What are the government's tax cuts and will they be good for the economy?
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Explainer

What are the government's tax cuts and will they be good for the economy?

How much tax will you pay under the government's tax changes? Should they be brought forward? And if they are brought forward, who will benefit the most?

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The 2020 federal budget will be among the most significant in recent memory. All will be revealed on Tuesday but the government has hinted for months it will bring forward tax cuts promised by the Coalition in the 2018 and 2019 budgets.

So how much tax will you pay under the changes? Should they be brought forward? And if they are brought forward, who will benefit the most?

Who will benefit most from tax cuts?

Who will benefit most from tax cuts?Credit:Getty Images

How do the tax cuts work?

Australia has a progressive tax system. This means those who earn more pay a higher rate of tax. A progressive system means a person faces a higher tax rate the more they earn.

Australia currently has four tax brackets.

A person earning the minimum wage of $39,176.60 pays a total of $4286.22 in tax. There is no tax on their first $18,000 of income, they pay 19 cents in the dollar on income between $18,001 and $37,000 and then they pay 32.5 cents in the dollar on the remaining $2197.60.

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This person has paid 10.9 per cent of their income to the taxman.

But for a person on $120,000, the tax bill comes in at $31,897 or 26.6 per cent of their total income. Like the minimum wage earner, they pay no tax on their first $18,000 of income plus 19 per cent on everything between that point and $37,000.

But they also have to pay 32.5 cents in the dollar on everything between $37,001 and $87,000. They then move into the 37 per cent tax bracket on every dollar earned between $87,001 and $120,000.

The issue the government wants to partly address is what is known as bracket creep. This is the process by which people, as they enjoy a wage rise, find more of their income taxed at a higher marginal rate.

Last year's federal budget predicted that by 2024-25 the proportion of taxpayers in the 19 per cent rate would shrink to 16 per cent while those paying the 37 per cent rate would rise to 29 per cent. A similar trend is seen in the top tax tiers.

Under the Coalition's three-stage plan, these brackets will change by 2024-25.

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The first stage was all about the Low and Middle Income Tax Offset otherwise know as the "lamington". The lamington is complicated but it meant the majority of low and middle income earners received a $1080 tax rebate in their tax return for 2018-19. We have completed stage one.

Stage two is scheduled to start on 1 July 2022. The change increases the top threshold of the 19 per cent tax bracket to $45,000 from $37,000, and expands the 32.5 per cent income threshold to $120,000 from $87,000.

Stage three kicks in from July 2024. A new 30 per cent marginal tax rate will be created for people earning between $45,001 and $200,000. This new rate will cover seven out of 10 earners. This puts an end to the 32.5 per cent and 37 per cent rates.

Confused? There's no doubt the various steps are complicated. But in the end the system is simpler. Australians will be left three tax brackets - 19 per cent, 30 per cent and top marginal rate of 45 per cent.

How come economists don't agree on the cuts?

Australians face some of the highest marginal tax rates when they get to twice the average wage. In Canada, a worker has to be earning four times the average wage before they face the top tax bracket, OECD figures show. In the UK it is 3.7 and in the US it is 9.2 times. This compares to 1.1 times in New Zealand.

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Bracket creep is a bad thing and reducing tax rates gives households more cash. There is little debate about the benefits many of these cuts have for lower paid workers.

But this is where the agreement stops. Arguments about fairness when cutting the tax rate for high income earners in stage three have been fierce. The Grattan Institute, a centrist think tank, argues it will leave the tax system "less progressive than it has been at any point since the 1950s" while left-leaning think tank The Australia Institute claims half of the benefits flow to the top 10 per cent of earners as those on high incomes will pay less tax as a proportion of their individual income.

Essentially, switching to three tax brackets means someone who earns $200,000 will pay the same amount of tax for every dollar they earn over $40,001 as someone earning $50,000. Previously, the individual earning the higher rate would have paid a higher percentage. This is the crux of the argument about the system becoming less progressive and is one of the reasons The Australia Institute senior economist Matt Grudnoff has called the cuts a "radical plan to increase inequality in Australia".

But a report this week on the federal budget by Deloitte Access Economics partner Chris Richardson was scathing about critics shunning the cuts on the basis of equity.

"Withdrawing government support by dropping proposed tax cuts would be downright dumb," Richardson says, describing the standard of debate about tax as "woeful". Richardson says the criticism of stage three is "entirely undeserved". Both Deloitte and Treasury modelling of the tax cuts, even when considering flat wages growth, shows the top income earners will contribute a relatively similar share of tax overall to government coffers with the plan as they would've without it.

