Bracket creep is as maligned as it is misunderstood. Indeed, it can even be a good thing. But while most people probably know that bracket creep refers to people getting tipped into higher marginal tax rates as their wages rise, few seem to realise that there is good bracket creep and bad bracket creep. But before I explain the different causes of bracket creep it’s important to understand why some economists think it’s such a big deal, and why some don’t.
[This article was published first in the Australian Financial Review – here]
In Treasury’s highly simplified model of the labour market it is the after-tax income that determines whether we work or not, and how many hours we work. The higher the after-tax wage rate, the more we work which means, by assumption, we all work more after a tax cut. It’s a neat little theory but it doesn’t cope very well with the mess of reality.
In theory, when our income tips into a higher tax bracket, and our after-tax income for our last hour of work falls, we all want to work fewer hours or quit our jobs altogether. Read that sentence a few times if you must and then ask yourself: do you know anyone who was earning $86,000 per year and paying the 32.5 per cent tax rate who got a raise of $4000, walked into their boss’s office and declared that now that they faced a 37 per cent marginal tax rate they now wanted to work four days per week? Or have you ever met someone who responded to a similar pay rise by saying “stuff it, at 37¢ in the dollar on my last $3000 of income I think I’ll just quit”?
Marginal tax rates can, and do, affect people’s willingness to work, but the problem occurs mainly at the bottom of the income distribution, not the top end where Scott Morrison is focused. That is, while few full-time workers respond in any way to small changes in marginal tax rates, there is evidence that parents deciding how many days per week, if any, to work after their children are born pay much closer attention.
Part-time workers in receipt of income support not only face a marginal tax ratebut they lose welfare benefits as their income rises. The result can be an “effective marginal tax rate” of over 100 per cent. Put another way, the more they work the less they get. These “poverty traps” are particularly inefficient and inequitable, but Scott Morrison’s plan to “fix bracket creep” will do nothing to fix it where it matters. It’s as if he’s just using bracket creep as an excuse to deliver tax cuts to high-income earners.
Which brings me back to the two different types of bracket creep. Imagine there was no productivity growth but 2 per cent inflation and 2 per cent wage growth. Despite the fact that real wages weren’t rising, a growing proportion of people would wind up in the highest tax bracket even though their real wages were falling not rising. That would be bad. But with record low wage growth and inflation, now is hardly the time to panic about bracket creep.
What’s the problem?
Now imagine there was no inflation and real wages were rising by 2 per cent per year in line with productivity growth. As people’s wages grow some of them would be lucky enough to wind up in the top tax bracket. Why is that a problem?
As real wages grow people can afford to buy more and more stuff and there is no economic reason that as a country gets richer it can’t decide to buy higher quality health, education, aged care and public transport services.
Similarly, with rising real wages, and rising numbers of very-high income earners, if we keep cutting marginal tax rates to ensure Scott Morrison’s arbitrary 23.9 per cent government revenue cap is met, then someone earning $300,000 per year in 2030 will pay a lot less tax than someone earning $300,000 today. Just why we should cut spending on services to boost the after-tax incomes of high-income earners in the future has never been explained by the Treasurer.
Put simply, the only good thing about the fact that CEO pay is rising much faster than everyone else’s pay is that we can collect more tax. Does anyone believe that CEOs will quit corporate life if we don’t cut their tax rate?
Richard Denniss is the chief economist at The Australia Institute @RDNS_TAI