stimulus packages would include measures to fully fund them after the downturn, over the medium term. Alternatively, the amount of fiscal stimulus that is recommended in downturns would be scaled back.
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