Terry Baucher looks at the effect of inflation and "bracket creep" and underscores yet another comparative disadvantage with Australia. Your view?

By Terry Baucher*

Even for tax practitioners this week’s Budget is likely to be a very dull affair.  We already know that there will be no tax “re-balancing” initiatives and that it will be a “Zero Budget” with no increase in overall spending.   Within that overall cap there will be some re-allocations in future spending similar to what’s already been announced regarding prescription charges and student allowances.  In short, the message will be “Move along, nothing to see here” as the Government continues its path towards a budget surplus by the 2014-15 year.  

It’s therefore not hard to cast an envious eye across the Ditch and look at the recent Australian Budget which contained a number of eye-catching announcements.  Julia Gillard’s government appears to be as full of holes as John Banks’ recollection of his conversations with Kim Dotcom, so there is no guarantee that what’s proposed will be passed.  Even so, the scope of the major proposals in the Australian Budget underscore the current gap between Australia and New Zealand and will almost certainly provide further incentives for those considering emigrating because of brighter opportunities on the other side of the Tasman. 

Quite apart from a projected return to surplus during the year ended 30th June 2013, the Australian Budget cancelled a proposed cut in company income tax in order to pay for a tripling of the tax free threshold for individuals from A$6,000 to A$18,200 (@NZ$23,600) with effect from 1st July this year.  This initiative is estimated to result in a million Australians no longer being required to file tax returns.  By any measure it’s a bold move.

By contrast, here in New Zealand income taxes were effectively increased for individuals from 1st April this year and through measures such as increasing the tax on cigarettes, raising prescription fees and the repayment rate for student loans, the Government has taken a number of initiatives to increase its revenue without explicitly increasing income tax.

A creeping inflation

You might be wondering “How did I miss that announcement about personal income taxes?” Actually, you didn’t as there wasn’t one.  Instead, because the Government has not adjusted the various income tax thresholds since they came into force on 1 October 2010, then as a result of inflation, income taxes effectively increased from 1st April. 

The combination of inflation and something known as “bracket creep” are a particularly effective means of raising tax revenue in real terms without anyone paying too much attention.   For more than 20 years New Zealand governments have been ready adopters of this method.

Inflation erodes the real value of money over time so without adjustments to take it into effect a person’s real (inflation adjusted) income will decline.  Inflation has the opposite effect with tax allowances and thresholds; if these are not revised to take inflation into account, then in real terms tax revenues will rise.  “Bracket creep” is where wage rises take a person’s income into a new tax bracket.  Combine inflation and bracket creep and then there is a strong likelihood of a person’s tax bill rising in real terms even if those wage rises are mostly adjustments for inflation. 

This is what happened to large numbers of taxpayers between 2000 and 2008.  When the controversial 39% top rate was introduced in April 2000 it was supposed to apply to the top 5% of taxpayers.  In fact, by 2008 more than 11% of taxpayers were in the highest tax bracket as thousands were pulled into higher tax brackets through the combination of inflation and bracket creep.

Taxation by stealth

Bracket creep is a common to all income tax systems but responses to it differ.   In the USA the Federal income tax thresholds and allowances are adjusted annually.  Inflation adjustments of allowances and thresholds are mandatory in Canada and the United Kingdom although they may be specifically overruled, something which for obvious reasons is done only rarely. 

Here in New Zealand, Governments of both hues have, in my view, been very cynical in their approach to the issue.  Over the past 20 years adjustments to income tax thresholds have been made intermittently, more often than not coinciding with an election year.  This is in marked contrast to ACC maximum and minimum earnings limits, the thresholds for Student Loan repayments and the amount of National Superannuation payable all of which are annually adjusted for inflation.  

The extent of these tax increases by stealth over the past decade can be seen by looking at what has happened with the ACC maximum earnings limit which is indexed for inflation.   For the tax year which began on 1st April 2000 the maximum earnings limit was $84,636. By 1st April this year the earnings limit had increased by 34.4 % to $113,768.  If the $60,000 threshold for the top rate of income tax introduced on 1 April 2000 had been indexed at the same rate as ACC thresholds, it would now be $80,650, or over $10,000 more than the current threshold of $70,000.  Viewed in this light, a significant portion of the recent “tax cuts” were for many people little more than inflationary adjustments. 

Gov't inaction

The British statutory requirement to index allowances and thresholds was the result in 1977 of a cross–party initiative, the leaders of which included Nigel Lawson, a future Chancellor of the Exchequer (Finance Minister) in Margaret Thatcher’s government.  Lawson and his colleagues Jeff Rooker and Audrey Wise argued that without indexation, inflation acted as an unauthorised, unintended and unknown increase in taxation.  They wanted more transparency so that it was apparent when any real changes in income tax thresholds were taking place. 

In the wake of the John Banks and Kim Dotcom donations imbroglio, there are calls for clearer rules around political donations.  In the same spirit of transparency it would be nice to see this week’s Budget brings greater openness around the setting of income tax thresholds and the effect of inflation.  Somehow I can’t see that happening....at least until the next election year Budget.

*Terry Baucher is an Auckland-based tax specialist with 20 years experience. He works almost exclusively with high net worth individuals and owners of medium sized and emerging businesses.