Bracket creep occurs when inflation increases peoples’ incomes, moving them into higher tax brackets.
Bracket creep occurs when inflation increases peoples’ incomes, moving them into higher tax brackets. They end up paying more tax as a result but their “real” earnings (as measured by their purchasing power) have not increased. Bracket creep is an automatic source of increased revenue for Government.
According to Statistics New Zealand, the 2015 median weekly earnings for employees was $880 (the average is a bit higher at $1,031)1. The annualised figure is around $45,700 ($53,600).
By comparison, in 2010, annualised median earnings were approximately $39,900 (the average: $46,200).
Based on current tax rates and thresholds, the marginal tax rate (i.e. tax on the next dollar of earnings) for those on the 2015 median salary or wage is 17.5%. However, the marginal rate is 30% for those on the 2015 average salary or wage.
At the time of the 2010 tax changes, a 17.5% marginal tax rate applied to both the median and average salary and wage earner. This means there has been bracket creep since 2010 for those earning the average salary or wage.
The current top marginal tax rate of 33% applies at a taxable income threshold of $70,000. This is approximately 1.5x median earnings (or 1.3x average earnings) in 2015.
Assuming wage growth of 1.5% each year, and no change to tax rates or thresholds, the current top marginal tax rate would apply to those earning the 2015 median salary or wage in 2044 (and those earning the 2015 average salary or wage in 2033). However, if we use a 2.5% annual wage growth rate assumption (which is closer to the average over the last 6 years), this would bring this date forward to 2033 (and 2026). So this is very sensitive to wage inflation.
More importantly, our analysis shows that the second highest marginal tax rate of 30%, which already applies to the average salary and wage earner, will apply as early as 2017 (depending on wage growth assumptions) for those on the median salary or wage.
Inflation-adjust income thresholds
If the Government’s aim is to correct for bracket creep, then according to our
analysis, it should adjust income thresholds by around 9%.
Our calculations are based on the assumptions that:
Making a 9% adjustment would result in the following “inflation-adjusted” income tax thresholds:
For someone on the 2015 median salary or wage, this change to the income thresholds would deliver a tax cut of around $88. (The low amount is because they already face a top marginal rate of 17.5%, so the extra benefit would be the 10.5% rate applying to a bit more of their income – i.e. up to $15,260 compared to $14,000 now.)
For someone on the average salary or wage, the tax cut would be higher at $628. (This is because they would face a 17.5% tax rate on income between $15,260 and $52,320, compared to $14,000 to $48,000 currently, and 10.5% up to $15,260.)
The Treasury has published its estimates of the revenue effects of changes to personal tax rates and income thresholds for 2015/16.3
Their revenue effect estimates are:
Based on the above revenue estimates, the cost of inflation adjusting income tax thresholds from 2010 would be approximately $800 million per annum. This is less than the $3 billion the Government seems to be budgeting for tax cuts, although it is not clear whether this is per annum or spread over a period of time.
If the Government intends to compensate for more than just inflation bracket creep there are a range of options it could consider. These include:
The result will answer the question of “who benefits from tax cuts”?
If the total amount available for personal income tax changes is $3 billion per annum, then some options are outlined below. (Please note that these are provided for illustrative purposes only – they are NOT intended to reflect a KPMG view of what a desirable personal tax rate structure for New Zealand might be):
(Note: the Treasury estimates of tax rate changes are for a single percentage point rate change only. The revenue effect of a greater change cannot be fully costed by simply multiplying the cost of a 1% rate change (e.g. reducing 33% to 30% is not $215m times three). However, the Treasury’s revenue effect estimates are the only available proxy. We have simply multiplied the relevant 1% rate to illustrate a possible revenue cost for each option.)
Although our high-level revenue costing of all three options is broadly the same, the distributional impact of the changes is not.
Changing income thresholds – particularly if weighted towards the middle income band – has a slightly more progressive impact on the distribution of tax cuts (when the cuts are measured as a percentage of income).
Changing tax rates (while holding the current income thresholds constant) can be less progressive; however, this is highly dependent on which rates are cut.
A combination of adjustments to tax rates and income thresholds can further moderate some of the distributional impact.
Our analysis excludes:
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