Don’t let tax creep up on you

Australia has a progressive income tax system. This simply means that higher income earners pay a greater proportion of their income in tax than low-income earners.

It is achieved by applying a different rate of tax to each income band or ‘bracket’.

For example, if you earn $25,000 a year you will pay $1292 in tax, or 5.2 percent of your total taxable income.

Earn $87,000, however, and your tax bill jumps to $19,822, or 22.8 percent of your taxable income.

Where it becomes creepy

So what happens if you are earning $87,000 a year and then receive a pay rise of three percent?

That extra $2610 will be taxed at 37 percent, so your total tax now rises to $20,788, or 23.2 percent of your taxable income.

This is what ‘bracket creep’ is all about.

As your taxable income rises and you move into higher tax brackets, the progressively higher tax rates mean that a greater proportion of your income is paid in tax.

Despite that, your take-home pay has still gone up by $1644, so what’s to complain about?

In a word: inflation. Bracket creep means your three percent pay rise has resulted in only a 1.9 percent increase in after-tax income.

Bracket creep is a bigger problem during periods when inflation and wages growth are higher than when wages are growing slowly.

However over time, and without action, it will still be felt.

It affects everyone with taxable income above the tax-free threshold, though in both dollar terms and as a proportion of taxable income, bracket creep has a greater impact on higher income earners.

What is the solution?

From a policy perspective, the obvious solution to bracket creep is tax indexation.

This would see tax thresholds automatically increase each year, in line with the consumer price index or a wages index.

If your taxable income rises at the same rate as the index, your average tax rate would remain the same.

Tax indexation has been talked about for decades, but it is a solution that no government has yet implemented.

One reason could be that bracket creep delivers an almost invisible tax windfall to governments.

Without changing any numbers or making any headlines, as wages rise the extra tax quietly rolls in.

What can you do?

A number of strategies can help reduce bracket creep.

Generally they revolve around the different tax rates that apply to personal income, superannuation contributions and earnings, or even company profits.

Salary sacrifice to superannuation is one option, provided the tax rate on super contributions is less than your marginal tax rate. Take care, however. Tax planning is a complex area, so make sure you seek the help of an appropriately qualified professional to develop your solution to the bracket creep. – Robert Goudie, authorised representative of Meritum Financial Group. the impact of