Stage 3 tax cut options the Albanese government could consider

The previous Coalition government did a good job of cornering the then-opposition into supporting its tax cut package, assisted by a Labor Party all too willing to hide in the corner after fighting and losing an election on taxes in 2019.

After voting in favour of the tax cuts, Labor doubled down in its 2022 election campaign by committing to keep them if elected.

While the thought balloon of tweaking them has been flown a couple of times through media backchannels, it has been lowered just as quickly.

So is the latest speculation around changes to stage 3 just that, or is the Albanese government about to bite the bullet and alter tax cuts that mainly go to higher income earners with absolutely nothing for Australia’s lowest paid?

Loading…Bracket creep returned … for the well-off

The chief argument for the tax cuts from many economists is that they are simply unwinding the effects of bracket creep.

That’s where more of people’s income falls into higher tax rates as inflation pushes both their salaries and cost of living up, but not the tax brackets, which aren’t indexed.

Steven Hamilton, an assistant professor of economics at George Washington University who specialises in taxation, says that’s why raising the income threshold for the 45 per cent tax rate makes sense.

“The top threshold has not increased in 16 years, which means it’s fallen substantially in real terms, drawing more and more workers into the top bracket,” he told me.

“The change does not offset 16 years of inflation.”

Steven Hamilton says two-thirds of stage 3 make sense, but one change is “difficult to rationalise”.(Owen Jacques, ABC News.)

He is also positive about another element of stage 3.

“Similarly, reducing the 32 [per cent] rate to 30 lowers marginal rates right in the middle of the income distribution where most workers are, maximising the positive incentive effects given the fiscal cost.”

However, Hamilton says one element of stage 3 simply gives higher income earners an extra boost, with no good economic justification.

“Lowering the 37 [per cent] rate to 30 is a lot harder to defend,” he argues.

“It costs roughly the same amount of money, but improves incentives for a tiny fraction of the workers.

“It is very difficult to rationalise having a flat rate all the way from $45k through to $200k. I can’t think of any leading public finance experts who would agree this is a good idea.”

So, while high income earners receive compensation for bracket creep, the stage 3 tax changes don’t compensate middle income earners enough or low income earners at all.

Gareth Hutchens and I wrote a piece explaining this about 18 months ago.

The numbers are easy to crunch and clear for all to see.

While a high-income worker with an annual taxable income of $200,000 will save $9,075 a year from stage 3, someone closer to average full-time earnings, say a teacher on $98,000 a year, will keep an extra $1,325 of their income.

The person who makes their coffee or cleans their car, on $45,000 a year, gets precisely nothing. That’s right, $0 a year.

Those in favour of the tax changes point out that those lower income workers have already received tax savings worth $1,080 a year from stages one and two of the tax package.

They also point out that high earners pay a much larger proportion of their income in tax, which is true but also an essential feature of a progressive tax system — that’s where those who have a greater capacity to pay contribute more, as opposed to a flat tax system where everyone just pays the same rate.

Assuming the government has decided that it wants to spread out the benefits of stage 3 so that “everyone” gets a tax cut, how might they go about it?

Juggle the top and bottom tax thresholds?

Treasury will be busy crunching the numbers around any government proposals.(ABC News: John Gunn)

One speculation in sections of the media would be to not increase the threshold for the top 45 per cent tax rate from $180,000 to $200,000 as currently legislated.

Instead, the money saved could increase the tax free threshold — the amount you’re allowed to earn at a 0 per cent tax rate.

Independent economist Chris Richardson reckons the government could afford to lift it from the current $18,200 to $19,500 without raiding the budget bottom line.

That would give everyone who earns more than $19,500 and less than $180,000 a year an annual tax cut of $247.

Associate professor Ben Phillips, an economist at ANU, says the tax free threshold could be raised further to an even $20,000 at a $2 billion cost to the budget, which would bump the tax cut to $342.

Associate professor Ben Phillips is an economist at ANU who specialises in modelling household finances and economic policies.(ABC News: Ian Cutmore)

The only people who’d lose out are those earning over $180,000 a year, who would still be paying 45 per cent tax on all their income over that level.

Phillips says someone on $200,000 a year would miss out on $2,658 of tax cuts through this change.

But, remember, they’re currently in line for a $9,075 a year tax cut, so their tax bill would still fall by more than $6,400 a year from July 1.

In part, that’s because they also get a (relatively small) benefit from a higher tax free threshold.

“When we have a limited fiscal and inflationary envelope, and we are concerned that those on low incomes need additional support, it would seem a strange policy solution to hand $250 to almost every taxpayer,” says Hamilton.

“An alternative, which is far more targeted, would be to boost the Low Income Tax Offset (LITO), which currently provides $700 per year to those earning $37,500 or less, tapering down with higher incomes until it’s phased out at about $66,667.”

