Payroll tax is a state tax paid by employers on the wages and salaries paid to their employees. It is also one of Australia’s least efficient taxes, according to the Henry Tax Review (2010). However, real-world analysis on the impacts of payroll tax on employers and employees in Australia remains scarce.

So how does payroll tax affect firm growth? We shed new light on this question by examining a 2019 South Australian policy change that increased the payroll tax-free threshold, resulting in a sharp increase in marginal tax rates for firms once they crossed the new threshold.

Using business income tax data, we find that:

• A large number of firms bunched just below the new $1.5m threshold to avoid paying the higher marginal tax rate. The number of firms just below the threshold increased by 21%, while the number just above decreased by 18%.
• Many of the bunching firms were productive and growing firms that likely would have crossed the threshold, if not for the policy change. This suggests the policy change created a material barrier to firm growth.
• South Australian firms in aggregate may have decreased their use of labour because of the increased barriers to firm growth. Our estimates suggest that firms just above the threshold decreased their payrolls by $5.9m (3.3%), more than offsetting the $3.5m increase by smaller firms.

Our findings highlight that firms do respond to changes in payroll tax and that protections for small businesses can be costly to firm growth.