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, and more Australians pay more (and 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, 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 all that happen without the Government really doing anything?
It happens because the Government fails to adjust tax thresholds over time, to keep up with inflation. To prevent bracket creep, the tax thresholds and/or income tax rates should simply be adjusted, every few years, along with inflation.
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 $45,000 last year, placing him in the 19% 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 – 32.5%. This means he will pay a higher percentage of his income in taxes, reducing his take-home pay and limiting 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 $119,000, working as a manager. Sarah’s salary falls in to the 32.5% tax bracket. Her salary has not changed for many years, and that means, as things like food and her mortgage all cost more money every year, now Sarah has less money to spend and has a harder time supporting her large family.
This year, Sarah got a raise to $125,000. The extra income she gets now is taxed at an even higher rate of 37%, even though Sarah’s standard of living has been going backwards.
Example 3: Eloise’s Promotions
Just a few years ago, Eloise worked for a low salary at a restaurant. She was in the lowest tax bracket, paying 19% of her income as tax.
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 $110,000.
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. On the other hand, Sarah thinks it is weird that she will be getting a tax cut next year when the Government’s Stage 3 Tax Cuts come into play, reducing tax for the highest earners.
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 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 2021-2022 Budget, they announced changes to the tax brackets to provide relief for taxpayers. The income threshold for the 32.5% tax bracket was increased, 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.
The Government’s tax cuts, however, include “stage 3” which reduces the tax paid by the biggest earners. Some wealthier people like this, while other people think this makes the Australian tax system less fair. They are concerned that it may reduce future Government revenue needed for important Government programs like social services and healthcare.
Expert Opinions on Bracket Creep
Economist Ben Phillips, Associate Professor at Australian National University, has written that,
[stage 3 tax cuts] “will certainly cost the budget money – leaving less money for services of the kind that mostly benefit lower income households – although nowhere near as much as the $243 billion quoted.
“But the cost will be temporary. The effect on inequality will be longer-lasting.”
Economist Danielle Wood, CEO of the Grattan Institute, has co-authored a range of articles that address bracket creep and the Government’s planned 3-stage tax cuts.
“Middle earners, those earning between the third to top and the third to bottom ten percents of the income distribution, would pay a larger share of tax in 2029-30 than they do today: 23% compared to 20%.
“But high-income earners, those in the top fifth of the income distribution, would pay a smaller share of tax: 65% in 2029-30 compared to 68% today.”
“Stage 3 of the tax cuts would return Australia to the 1950s”
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.