Keeping the Stage 3 tax cuts is just sound economics

The federal budget demonstrates that the need for fiscal reform is urgent, but the government’s efforts to stabilise the nation’s finances should stop short of dropping Stage 3 tax cuts – which bring broader economic benefits.

Overall, Jim Chalmers has delivered a low-risk budget, showing restraint in spending on new policies which should ensure any impact on inflation is minimal.

Yet the longer-term fiscal trajectory underlines the extent of the task facing the government. The deficit is now forecast to rise to 1.8 per cent over the four-year forward estimates, while gross debt-to-GDP is projected to climb steadily to 47 per cent by 2032-33, marking a reversal from the pre-election financial outlook in March which had envisaged a gradual decline to 40 per cent.

While the definition and measurement of a structural deficit can be debated, we certainly can’t ignore a projection which shows the gross debt-to-GDP ratio deteriorating so quickly, despite near-term improvements in the starting position. The fiscal repair job will require action on both the payments and revenue sides of the budget. For example, over the forward estimates, payments are holding at 27.1 per cent of GDP compared to the historic average of 24.9 per cent.

Westpac chief economist Bill Evans. Picture: John Feder

Meanwhile, the political cycle provides the government with only a narrow window for genuine reform, with the May budget presenting the best opportunity. The following budgets, in 2024 and 2025 (if necessary), will be too close to an election to make those tough decisions. The Treasurer need only look to the recent budget handed down by Liz Truss in the UK or the Abbott government’s budget of 2014 to see that reform can quickly translate to acute electoral danger.

In the lead up to this budget the future of Stage 3 tax cuts, which are scheduled to be introduced in June 2024, has been the subject of much speculation. These cuts are costed at around $20bn per year, or around 1 per cent of GDP.

Other things being equal, eliminating these cuts would reduce the deficit from 2 per cent of GDP to around 1 per cent in 2024-25, and lower future deficits by similar proportions. Adopting such a policy would certainly improve the gross debt-to-GDP projections. But it would not be good economics.

The benefits to higher income earners from the changes are broadly proportional to their share of income tax, whereas the Stage 1 and Stage 2 tax cuts were disproportionately aimed at low-income earners. The Stage 3 cuts will offset bracket creep and help to rebalance a lopsided share of direct income tax relative to most other developed economies.

Former prime minister Malcolm Turnbull last week pointed out that the Stage 3 cuts come in two stages. The first, introduced in the 2018 budget, eliminates the 37 per cent tax bracket and raise the top rate threshold to $200,000, from $180,000, costing $49.9bn over six years.

The second, which came in former prime minister Scott Morrison’s 2019 budget, lowers the tax rate from 32.5 per cent to 30 per cent for those in the $45,000 to $120,000 earnings bracket, costing $95.4bn. Turnbull concluded that while the second stage was more expensive than the first, the real incentive/productivity effects were to be found in the first stage.

Despite the advantages of reversing the second stage, it seems highly unlikely that a Labor government would effectively raise the tax rate on income earners in the lower to middle income range.

Unlocking gains in productivity are the surest way to future-proof growth prospects, and as such eliminating the Stage 3 tax cuts would be bad economics. The government should look elsewhere to stabilise the budget, including on the payments side.

Bill Evans is chief economist at Westpac.