Bracket creep is a situation in Australia where inflation and wage increases push more and more people into higher tax brackets.
The result is that income tax takes more and more of people’s earnings, even though the Government did not formally raise tax rates.
Let’s dig into the concept of bracket creep, its impact on typical taxpayers, and look at some examples of how bracket creep affects a lot of different people.
What is Bracket Creep?
Bracket creep occurs when incomes rise, due to inflation, wage growth and promotions, pushing most individuals into higher tax brackets overall.
The tax system in Australia is designed to be progressive, meaning that as income increases, the tax rate also increases. However, the tax thresholds, or the income ranges for each tax bracket, are rarely adjusted by the Government to account for inflation or wage growth. This results in more taxpayers moving steadily up into the higher tax brackets, and fewer people remaining in low tax brackets.
Across many years, the effect is huge. This feeds the Australian Government with steady growth in income tax revenue year after year. So more Australians pay more ( and more) of their income in taxes, reducing their take-home pay.
A progressive tax system like Australia’s is based on the idea that people who earn more money can afford to pay a bigger percentage of their income, as income tax. That seems fair enough to most people. What’s not fair, however, is that bracket creep forces almost everyone into higher tax brackets. This often occurs even if their salary never increased by more than inflation. And that means, their standard of living may be decreasing over time, while the Government collects more in taxes.
How Does Bracket Creep Impact Taxpayers?
Bracket creep can have a significant impact on normal taxpayers like you.
Let’s consider how bracket creep affects three taxpayers, Andrew, Sarah and Eloise.
Examples That Explain Bracket Creep
Example 1: Andrew’s Experience
Andrew earned $44,000 last year, placing him in the 16% tax bracket. This year, Andrew’s employer applied a CPI increase to salaries and his income increased to $48,000.
Andrews additional earnings are now taxed at a higher rate – 30%. This means he will pay a higher percentage of his income in taxes. This also reduces his take-home pay and limits the benefit of his hard-earned raise. Even though the increase in his salary did not cover the rising cost of his rent.
Example 2: Sarah’s Situation
Sarah earns $123,000, working as a manager. Sarah’s salary falls into the 30% tax bracket and her salary has not changed for many years. At the same time, things like food and her mortgage all cost more money every year. As a result Sarah now has less money to spend and has a harder time supporting her large family.
This year, Sarah got a raise to $136,000. The extra income she gets now is taxed at an even higher rate of 37%. Even though she got a raise, Sarah’s standard of living has been going backwards due to bracket creep.
Example 3: Eloise’s Promotions
Just a few years ago, Eloise worked for a low salary at a restaurant. She was in the lowest paying tax bracket of 16%.
While she worked at a restaurant in the evenings, Eloise was studying engineering at university. Last year she graduated and quickly got a great job paying $130,000.
This year, Eloise will get a big promotion, and a big raise. Pretty soon, Eloise will be in the highest tax bracket, paying as much as 45% tax. Eloise is surprised at how much money all the tax adds up to, but she feels good about that; her standard of living has improved a lot, she is saving money, and she is comfortable. She thinks it’s fair that she can help pay the taxes that keep our country running.
Bracket Creep Affects People Differently, But On Average, Negatively
You can see how bracket creep affected Andrew, Sarah and Eloise differently. Eloise is paying more tax, and that works out fine because she has been getting big promotions and raises. Andrew and Sarah, however, are paying more in tax over time while their prosperity and standard of living may be declining.
What Can The Government Do About Bracket Creep?
Governments can tackle bracket creep in several ways. One approach is the “indexing” of tax thresholds to inflation. By regularly adjusting the tax thresholds, the Government ensures that they rise in line with the cost of living. This helps to prevent individuals from being pushed into higher tax brackets solely due to inflation.
Alternatively, governments can periodically adjust the tax rates, without changing the tax brackets. This still creates an outcome where people pay a fair portion of their income in taxes, without the hidden burden of bracket creep.
The Australian Government occasionally recognises the need to address bracket creep. In their latest Budget, they announced changes to the tax brackets to provide relief for taxpayers. The income thresholds for most tax brackets were amended, allowing individuals to earn more before moving into a higher tax bracket. This adjustment aimed to alleviate the impact of bracket creep and ensure that individuals can keep more of their hard-earned money each pay.
How Did Stage 3 Tax Cuts Affect Bracket Creep?
Bracket creep was addressed by the recent Stage 3 Tax Cuts which adjusted marginal tax brackets and tax rates for almost all Australians. This means that even though the average salary has increased, the amount people owe in tax is reduced, leaving more money in their take home pay each week.
However, bracket creep could become a problem again with the continued increase in wages each year. If tax brackets and rates are not adjusted for another 20 years, like what happened prior to the Stage 3 tax cuts, we will be left in the same position as before.
Conclusion: Where is bracket creep heading?
The basic answer is, usually it is heading upwards!
As incomes rise due to wage growth and inflation, Aussies may find themselves paying a larger proportion of their earnings in taxes, reducing their actual take-home income.
Bracket creep is a significant issue that affects taxpayers in Australia. Gradually, they are pushed into higher tax brackets, increasing the percentage of their income that they pay in tax. All while their real standard of living may have been stable or even going down.
By addressing bracket creep, the Government can support economic growth, incentivise productivity, and reduce the tax burden on hardworking Australians. Future adjustments to the tax system may help maintain a fair balance between taxation, standard of living and economic progress.
