John Quiggin looks at the longer term trend in average tax rates
DURING the 1980s and 1990s, governments faced chronic difficulties in meeting growing demands for public expenditure on a wide range of services, while experiencing weak growth in revenue and fierce resistance to any increase in taxation (the ‘tax revolt’). The problem was referred to in academic circles as ‘the fiscal crisis of the state’.
In response to these problems, governments adopted a pattern of fiscal policy geared to the electoral cycle. The first budget after an election, particularly an election involving a change of government, was always a tough one, with election promises being discarded, expenditure programs cut and a focus on reducing the budget deficit. Although income tax rates were never increased the operation of bracket creep (discussed below) ensured an automatic increase in the average rate of taxation. If the first-year cuts were successful in restoring balance, the government sought to maintain this position in its second year, before offering tax cuts and new expenditure in its election-year budget.
After nearly fifteen years of steady economic expansion, the federal government has finally reached a point where it has more than enough revenue to meet its expenditure needs. As a result, the Howard government has reverted to a more traditional electoral-budget cycle. The budget before the election, and the promises made during the election were aimed at securing the support of swinging voters in marginal seats. The post-election budget is designed almost exclusively to reward the government’s core supporters, those on incomes well above average weekly earnings.
This point is clearly illustrated by last week’s budget. Those on less than $55,000 per year received only a $300 tax reduction, which is supposed to cover both 2005-06 and 2006-07. This is about nine months worth of bracket creep for someone on $40,000 a year. By contrast, those on higher incomes not only receive large tax cuts but benefit from the abolition of the superannuation surcharge.
In view of the political calculations that go into any individual budget, it’s more useful to look at the change in average rates of income tax over the Howard government’s period in office. Before considering this, it is necessary to look at the idea of bracket creep, which actually refers to two distinct effects of a progressive tax system. As nominal incomes rise, the operation of a progressive tax system ensures that the proportion of income collected in income tax rises steadily. This phenomenon is actually two effects in one. Real bracket creep arises when real economic growth raises average incomes. From a public finance point of view, some real bracket creep is desirable, because, as income rises, so does the demand for the kinds of goods and services usually financed by governments, such as health, education and law and order. Real bracket creep ensures that this demand can be met. Nominal bracket creep arises when money incomes are pushed up by inflation, and is definitely a bad thing. With no real change in their circumstances, workers face increasing rates of tax.
During the 1970s and 1980s, nominal bracket creep was dominant, since growth in nominal incomes was primarily driven by inflation. Since the early 1990s, however, inflation rates have been low, and real bracket creep has been about as important as nominal bracket creep. To assess the effects, it is best to look at the average tax rate faced by taxpayers on different multiples of average weekly earnings. Tables 1 and 2 give a comparison between the 1996 scales and those that will apply in 2006, when the second round of the budget tax cuts is phased in.
Single taxpayers on average weekly ordinary time earnings faced an average income tax rate of 22.8 per cent in 1996, and that will be pretty much unchanged at 22.2 per cent when the second stage of the budget tax cuts are phased in in 2006. Since the GST has come in in the meantime, raising more revenue than the indirect taxes it replaced, we can conclude the tax rate for this group has risen. Also, since the mean exceeds the median, this shows most single wage-earners are paying more tax than they did in 1996.
The effect is stronger at 0.6 times AWOTE, where the average income tax rate has risen from 15.4 per cent to 16.9 per cent. On the other hand, for those on 1.5 times AWOTE, the average rate has fallen from 29.4 per cent to 26.2 per cent, and for those on twice AWOTE, from 33.8 per cent to 30.1 per cent.
This analysis suggests a significant reduction in the progressivity of the tax system. However, there are a number of issues that would need to be considered in a more complete analysis.
First, this analysis is focused on single taxpayers. It’s important to remember, however, that the Howard government has generally given more favourable treatment to families with children than to single taxpayers.
Second, the analysis assumes that people pay tax on their full income. In reality, it’s necessary to take account of tax avoidance and evasion.
Finally, its important remember that the income tax is the only significant progressive element of the system. GST and other taxes are generally somewhat regressive. Except for the bottom 20 per cent, the tax system as a whole was roughly proportional before the latest changes, and is likely to become increasingly regressive if policy continues along these lines.
Professor John Quiggin is a federation fellow in economics and political science based at the University of Queensland and the Australian National University.