Date created: 28 November 1996
Last modified: 18 November 1997
Maintained by: John Quiggin
John Quiggin

Increase taxes and kill off the last sacred cow

Australian Financial Review

Nov 1, 1994

Over the last twenty-five years, many of the sacred cows of Australian politics have been killed off. The White Australia policy, the tariff and, in large measure, the Arbitration system, have disappeared. Liberal governments have done deals with Communists and Labor governments have sold off public enterprises. But there has been one taboo that no government has dared to violate. No Australian government in this period has enacted an increase in income tax rates.

The reason quite simply is that no government has had to. As nominal incomes rise, the operations of a progressive tax system ensures that the proportion of income collected in income tax rises steadily. This phenomenon, well-known as bracket creep, is actually two effects in one. Real bracket creep arises when real economic growth raises average incomes. From a public finance point of view, real bracket creep is a good thing, because, as income rises, so does the demand for the kinds of goods and services usually financed by governments, such as health, education and law and order. Real bracket creep ensures that this demand can be met. During the fifties and sixties, when economic growth rates were high and inflation was generally low, real bracket creep was the order of the day.

Nominal bracket creep arises when money incomes are pushed up by inflation, and is definitely a bad thing. With no real change in their circumstances, workers face increasing rates of tax. Since about 1970, nominal bracket creep has been dominant.

Both kinds of bracket creep are very convenient for governments since they allow tax revenue to rise invisibly. Depending on their proclivities, governments can either spend the revenue in electorally appealing ways, or make a show of magnanimity by handing the money back in appropriately targeted tax cuts.

The first Australian leader to recognise the potentialities of bracket creep was Gough Whitlam, who observed that his expenditure programs could be financed by the 'massive and automatic increase in revenue' generated by bracket creep. (To be fair, it is not clear whether Whitlam recognised the difference between real and nominal bracket creep). Much of the wage explosion of 1974 reflected attempts to maintain real post-tax wages in the face of severe bracket creep. Of course, the idea that we could have both a massive increases in public services and constant or increasing disposable incomes was one of the illusions associated with inflation.

Whitlam's successor, Malcolm Fraser was the only politician in Australia, and perhaps in the world, to voluntarily forgo the benefits of bracket creep by indexing tax rates. However, he soon realised his mistake and the experiment has not been repeated. Although it was customary in the eighties for Liberals to castigate Fraser for wasting the opportunities for reform, none of them ever suggested reintroducing indexation.

Indeed, the Fightback manifesto, presented as the last word in tax reform actually introduced an innovation in the use of bracket creep. Instead of handing back the proceeds of past inflation, Fightback promised future tax cuts, funded by inflation that had not yet taken place. This innovation was taken even further by Paul Keating, whose copycat tax cuts were enacted into LAW.

At the same time, of course, both parties were pledging their commitment to eliminate the inflation on which their fiscal policies relied. When, to the surprise of policy-makers, the recession 'snapped the twig' of inflation, Keating was left with a set of budgetary commitments that could not be made to add up. Even after the 1993 Budget deferred indefinitely the second stage of the One Nation tax cuts and jacked up indirect taxes the problem remains almost insoluble.

From almost any perspective, the case for an increase in income tax rates seems unanswerable. In terms of countercyclical fiscal policy, after three years of expansion, we need faster reduction in the deficit now if there is to be any scope for stimulus in the next downturn. Even if there was room for disagreement on timing, the issue has been pre-empted by the Reserve Bank and the money markets, which have made it clear that the only alternative to a lower deficit is a sharp increase in real interest rates.

In the longer term, concern with public savings can only be met by increasing revenue. Transfer payments have been squeezed as far as appears possible, and cuts in public investment in physical and human infrastructureimply reductions, not increases in national savings. Alternatives such as pseudo-private infrastructure projects represent a juggling of categories with no net effect.

Finally, and most importantly, a serious approach to reducing unemployment and optimal resource allocation requires an expansion of employment in the community services sector and therefore in public expenditure. The refusal to countenance higher taxes has led both to underemployment of national resources and a misallocation of those resources that are employed.

With the end of high inflation rates, politicians can no longer rely on bracket creep to deliver painless increases in income tax rates. Yet an increase in income tax rates has never been more obviously necessary than it is today. It is time to break the last taboo in Australian politics.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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