Bracket creep has been in the news lately as debate rages about the Albanese government’s changes to the stage-three tax cuts.

But what exactly is it?

Explained

Bracket creep occurs when an individual’s income growth causes them to pay higher average income tax rates each year.

• Australia’s tax system is made up of a series of brackets tied to tax rates that change based on the amount of income an individual earns
• Brackets with lower-income thresholds pay less tax on their income, while brackets with higher-income thresholds pay more – this is often described as a progressive income tax system
• However, incomes change over time, generally increasing with inflation and wages growth, while the tax brackets are static unless the government introduces new laws to change them
• That creates a creeping effect where individuals can move up a bracket and begin paying more tax even if they only receive incremental increases in their income over time.

In practice

Imagine a construction worker who earned $118,000 in taxable income in 2022-23

• They would fall within the $45,000-$120,000 tax bracket, which requires individuals to pay about $5000 plus 32.5 cents for each $1 they earn over $45,000 in tax
• The same worker received a 5 per cent pay rise at the end of the financial year and will now earn more than $120,000 in 2023-24, which means they will now pay 37 cents on the dollar instead
• It’s important to remember that the worker only pays the higher tax rate on income earned over the $120,000 threshold.

The problem

Bracket creep is seen as unfair on workers because they can end up paying more tax for doing the same job.

The problem can become significantly worse if left unaddressed because income increases compound, meaning that over a decade someone can pay thousands more in income tax.

The solutions

There are two main ways bracket creep can be addressed:

• Indexing tax brackets by inflation or income growth, which would automatically adjust them based on how wages and prices are changing across the economy
• Governments can change tax rates through legislation, adjusting them to reflect changes in incomes and inflation, as well as policy priorities about who should pay the most tax.

What Australia has done

The past two federal governments have made changes to the tax system to address bracket creep:

• The Morrison government pursued two stages of tax cuts from July 2018 that increased the thresholds on tax brackets for low- and middle-income earners
• The Albanese government later reformed a third stage of the tax cuts that will come into force from July 1
• These changes will retain the spirit of the original reforms in reducing bracket creep while making them less generous to richer Australians.