By any global standard, Australians are unaccustomed to serious fiscal pressure. Over two decades, we have had global shocks and bouts of disappointing growth, but no fiscal reckoning. In fact, our strong finances gave us options to cushion these blows.
Of course, every annual budget (state and federal) involves hard decisions, but they have been business-as-usual trade-offs. The question policymakers now face is whether a more fundamental recalibration is coming our way – a point of realisation that some core fiscal habits and political assumptions are no longer compatible.
Here are two such assumptions:
- Government spending will rise as a share of GDP as the Australian population ages;
- Australia will finance this growth through an income tax with a high degree of progressivity.
These assumptions are well entrenched but getting harder to reconcile.
The symbolic present-day skirmish is the argument between the Commonwealth and States over health funding. Hospitals are under strain, partly due to an ageing population. But the states are seeking growth in hospital funding well above the sustainable growth rate of any tax base – state or federal.
This is from a starting point where the combined (state and federal) deficit is around 3 per cent of GDP, and levels of combined government spending are already at historic highs.
At the Federal level, the Parliamentary Budget Office’s 2025 medium term outlook projects that government spending will remain higher than tax revenue until at least 2036. Interestingly, that assumes relatively flat spending as a share of GDP over the next decade, despite rapid ageing. Even if this proves possible for the Federal Government, it is less likely for the states.
So, the tax to GDP ratio has to rise – to fund the increased spending already locked in, and to cover any further ageing-induced rise in spending to GDP. The income tax is the workhorse of Australia’s tax system. It underpins Federal spending but also tied grants to the states (e.g. for hospitals). And sure enough, it is the income tax which will bear the burden of funding the expansion of government.
When we add together individual and corporate income tax, we see that in 2024, the combined tax receipts reached 18.7 per cent of GDP, the highest level on record and accounted for 71 per cent of total revenue raised.
To date, a significant driver of high-income tax receipts has been good fortune – a surge in the terms of trade and strong domestic demand has boosted corporate income, leading to higher tax receipts from businesses.
Personal income tax receipts have risen to 12.7 per cent of GDP, the highest share since the introduction of GST in 2000. The Parliamentary Budget Office projects that personal income tax receipts will need to rise to an unprecedented 14.5 per cent of GDP in 2036 – and that is just to meet current spending levels as a share of GDP.
But the key point is this: if we are to raise an additional 2 percentage points of GDP from personal income tax over the next decade, the system is likely to become less progressive.
If there is some upper bound on the top marginal tax rate, then the likelihood is that extra revenue will come disproportionately from the middle and low end of the tax scale. This is what bracket creep does by default – it tends, over time, to create a flatter tax scale.
Governments have maintained the progressivity of the system by handing back bracket creep through tax cuts designed to provide relief to low and middle income earners, as described in prior e61 work. If the implicit strategy is to hang on to bracket creep for the next decade, then this channel to maintain progressivity is blocked off.
As Richard Holden from UNSW has pointed out, if bracket creep was allowed to occur unabated for ten years, then the tax paid by an average earner would rise from 20.8 per cent to 23.9 per cent.
If the current average worker experienced no real income growth over the next decade, the tax rate they would pay would increase by 2 percentage points – from 20.8 per cent to 22.8 per cent. However, the increase in effective tax rates would be larger for low-income workers. For instance, an individual receiving $45,000 annually sees their average tax rate rise by 4.5 percentage points (from 9.5 per cent to 14 per cent). To some extent, the 2025-26 Budget tax cuts ameliorate this – following these changes, this same individual would instead see their tax rate rise to 13 per cent by 2035 – still a fairly big tax increase on a low income.
On the other hand, research suggests that the scope for targeted tax increases at the top end of the income scale is limited.
In 2012, the welfare cost of increasing the top tax rate – that comes in at a globally low level of income – was found to be higher than for other groups due to individuals either stopping income earning activities or changing the way they earn income. And, new research has reinforced this by highlighting the significant income shifting that occurs by high income earners under the current system due to tax vehicles like trusts.
Unfortunately, it’s not just high-income earners affected. Researchers have found that a significant number of lower income earners were on the “wrong side of the Laffer curve” due to benefit abatement. Put another way, higher tax rates and benefit taper rates could actually reduce the revenue raised from these individuals.
And, there are also efficiency costs to grapple with. General equilibrium model estimates of the economic value lost for each dollar of revenue raised – also known as the marginal excess burden – are relatively high. The efficiency costs rise as tax rates increase.
Past and forthcoming e61 work shows that part of the expansion of government has come through a discretionary shift towards increased universal, in-kind services rather than means-tested income transfers. That makes government spending a bit less redistributive on average. Funding this through more income tax will likely reduce the extent of redistribution (per dollar raised) on the revenue side.
The Australian tax system cannot easily pay for European safety nets. And even meeting existing, age-adjusted, service obligations will strain the income tax in terms of efficiency and equity.
At some point, policymakers will face the stark choice: either find a second workhorse, or lighten the load.
