Stage-three tax cuts: what are they, how do they work and why do they exist?

Posted On Oct 10, 2022

The stage-three tax cuts, due to come into effect in July 2024, are the third phase of the Morrison government’s legislated tax plan.

The legislation passed with Labor’s support in 2019 despite the party’s reservations, and Anthony Albanese went to the 2022 election promising no changes to what had been legislated. Since then, the treasurer, Jim Chalmers, has said the government’s position on the tax cuts has not changed.

But the Albanese government has left open the prospect of amending the tax cuts, with Chalmers repeatedly pointing out that global economic conditions have changed and Australia’s economic outlook has changed with them: inflation is rising, government debt is higher and the future is very uncertain.

While the fate of the stage-three cuts remains uncertain, here’s what we know about them and how they might they affect you.

What was the Morrison government’s tax plan?

The 2019 tax plan had three phases.

Stage one was a low- and middle-income tax offset (Lmito) worth up to $1,080 a year to taxpayers earning between $30,000 and $126,000.

Stage two, which was brought forward from 2022 to 2020 when the Lmito was extended for another two years, raised the 32.5% marginal tax bracket from $37,001-$90,000 to $45,001-$120,000, and the threshold for when the 37% tax rate kicked in was raised from $90,000 to $120,000. The existing low-income tax offset was also increased to include anyone earning less than $45,000.

Stage three abolishes the 37% marginal tax bracket completely and lowers the 32.5% marginal tax rate to 30%. It also raises the threshold for the 45% marginal tax rate, meaning everyone earning between $45,000 and $200,000 will pay the same 30% tax rate.

A marginal tax rate is how much tax you pay on income in that bracket. For example, if you earn $97,000, under state three you would pay no tax on the first $18,200 you earned, 19% for every dollar between $18,2001 and $45,000, and 30% on every dollar between $45,001 and $97,000.

Why were the changes introduced?

It was a different world – pre-pandemic and pre-Ukraine war, and before the energy, supply chain and inflation pressures we are feeling now.

The Coalition was looking at achieving its long-awaited “back in the black” budget and wanted to stimulate the economy through tax cuts. It also wanted to address “bracket creep”, something the Coalition had been railing against since 2015.

“Securing future tax cuts now will provide confidence to Australians that they will be rewarded for their hard work and it will help protect their future pay increases from bracket creep,” the treasurer at the time, Josh Frydenberg, told parliament in 2019.

What is bracket creep?

Bracket creep is when pay rises lead to people paying a bigger fraction of their income in tax, as taxpayers “creep” up the tax brackets outlined above over time.

The tax brackets are not automatically adjusted for inflation. So when an individual’s pay goes up, their average tax rate increases because more of their pay is in their highest tax bracket.

And occasionally some of their income moves up into the next tax bracket, taxed at a higher rate.

In an economy in which average incomes are usually increasing, and tax brackets are fixed, bracket creep is inevitable.

So isn’t stage three a good thing?

There have been many, many arguments for addressing the number of tax brackets in Australia’s personal income tax system, including increasing and lowering the thresholds for each bracket.

But the tax brackets are still fixed. The stage-three cuts only really fix bracket creep for the top income earners, who will see their marginal tax rates fall from present levels. For people earning less than $120,000 – which is about 90% of Australian taxpayers – bracket creep will still be an issue.

A parliamentary budget office analysis found that someone earning $49,000 will see their average tax rate increase by 5.9% over the next decade, while the stage-three tax cuts will only lower their marginal tax by 0.9%. Someone earning over $120,000 will see their bracket creep cancelled out by the tax cuts.

No government since the Fraser government in the 1970s has seriously contemplated indexing tax brackets to inflation, despite the nominal boost to pay packets this would provide. Why? Because bracket creep can help governments repair the budget without having to do anything (which is one of the reasons the Fraser government abandoned indexation shortly after bringing it in).

Bracket creep can help close fiscal gaps without cutting services or increasing taxes. The average income tax rate is increased without people noticing, meaning governments reap additional income tax, improving the budget’s bottom line. Even with stage three.

What about the cost to the budget?

The stage-three tax cuts are estimated to cost the budget $243bn in lost tax revenue over the decade after they are introduced.

Original Post: Stage-three tax cuts: what are they, how do they work and why do they exist?