The nominal tax rates in Australia look fairly normal and progressive, starting with the tax-free threshold and then rising to 16%, 30%, 37%, and 45%.

This is misleading. Once we factor in the Low-Income Tax Offset (LITO) and the Medicare Levy (ML) the actual tax rates become more complex and partly regressive.

Removing the 10% Medicare Levy bracket on low-income earners

Removing the Medicare Levy entirely would obviously remove the ML regressive element in tax system, but at a budget cost of roughly $25 billion this is probably outside what the major parties would consider. It has also been explained to me by savvy politicians that the Medicare Levy is actually a relatively popular tax, because people mistakenly believe it has something to do with Medicare.

There is an easier and cheaper solution. Instead of removing the entire ML the government should simply remove the unnecessary 10% ML bracket that applies to income between $26k and $32.5k. This would cost the budget a far more manageable $2-3 billion, while lightening the tax burden on low-income earners and removing the first regressive part of the tax system.

Replace LITO and WRE tax deductions with a higher tax-free threshold

The Low-Income Tax Offset (LITO) superficially looks like a nice policy, pushing up the effective tax-free threshold to $22.5k while not costing the budget too much. The problem is that this outcome is achieved by effectively pushing up the tax rates on people earning between $37k to $67k as LITO is withdrawn. Not only does this add an extra tax burden on those low-income earners and discourage effort, but it also causes a regressive step in the tax system. The ATA has long argued that LITO (and its twin LMITO) are mediocre policy that are more about looking good than doing good.

The solution is a three-part change to the tax system:

Increase the tax-free threshold from $18.2k up to $24k
Remove LITO entirely, since the above change already provides a larger tax-free area, but without the higher marginal tax rates on working families or the regressive step.
Simply the tax system by removing the many complicated work-related expense (WRE) tax deductions.

This would significantly simplify our tax system, benefit most taxpayers, improve the incentives for middle-income earners, and remove a regressive part of the tax system. The trifecta = simplicity, efficiency, fairness. The impact on the budget would be relatively mild at roughly $1 billion.

Our proposal provides a tax cut of $928. For low-income earners this would replace the current $700 benefit they get from LITO, and for middle-income earners this would replace the WRE tax deduction which has an average benefit of $820 for middle-income earners (from $45k to $190k). Some high-income earners will lose out of this policy since their average WRE deduction is greater than the proposed tax cut, which is why this policy change should be matched with productivity tax cuts for people in the top two tax brackets (covered in a future ATA tax policy proposal).

From an economic perspective, the best thing about this change is the improved incentives for workers who earn between $37k and $67k. Those taxpayers are currently hit with a LITO-related effective tax of 5% (up to $45k) or 1.5% (above $45k), and that tax burden would now be removed. Using the ATA dynamic tax model, this would boost GDP by $2.6 billion.

Perhaps the biggest losers would be tax accountants and tax cheats, who currently benefit from our complicated maze of tax offsets and tax deductions. This too is to be celebrated. The tax return process will become much simpler for most taxpayers, and the true nature of our tax system will be more transparent.

Remove the regressive steps in income tax