Bracket-creep: What is it?
There’s a lot of talk around at the moment focussing on the need to eradicate bracket-creep. Just a couple of weeks ago, the Treasurer Joe Hockey claimed that bracket-creep is a disincentive for hard work: “Why should the reward for hard work and endeavour be swallowed up by higher taxes?”, he asked.
So, what is bracket-creep?
The phenomenon arises where static tax rates and thresholds gradually pull more people into higher tax brackets simply through the impact of rising wages and inflation. Some 300,000 people are expected to be dragged into the second-highest tax bracket over the next two years and overall the government is forecast to fill its coffers to the tune of $25bn in extra income tax receipts over the next four years unless something is done to end bracket-creep.
Let’s look at some numbers to show how bracket-creep can affect us all.
Say I’m on a salary of $75,000. My top marginal tax rate is 32.5%, which is the rate that applies up to $80,000. Let’s say that the $80,000 threshold remains fixed but over the course of a few years, I enjoy an annual pay rise of 3% each year.
After receiving my pay rise in year three, I now earn more than $80,000 which means that my top marginal tax rate is now 37%. But that higher tax rate only applies to my income over $80,000. So on that income only, I’m now paying tax at the second highest rate of 37% (the income below $80,000 is still taxed at the lower rates).
The argument is that this is unfair because I’m still doing the same job, I haven’t received a promotion but because the government hasn’t changed the tax rates or thresholds, I’m now paying tax at a higher rate on part of my income.
If nothing is done, the problem compounds over the years. Each year, my 3% pay rise takes my earnings further into the $80,000+ tax bracket, so an ever-increasing proportion of my income is taxed at the higher level.
How can bracket creep be stopped?
There are really two solutions:
- Index the thresholds by one of the measures of inflation so that they are automatically increased on an annual basis. That way, even though I get a pay rise every year, the thresholds also go up so in theory I should never move into the higher tax bracket (unless I get a promotion with a big salary increment to recognise my increased responsibility). This is the solution H&R Block recommended in our submission to the government’s tax reform process earlier this year (read our full submission at http://bettertax.gov.au/files/2015/06/HR_Block_Australia.pdf)
- Alternatively, cut the headline rates of income tax every few years so that the dollar amount of tax paid remains broadly the same for a given level of income, even though the thresholds themselves don’t move. This appears to be the preferred option of the government.
Later this month, the Treasurer will be joining his opposition counter-part and a host of tax experts at a National Tax Reform summit in Sydney and no doubt bracket creep will be on the agenda for discussion. H&R Block will be there and we’ll keep you informed of developments.