Stage 3 tax cuts are no big deal, with one exception

The stage 3 tax cuts are back in the news, with inflation added to their list of ill effects.

Teal independent MP Monique Ryan has suggested we trim $8 billion from them and spend the money on building houses and boosting rent assistance for those on low incomes.

Treasurer Jim Chalmers has some tricky decisions ahead.Credit: Alex Ellinghausen

More than a year ago in these pages, I suggested a redesign of one part of stage 3, not because of inflation but as a matter of basic tax design. Today, it’s worth asking: are the ongoing critiques of stage 3 reasonable, and does persistent inflation change things?

Stage 3, as the name suggests, is the third of three stages of tax cuts, with the earlier stages focused on low and middle earners. Due to start on July 1 next year, stage 3 is a package of three changes: a reduction in the marginal tax rate from 32.5 per cent to 30 per cent on all income earned between $45,000 and $120,000; the elimination of the 37 per cent bracket between $120,000 and $180,000; and an increase in the income, from $180,000 to $200,000, at which the top 45 per cent tax rate kicks in.

The main criticism of stage 3 has been about fairness. And there’s no doubt it’s skewed towards higher income earners. But some context is needed.

Tax relief for low and middle earners came with the earlier stages, and stage 3 does deliver at least some tax relief to all those earning more than $45,000.

Keeping the 37 per cent rate and reallocating $8 billion to home construction and rent assistance, as independent MP for Kooyong Monique Ryan has proposed, would clearly raise, not lower, inflation.Credit: Alex Ellinghausen

Do higher earners get more tax relief when considering all three stages combined? Absolutely. Because they pay a lot more tax! Someone with a taxable income of $200,000 per year pays around $61,000 in income tax, while someone on $50,000 pays just $6700. Four times the income – but nearly 10 times the tax.

That means if you cut each of their taxes by 1 per cent, the higher earner gets a cut that’s 10 times as big. Ultimately, in terms of average tax rates, stage 3 doesn’t dramatically alter the progressivity of the tax schedule.

The reduction in the 32.5 per cent rate to 30 per cent is defensible on the benefits it will bring in improved incentives to work, particularly among sensitive groups such as women working part-time. Any positive labour supply effect will also put downward pressure on inflation.

Moreover, with wage growth at decade highs, people’s average tax rates have been rising at the fastest rate in decades, and this is a perfectly reasonable way to offset that. With the income thresholds not automatically adjusted over time, our tax system is designed for tax relief to be provided periodically to reverse an automatically rising tax take.

The increase in the top threshold is reasonable – even arguably insufficient – given it hasn’t been touched since 2008. Just to keep up with inflation, it would have to be raised far higher than $200,000.

The part that’s hardest to defend is the elimination of the 37 per cent bracket, creating one big 30 per cent bracket from $45,000 to $200,000. Under a progressive tax system, marginal rates rise with income. To have someone on $45,000 a year paying the same marginal rate as someone earning $200,000 doesn’t make much sense.

Scrapping just that part, as I advocated last year, would save $8 billion a year. Everyone who was getting a tax cut would still get one, just a little less for those on more than $120,000.

What about inflation? I’ve been among the strongest advocates, since all the way back to the Coalition’s final budget in March 2022, of the government exercising extreme restraint so as not to make inflation worse. But here too we need some perspective.

For inflation, it doesn’t just matter how much money the government distributes, it also matters to whom they distribute it.

Keeping the 37 per cent rate and reallocating $8 billion to home construction and rent assistance, as Monique Ryan has proposed, would clearly raise, not lower, inflation. Worker shortages have been a source of inflation and higher construction demand would only make that worse.

So too would funnelling the money to lower earners, since they are much more likely to spend, boosting demand, and thus inflation. Indeed, the fact stage 3 is skewed towards higher earners is an inflationary virtue, not a vice. There’s just nothing much that can be done with the savings to lower inflation – other than banking them.

The $8 billion in tax relief that would flow by eliminating the 37 per cent bracket is in fact $6 billion less than the $14 billion in new additional discretionary spending the government undertook in this year’s budget, which the Grattan Institute claimed would have only a modest inflation impact.

If you are still worried about inflation, simply delay them a year. Problem solved.

Inflation seems like a convenient excuse for those who ultimately desire bigger government funded by higher taxes on higher earners. That’s a perfectly fine position to hold. But let’s not pretend it’s an objective truth. From where I stand, as a public finance expert, stage 3 is mostly fine and just not as big a deal as many have claimed.

Steven Hamilton is assistant professor of economics at the George Washington University and visiting fellow at the Tax and Transfer Policy Institute at the ANU.