Bracket creep, or fiscal drag, is the result of a progressive tax system. It encapsulates the idea that over time people pay more tax on average due to inflation.
In one sense, that's a good thing: it raises revenue and is the major contributor to fiscal repair. To put that into context, of the total budget repair in the four years of the forward estimates following the 2014 budget, the majority arose from bracket creep. By contrast, the Temporary Budget Repair Levy, which provided an additional 2 percent levy on taxable income for taxpayers earning above $180,000 for 3 years, repaired the budget by just 3 percent.
Yet this does not alter the fact that bracket creep is inequitable. Not only does it increase the absolute burden of taxation in real terms, it changes the relative burden of taxation among taxpayers. It hurts those on a lower income most because the loss of real income in the form of additional tax represents a higher percentage of their income.
Bracket creep is also hidden by and large. In fact, most Australians do not know it is there. The budget does not publicise it (economists are left to do that); nor is it directly dealt with by the government. At best, it is indirectly addressed through 'tax cuts' which tend to be framed as other policy initiatives in any case.
There are a number of possible solutions. Several countries, including the United States, Canada and Switzerland, index their thresholds to either prices or wages. However, while this approach was mooted in Australia, ultimately it was abandoned.
People generally view what is fair and equitable based on 'what most people are getting'. With this in mind, we believe the best way to address bracket creep is to use the average full time earnings (AFTE) – currently sitting at $80,000 – as a significant measure.
On this basis, we would suggest four tax bands. The first tax band would be from nil to one-third of AFTE, currently about $27,000, and set at a rate of 15 percent. The second band would be between one third and AFTE – that is, $27,000 and $80,000 – and set at 25 percent. The third band, meanwhile, would apply from AFTE to twice AFTE, currently $80,000 to $160,000, and would be set at, say, 35 percent.
Finally, the contentious top band would apply from twice AFTE, currently $160,000, and potentially be set at a rate of 45 percent – reflecting the general consensus that it should be somewhere between 40 and 50 percent.
This approach, in effect, drops the tax free threshold – a proposition that might cause initial concern. However, protection for low income earners would be assured through greater use of the Low Income Tax Offset (LITO) and a new Work Incentive Tax Offset (WITO). The settings and taper rates for both would have regard to the other changes.
WITO, which would sit on top of LITO, would offer the additional benefit of encouraging greater participation in the workforce among the low incomes, generally second incomes, in a family. The hope is that this would assist in increasing female participation.
While these proposals represent sweeping changes to our personal income tax, they make good sense. There is a simplicity to this system which is attractive. It is also fair. Yet doubtless it will take considerable political conviction to get it over the line.
Read more about KPMG's submission to Treasury.
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