How does Australia’s progressive tax system work – and what is ‘bracket creep’?

This article is part of The Conversation’s “Business Basics” series where we ask experts to discuss key concepts in business, economics and finance.

It’s July, which means if they haven’t already, many Australians will be thinking about and filing their tax returns.

You’d be hard pressed to find someone who likes paying taxes, but they fund essential public services such as health care, education, infrastructure, defence spending and social services.

In Australia, we tax individuals under a progressive tax system – the tax rate increases as your income rises. Such a system is designed to ensure those who earn more contribute a larger percentage of their income towards the country’s revenue.

But this isn’t the only way to tax individuals’ income. Some countries^[1] including Estonia and Bolivia have a “flat” tax system that imposes the same income tax rate on everyone, no matter how much they earn.

So how does Australia’s tax system work for individuals – and how has it just been changed?

First, working out what you earn

Each financial year, every taxpayer must either lodge a tax return – detailing their income and any deductions or offsets to which they are entitled – or submit a “non-lodgement advice^[2]” form.

Read more: What are financial years – and why are they different from calendar years?^[3]

To prepare a tax return, a taxpayer has to work out their taxable income, which the Australian Taxation Office (ATO) defines^[4] as “assessable income minus any allowable deductions”.

At one end of the scale, a person’s assessable income might just include their salary or wage payments made over the course of a financial year.

But for others with diverse income streams – which could include interest, investments, government payments and profits from owning a business – preparing a tax return will be more complicated. These income streams may face their own tax implications before being taxed progressively.

Taxpayers are often able to make deductions^[6] against their taxable income, including for certain work-related expenses, charitable donations and educational costs.

Depending on their income and level of private health cover, individuals may also have pay to a Medicare levy^[7].

It’s important to note that our discussion here is only general in nature, and tax laws are always evolving. Consider seeking professional advice to manage your own tax return.

Read more: Beware of 'tax hacks' to maximise your return this year. The tax office is taking a close look at incorrect claims^[8]

The more you earn, the more you pay

Once we’ve worked out how much someone has earned, we tax them on a progressive scale, where tax rates increase with income.

But you don’t pay a higher rate of tax on all of your income, only on your respective earnings above and within certain thresholds.

For example, under the tax brackets for the last financial year (2023–24), Australian residents faced marginal tax rates of:

Bracket creep

But there’s a problem. Over time, inflation in an economy increases the general cost of goods and services, eroding the purchasing power of money. As a result, people demand higher wages so their living standards don’t decrease.

Over the years, these higher incomes amid high inflation can push people into new tax brackets, meaning they might pay higher rates of income tax without seeing any improvement in purchasing power. This is called “bracket creep” or “tax creep”.

As the Parliamentary Budget Office explains^[9], even those who aren’t pushed into new tax brackets can still be impacted by bracket creep. This is because the design of our system means the more a taxpayer earns, the greater the proportion of their income will be paid in tax.

Put simply, they face a higher average tax rate^[10] – total tax calculated as a proportion of total taxable income – as their income increases, even if they stay in the same bracket (excluding those below the tax-free threshold).

Avoiding bracket creep was one of the key rationales for Australia’s recent income tax cuts, stage three of which came into effect^[12] on July 1. As you might remember, these cuts were changed from what was originally planned.

The previous Coalition government’s original plan was to eliminate the 37% tax rate, reduce the 32.5% bracket rate to 30% and expand it to cover earnings all the way up to $200,000, and apply the 45% tax rate to earnings over $200,000.

But the current Labor government ended up instead lowering^[13] the 19% rate to 16%, reducing the 32.5% rate to 30% for earnings up to $135,000, keeping the 37% rate above this higher threshold, and applying the 45% marginal tax rate to earnings above $190,000.

These changes mean that over the current financial year (2024–25), Australian residents will face the following new marginal rates of income tax:

The changes have reduced some of the tax savings for those on high incomes. For example, a worker earning $200,000 will see a tax saving this year of $4,529, down from $9,075 under the original plan^[14].

Not the only way to tax

It’s sometimes argued that an alternative system of flat taxes – applying the same tax rate to everyone no matter how much they earn – could increase simplicity^[15] and economic efficiency.

But like many other countries, Australia’s progressive tax system is designed to ensure that those who earn more contribute more accordingly. One of the biggest challenges is ensuring it stays fair over time.

References

1. ^{^} Some countries (worldpopulationreview.com)
2. ^{^} non-lodgement advice (www.ato.gov.au)
3. ^{^} What are financial years – and why are they different from calendar years? (theconversation.com)
4. ^{^} defines (www.ato.gov.au)
5. ^{^} RomanR/Shutterstock (www.shutterstock.com)
6. ^{^} deductions (www.ato.gov.au)
7. ^{^} Medicare levy (www.ato.gov.au)
8. ^{^} Beware of 'tax hacks' to maximise your return this year. The tax office is taking a close look at incorrect claims (theconversation.com)
9. ^{^} explains (www.pbo.gov.au)
10. ^{^} higher average tax rate (www.pbo.gov.au)
11. ^{^} Andrey_Popov/Shutterstock (www.shutterstock.com)
12. ^{^} came into effect (treasury.gov.au)
13. ^{^} lowering (treasury.gov.au)
14. ^{^} original plan (australiainstitute.org.au)
15. ^{^} increase simplicity (www.wsj.com)