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12 Jan 2024 ⏲ 12 Minutes Policy
Stage 3 income tax-cuts – as administered by the previous Federal Government – are currently being implemented to reduce the total tax paid by Australians and lower surging bracket creep. However, many decision makers have the view that this policy has wider implications to economic growth, through its ineffectiveness and significant costs to achieving efficiency and equity. This article analyses the implications of Stage 3 tax cuts to equitable distribution and efficiency of this distribution, using an economic interpretation.
Quick Introduction to the Stage 3 Tax Cuts
Stage 3 tax-cuts implement three key changes: the 37% tax bracket is abolished, threshold of the highest bracket is raised from $180,001 to $200,001 and existing marginal tax rate of 32.5% is lowered to 30% (Janda & Hutchens, 2022).
Are the Stage 3 Tax Cuts Distributed Equitably?
Expanding existing income-brackets and removing 37% bracket temporarily reduces bracket creep, especially for middle-income earners paying 30% tax. This likely incentivises labour upskilling and higher wage growth without facing higher tax costs, stimulating economic growth through higher spending. However, average tax paid on nominal income is fixed, not indexed to inflation. Over the long-term, inflation-induced wage growth will likely see increases in average tax paid and decreased purchasing-power, deeming the policy ineffective (Janda & Hutchens, 2022).
Furthermore, total tax-cuts are disproportionate towards high-income earners. Due to marginal tax rates paid at the highest bracket being lessened and middle 32.5% bracket reduced, upper-income earners of above $200,000 will see significant reductions in tax paid. With estimated cuts of $9,075 annually, 52.7% of tax offsets will disproportionally go to the top 10% wealthiest income group (Australia Institute, 2023).
Comparatively, low-income brackets receive no benefits as such and remain largely unaffected. Within context of stage 1 and 2 tax-cuts however, earners on low income (~$45,000/annually) previously receive $1,080 from tax packages (Wood, Griffiths, & Cowgill, 2019). Although, surging differences in cuts for lower- and upper-income brackets places pressure on Australia’s income inequality, widening the disparity. This is as tax-cuts to wealthiest bracket induce a more regressive tax system.
The trade-off from the policy is foregone government tax revenue, estimated at $243.5 billion across a 10-year span. Economists argue this represents major opportunity costs to Australia’s GDP and national budget spending, with a growing budget deficit discouraging medium-term economic growth (Read & Mcllroy, 2022). Reductions in government revenue will reduce Australia’s redistribution tax-and-transfer policies that ensure a more equitable society.
Are the Stage 3 Tax Cuts Distributed Efficiently?
Efficiency is maximised by reducing the excess economic burden of new taxes to society. This is measured through payments taxpayers make and economic loss through reactionary behaviour to labour-leisure trade-offs. Reduced excess burden to society is conditional to elasticity of labour supply (Hines, 2007).
Consider that majority of tax-cuts is distributed to the wealthiest bracket. Experimental studies reveal that amongst higher-income earners, labour supply curve is downward sloping inelastic, i.e. marginal increases in additional income (tax-cut income) produce minimal change in supply of hours worked (Dandie & Mercante, 2007). This is likely due to diminishing marginal utility of higher income, decreasing necessity for labour. In figure 1, as wage increases from W1 to W2, the effect of higher-income earners on upward-sloping market labour supply sees only minimal reductions in excess burden deadweight loss (Area A). This is as tax-cut income majorly flows to high-income group, who are unresponsive to economic changes. Efficiency is not truly maximised.
Figure 1: Market Labour Supply DWL after tax cuts
Figure 2: Backward Bending Labour Supply
In figure 2, for upper-income earners, new tax is not located at the efficiency-maximising point E2. Rather, total wage increases from E2 to E3 and number of hours worked decreases from L2 to L3. This will see the income effect exceed the substitution effect, translated in figure 3 where total effect is positive: point (B→C) exceeds (A→B). Thus, opportunity cost of substituting labour for leisure remains lower, incentivising higher-income earners to adopt leisure and work less. Decreased labour hours worked stimulates less economic activity.
Finally, any incentive to spend is distilled by diminishing marginal utility of high-income earners, correlating with demand for goods and services becoming inelastic. The sub-group adopt a higher marginal propensity to save, which limits economic growth through less stimulated spending (Buckley, 2021).
Figure 3: Labour-Leisure Model for High-income Households
Close
Stage 3 tax-cuts do not achieve the optimal equity-efficiency balance, primarily due to majority of tax-cut benefits being received by upper-income earners. The policy could provide larger tax-cuts to low- and middle-income brackets, who show more elastic labour supply curves. While the 32.5% reduction to 30% should remain, 19% tax rate for income $18,201-$45,000 could reduce to 17%, providing larger cuts to <$120,000 income earners (Jericho & Grudnoff, 2023). Elastic labour supply will allow substitution effect to exceed income effect, incentivising higher economic activity from increased hours of labour. Hence, the impact on the government budget will only see $111 billion foregone budget instead of former $243.5 billion.
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References
Australia Institute. (2023). 17 Reasons why the Stage 3 tax cuts should be scrapped. Retrieved from The Australia Institute: https://australiainstitute.org.au/post/17-reasons-why-the-stage-3-tax-cuts-should-be-scrapped/
Buckley, J. (2021). Stage 3 tax cuts to ‘exacerbate’ further inequality . Retrieved from Accountants Daily: https://www.accountantsdaily.com.au/tax-compliance/15790-stage-3-tax-cuts-to-exacerbate-further-inequality
Dandie, S., & Mercante, J. (2007). Australian Labour Supply Elasticities: Comparison and Critical Review. Australian Treasury.
Hines, J. (2007). Excess Burden of Taxation. Office of Tax Policy Research.
Janda, M., & Hutchens, G. (2022). What are the stage 3 tax cuts? Why won't they fix bracket creep? Retrieved from ABC News: https://www.abc.net.au/news/2022-10-06/stage-three-tax-cuts-wont-fix-bracket-creep/101503456
Jericho, G., & Grudnoff, M. (2023). Stage 3 Better: A way for the government to deliver better, fairer tax cuts and save money . Retrieved from The Australia Institute: https://australiainstitute.org.au/post/stage-3-better-a-way-for-the-government-to-deliver-better-fairer-tax-cuts-and-save-money/
Read, M., & Mcllroy, T. (2022). Who gets what from stage three tax cuts and why (in four charts). Retrieved from Australian Financial Review: https://www.afr.com/politics/federal/who-gets-what-from-stage-three-tax-cuts-and-why-in-four-charts-20221006-p5bnm4
Wood, D., Griffiths, K., & Cowgill, M. (2019). Stages 1 and 2 should pass. Stage 3 would return tax to the 1950s. Retrieved from The Conversation: https://theconversation.com/stages-1-and-2-should-pass-stage-3-would-return-tax-to-the-1950s-119637
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