Indexing income tax scales — another bad idea from the Coalition

The Coalition’s plan to index income tax scales to inflation may seem fair on paper, but critics argue it risks fueling inflation, ballooning the budget and tying the RBA into knots, writes Stephen Koukoulas.

OPPOSITION LEADER Angus Taylor like that promisingIf elected, he will index income tax scales to the inflation rate.

Although details of the commitment are scant, the concept is that once a year the various income tax scales will be increased by the previous year’s inflation rate.

Currently, when wages increase by an average of 4-5% each year, many workers move into a higher income tax bracket, meaning a large portion of the wage increase they receive is taxed.

This is a way for the Budget to shrink when inflation is high and rising and not damage the economy when inflation is very low.

Taylor’s policy idea is not a good idea for many reasons.

It has many black holes and consequences, making it an economic can of worms and causing more harm and uncertainty in the economy than good.

“First of all, indexing income tax brackets to the inflation rate is what we call in economics,” he said.pro-cyclical”.

This means that when inflation is high and rising, indexing will provide large and growing income tax cuts, which will stimulate the economy just in time for the Federal Reserve (RBA) raises interest rates to bring inflation back under control and cool the economy. In this high inflation environment, the best policy is to keep income tax deductions to a minimum, preferably none at all.

The same is true when the opposite happens: low and falling inflation. When this happens, the increase in income tax brackets will be small and therefore do little to provide the economy with the stimulus it needs to boost growth in such situations and push the economy back into inflation. The RBA will have to cut interest rates more than it normally needs to.

an illustration

The annual income level at which a worker would leave a place if inflation were 2.5% tax rate The 30% to 37% rate was increased from $135,001 to $138,376. These are automatic income tax deductions on a $3,375 increase in income (plus the impact on lower income tax brackets, which will also be indexed).

If inflation is 5% as it is now, the tax scale will increase from $135,001 to $141,751. This means a huge increase in scale and a huge tax cut at a time when inflation is soaring.

The problem with such a plan is that it is clearly cyclical.

This would see the policy working against the RBA’s anti-inflation stance in this example. As a result, interest rates would be even higher and the RBA would be forced to raise interest rates much more than it otherwise would.

In current conditions where inflation is high and rising, the RBA is opposed to this. overstimulation from the government sector. Indexation of income tax scales will fuel demand and therefore inflation.

The opposite is true in an era of low inflation, where tax scales are not increased much and limited incentives are given to the economy whenever it needs it.

The proposal would make it much harder for the RBA to achieve its inflation target and/or require much greater volatility in interest rates as the RBA struggles to balance the pro-cyclical nature of indexing tax scales.

The proposal has other problems, too.

There is a huge cost to the budget. According to the limited details in Mr. Taylor’s proposal, it would cost up to $35 billion in the first four years of operation, approximately 250 billion dollars It increased the budget deficit and government debt in its first decade of operation.

The proposal also has the problem of not completely getting rid of bracket creep. This is because wage increases are generally higher than inflation. Someone who gets a 4% pay rise when inflation is 2.5% is still experiencing bracket drift despite Mr Taylor’s indexation proposal.

This problem could be overcome if the tax was scaled according to wage growth, but the cost would be too great and the cyclical impact too great.

Indexing income tax scales increases economic volatility, poses additional challenges to the RBA in meeting its inflation target and negatively affects budget settings.

This is an interesting idea, but it is not practically feasible.

Stephen Koukoulas is one of Australia’s most respected economists, the former chief economist of Citibank and senior economic advisor to the Australian Prime Minister. You can follow Stephen on Twitter/X @TheKouk.

Support independent journalism Subscribe to IA.