Although, being an offset, taxpayers don’t receive it until after the end of the financial year, when it is applied to their tax return.

Keep the 37 per cent tax rate

Another option, more popular with many economists, is to keep the 37 per cent tax rate, which currently applies to each dollar earned between $120,001-$180,000 and is set to be abolished completely by stage 3.

Steven Hamilton earlier said it would be “unforgivable” for the government to tinker with stage 3 but without retaining a 37 per cent tax bracket.

“It creates a huge cliff between the 30 per cent and 45 per cent rates at $200,000 and delivers truly massive tax relief to a small number of people.”

Greg Jericho from Centre for Future Work at The Australia Institute think tank agrees.

Greg Jericho is chief economist at the Centre for Future Work.

“The biggest problem with the stage 3 tax cuts is the removal of the 37 per cent marginal tax rate — a tax cut that provides nothing to anyone earning less than $120,000 and yet which accounts for more than a third of to total cost of stage 3.”

If the government kept the 37 per cent tax bracket, but raised the threshold from $120,000 to $150,000 and maintained the current plan to lift the top 45 per cent tax rate threshold to $200,000, Ben Phillips said that would generate enough savings to almost completely fund an increase of the tax-free threshold to $20,000.

“It’s not budget neutral, but it costs about $850 million,” he told me.

Economists at the Grattan Institute modelled the same proposal, and found an even smaller budget cost, with the change actually becoming budget positive by the third year.

As for how it would affect individuals, Ben Phillips said it redistributes income from higher to middle-income households, compared to the current stage 3 plan.

“The top income quintile would on average be worse off by about $800 a year, whereas the third quintile and fourth quintile were both ahead by about $470 per year,” he said.

“So it still tends to give more money to middle income families, but it does hit the higher income families more substantially.”

Using our previous examples of someone on $45,000, $98,000 and $200,000 a year, this change would make the lower and middle income earner both $342 a year better off than under the currently legislated stage 3 plan and the high income earner $3,158 worse off.

Overall, if stage 3 looked like this, from July 1 our worker on $45,000 would be $342 better off, our middle-income $98,000 worker would keep an extra $1,667 of their earnings, while our $200,000 a year worker would still save $5,917 in tax compared to this financial year.

The Grattan Institute also modelled keeping the 37 per cent tax rate for income between $140,001-$200,000.

That would improve the budget bottom line by more than $4 billion over the next four years compared to the stage 3 tax cuts as currently legislated, but at a slightly heavier cost to high income earners — someone on $200,000 would save a mere $5,217 from their tax bill next year.

Use tax savings to increase welfare spending

However, the Grattan Institute’s preferred option is simply retaining the 37 per cent tax bracket for incomes between $120,001 to $200,000, which would raise an estimated $8.5 billion next financial year.

“The $8 billion a year in savings could be used to provide more targeted cost-of-living relief than a broader increase in the tax free threshold,” says Grattan’s program director for economic policy, Brendan Coates.

Brendan Coates is the economic policy program director at the Grattan Institute think tank.(Supplied: Grattan Institute )

“Such as raising Rent Assistance by another 22 per cent, or roughly $1,000 a year ($1.2 billion a year), and raising JobSeeker and other working-age allowance payments by a further $55 a week (around $3.5 billion a year) and still reduce the total outlay.”

Low income workers still wouldn’t see a tax cut under this proposal, middle income workers up to $120,000 a year would see their tax cut unchanged ($1,325 for our $98,000 a year worker), but our $200,000 a year worker would see their stage 3 tax cut slashed from $9,075 to $3,475.

Coates says pocketing some budget savings from any tweaks to stage 3 would offset the inflationary effects of giving more cost-of-living support to low income households.

“Any cost-of-living relief package needs to be designed to minimise the risk of further stoking inflation, especially since support for low income earners is more likely to be spent, and therefore add to inflation.”

ANU’s Ben Phillips agrees that the 37 per cent tax bracket should be retained, with some of the proceeds spent to enhance welfare payments.

“A lot of retirees, pensioners, jobseekers, those on disability support pensions, carers, single parents, these sorts of people and families would receive not much from tax cuts, because they’re not paying personal income tax in the first place,” he says.

“The welfare system is there to help people who are in need, and it’s probably not doing good enough, particularly for jobseekers, single parents and low income renters, and we need to do more work there.”

Whatever option the government chooses, Greg Jericho says it’ll be an improvement on what the Morrison government legislated.

“So massively skewed are the stage 3 tax cuts to the top 10 per cent [of income earners] that there are many ways to change them that would give 80 to 85 per cent of taxpayers a bigger tax cut than they would under the current stage 3 and yet spend up to $130 billion less over 10 years,” he argues.

Although the government’s decision about which, if any, of those reform options to adopt will likely be as much about the politics as the economics … and those 10 per cent are a very loud and powerful group.