On Deloitte's figures by the time the cuts kick in by 2024, the top 10 per cent of earners will contribute 44.8 per cent to total income tax collected by the government - effectively the same as now. The wealthiest 1 per cent would pay a higher proportion on all these measures.

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On this basis, he says it's hardly a radical plan to increase inequality but "more of a radical plan to stay the same".

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Grattan's Danielle Wood, Kate Griffiths and Matt Cowgill last year wrote a paper acknowledging all taxpayers would benefit under the cuts by 2030 but they still warned it wouldn't be fair. They used a different measure from Deloitte and Treasury to come to this conclusion. Instead of the overall contribution to tax collected, they looked at the share of individual earners' income paid in tax. On this measure someone on a high income would eventually pay a lower share of their income tax than they currently do but at the same time middle-income earners would pay more.

In terms of cumulative tax relief from 2018-19 to 2024-25, a worker earning $80,000 gets $8435 in tax relief but someone on $200,000 reaps $17,130 in savings. Richardson is dubious when analyses look at the dollar value as a measure of equity.

It depends on which way you look at it and determining what is fair isn't entirely clear cut.

Are the cuts a good way to help economic activity?

Regardless of the disagreement over the tax cuts themselves, taking less from people's wages is one way to get more cash flowing into households' bank accounts. Last year, then-CBA economist Michael Blythe said tax cuts could have an effect as significant as a 0.5 per cent interest rate cut from the Reserve Bank - a significant stimulus measure.

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In theory, tax cuts should lead to higher levels of spending. But in practice this is not straightforward.

By October 2019 about $24.2 billion worth of refunds were handed back workers from the stage one cuts, up 30 per cent on the same time in 2018, but there was hardly any improvement in retail spending on official Australian Bureau of Statistics data for the period following tax refunds.

Some Australians used it to pay down debt or shore up their savings accounts and were less inclined to treat their tax refunds in the same way as direct stimulus cheques. This could dampen the effects of getting more back at tax time. Whether the same pattern could be expected this time around is a big question.

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High income and low income households have reacted very differently during the coronavirus crisis. On Alphabeta data released earlier this year top earners were spending 29 per cent less than their pre-pandemic norm while lower-income shoppers' spending surged 14 per cent. Some of this can be explained by government stimulus payments worth $750 but in general economists agree top earners are more easily able to cut back during tough times because their overall discretionary spend is typically higher already.

Grattan's Danielle Wood thinks the case for bringing stage three forward in particular is even less clear-cut during the pandemic.

"I don't think it's good stimulus. This particular set up won't deliver the sort of boost we need," she says, adding it would take too long for the benefits to flow through into bank accounts at a time when the economy needs a big jolt. "It won't help us out of the danger zone of the next nine months ... If this is the centrepiece of the budget, and it's a high dollar cost so it's likely, it's a missed opportunity to do other things."

Grattan was also concerned about the "substantial impost on the budget" worth $85 billion over the following six years. The cuts are estimated to cost the budget $30 billion-a-year in uncollected tax and Richardson has also raised concerns the cuts might be "too big". Despite these views, Richardson and many other economists of all stripes consider accelerating these cuts to be a positive though not enough on their own to keep the country afloat during the recovery. There are, of course, other form of stimulus available to the government.

Modelling from EY has found an extra $60 billion spent on reducing personal income tax, increasing the dole and boosting infrastructure projects could get an extra 135,000 people into work. Independent economist Saul Eslake, EY economist Jo Masters and ANZ economist Cherelle Murphy all told The Sydney Morning Herald/The Age Scope survey last month the cuts could help as an additional stimulus measure.

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PwC Australia chief economist Jeremy Thorpe also says the government needs to prioritise growing consumer and household demand to help boost confidence, but wants several measures introduced on Tuesday to achieve this.

"[The government] can do this by continuing to get money into the hands of those most affected by the pandemic, introducing more personal tax cuts, bringing back the loss carry-back for companies and accelerating existing plans for positive change such as increasing infrastructure investment."

All that remains to be seen is precisely what stimulus is introduced next Tuesday and the role tax cuts play in this mix.

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If you'd like some expert background on an issue or a news event, drop us a line at explainers@smh.com.au or explainers@theage.com.au. Read more explainers here.

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