Saturday, September 15, 2018

Morrison optimistic we’ll get much bracket creep

The mystery revealed. Consider this: how does the Morrison government cut income and company taxes and avoid big cuts in government spending, but still project ever-rising budget surpluses and ever-falling net public debt over the next decade?

With publication of the Parliamentary Budget Office’s report on the May budget’s medium-term projections, we now know. Short answer: by assuming loads more bracket creep between now and then.

You may remember that, at the time of budget, I was highly critical of the rosy forecasts and assumptions used in the budget’s “forward estimates” from 2018-19 to 2021-22, and then in its “medium-term projections” out for a further seven years to 2028-29.

They showed the budget’s underlying cash balance returning to a tiny surplus in 2019-20, then the surplus growing steadily to about 1.3 per cent of gross domestic product by the end of the decade.

As a consequence, the government’s net debt would peak in June this year at 18.6 per cent of GDP, then fall sharply to just 3 per cent in 2028-29 as the annual surpluses were used to repay debt.

There you go. Big cuts in company tax and a plan for three cuts in income tax, but we’ll soon be back in the black and eliminating the debt. I thought then it sounded too good to be true.

The budget office, which is independent of the government, is required by its Act to accept the government’s forecasts and macro-economy assumptions for its projections. But the budget papers gave no details of how, according to the government’s projections, the budget surplus would grow from 0.8 per cent of GDP in 2021-22 to 1.3 per cent in 2028-29.

This is what the office’s report tells us. It does so using its own modelling of each of the main taxes and 23 big spending programs, while sticking to the government’s macro-economy assumptions.

The report’s projections show total receipts ending the seven years where they began, at 25.5 per cent of GDP, while total spending grows more slowly than GDP so that it falls from 24.7 per cent to 24.1 per cent.

This implies that all the projected improvement in the budget surplus is expected to come from many years of amazingly disciplined spending restraint. But such a conclusion misses an obvious question: how can total receipts stay growing as fast as the economy is projected to grow when the government is planning to cut the rate of company tax by a sixth (from 30 to 25 per cent) and have three cuts in income tax?

Ah, that’s the report’s big reveal. Its projections show company tax collections declining as a proportion of GDP and “other receipts” also declining, but with this being exactly offset by the growth in income tax collections.

And that would be made possible by the fiscal magic of bracket creep. Remember bracket creep? It was the justification for the tax cuts and, according to then-treasurer Scott Morrison, the tax cuts would “eliminate bracket creep for the middle class”.

Or not. Turns out, according to the report’s projections, there’ll be so much continuing bracket creep as to more than wipe out the benefit from the promised tax cuts.

Taken over the full 10 years – and remembering that the first of the tax cuts began in July this year - income tax collections are projected to rise from 11.2 per cent to 12.5 per cent as a proportion of GDP, a huge jump of 1.3 percentage points.

Over the same decade, the average tax rate across all taxpayers is projected to rise from 22.9¢ in every dollar to 25.2¢. But here’s another important revelation by the report: some people do much better from the tax cuts than others, while bracket creep doesn’t affect everyone equally, either.

The report ranks everyone paying income tax according to their income, then divides them into five groups of about 2.9 million each - “quintiles” – from lowest to highest. It then looks at the way the average tax rate in each quintile is affected by the tax cut and by bracket creep. It looks at the change from 2017-18 to 2026-27.

On average, the three-stage tax plan will cut the average tax rate paid by people in the bottom quintile by just 0.3¢ in the dollar. Those in the second and third quintiles will save 0.9¢, while those in the fourth quintile save 1.1¢ and those in the top quintile save 2.1¢ in every dollar.

(This, BTW, is the proof that the three-stage tax plan does change the progressive income tax scale in a regressive direction, making it significantly less progressive.)

Now, the effect of bracket creep (before allowing for the tax cuts). It raises the bottom quintile’s average tax rate by 1.1¢ in the dollar, then the second and third’s by 5.4¢, but the fourth’s by 3.7¢ and the top quintile’s by just 2.9¢ in the dollar.

Leaving aside the bottom quintile (where most people rely on benefits and earn little income), the big net losers - bracket creep less tax cut – are those in the second and third quintiles. That is, those earning between 30 percentage points below the median income and 10 points above it.

Another name for such people is “low to middle income-earners” – the very people Morrison claimed his cuts were aimed at helping most.

But before you get too steamed up, remember that the budget office is merely exposing the previously hidden implications of the government’s medium-term projection and the rosy assumptions it depends on.

The key assumptions are “above-trend economic growth for much of the period” – which contains a hidden assumption that our record of 27 years without a severe recession will roll on for another 10 – and, in particular, “a return to trend wage growth”.

That is, it will take only a few years before wages are back to growing by 3.5 per cent a year – a percentage point faster than prices – and will stay growing that fast for the duration.

It’s this strong wage growth that does most to produce the bracket creep. So, if you’re not as optimistic about wages grow, you don’t need to be as concerned about bracket creep. By the same token, however, we wouldn’t be making as much progress reducing public debt.