Ignore Turnbull’s rhetoric on income tax cuts until he explains how he’ll pay for them | Greg Jericho

The rather unexpected allusion by the prime minister this week in a speech to the Business Council of Australia to the government’s pursuit of further income tax cuts is not one that should be treated with too much respect until he also talks about how to pay for them. With the return to surplus built on income tax revenue, any income tax cuts are unlikely to come before the next decade without either increases in other taxes or big cuts to government services.

Amid the usual “free markets are great” rah-rah that the prime minister doled out to the Business Council of Australia on Monday night, Malcolm Turnbull also slipped in a line on income tax cuts, noting that he was: “Actively working with the treasurer and all my cabinet colleagues to ease the burden on middle-income Australians, while also meeting our commitment to return the budget to surplus.”

This was a bit of a surprise given the current state of the budget is such that the government is projecting that a return to surplus only in 2020-21and that net debt at that point will total $366bn, or 17.6% of GDP.

Even in the best of times, promising income tax cuts as the budget is in deficit is a courageous position to take for a political party that likes to prides itself on “budget responsibility”.It is even more courageous when the path back to surplus is built on a foundation of income tax revenue.

Individual’s income tax has always been the biggest tax in the budget. During the mining-boom years it declined slightly in importance as company tax exploded in value from 3.3% of GDP in 1998-99 to5.3% of GDP in 2005-06. But in the current financial year, individual income tax accounts for just over half of all tax revenue.

Now that in itself is a bit of a problem (the IMF and OECD have made calls for Australia to lessen its reliance on income tax) but it is a bigger problem for Turnbull and his call for tax cuts while also “meeting our commitment to return the budget to surplus.” The issue it that of the extra $88.1bn in tax revenue the government hopes to gain between now and 2020-21, $48.5bn of it is to come from individual income tax.

This means that income tax is actually bearing a greater burden of the increase in tax than would be expected.

Income tax makes up 50.6% of total tax revenue, but accounts for 55% of the increase in tax revenue between now and 2020-21. By contrast, company tax currently makes up 19.2% of total tax revenue and accounts for a similar 19.5% of the expected growth in tax revenue.

The GST is actually predicted to become less important over the next four years as we continue to move our spending to non-GST items and services.

Now $8.5bn of that extra income tax is to come from the rise in the Medicare levy, but overall the budget predicts that the next four years will see individual income tax revenue grow by more each year than it has in all but one of the past five years.

This is partly based on a hope for continuing solid employment growth and partly on increased revenue via wages growth.

As I noted last week, the budget predicts that by June next year, wages will be growing annually by 2.5% – something they haven’t done since June 2014. By June 2020-21 the budget further predicts they will be growing at 3.75%, which hasn’t happened since June 2011.

If this does not come to pass, then the income tax figures are in great danger of being below expectations.

On Tuesday night the governor of the Reserve Bank, Philip Lowe, gave the audience at the Australian Business Economists Annual Dinner little reason to expect that wages growth would pick up to that extent. Rather he noted that the growth in average hourly earnings “is running at the lowest rate since at least the 1960s”.

You can understand however why Turnbull is concerned about cutting income tax. The bogeyman of bracket creep is a major factor. Bracket creep occurs when purely though wage inflation (ie a pay rise for doing the same job) you are pushed into a higher tax bracket – and thus you end up paying a higher average tax rate.

This was the reason behind the government’s decision last year to raise the second highest tax bracket threshold from $80,000 to $87,000.

The Parliamentary Budget Office predicts that by 2020-21 those on median incomes will see the biggest rise in their average tax rate – up 3.8% points – and the main reason for it is inflation:

But the decision to raise the tax threshold from $80,000 to $87,000 cost $4bn over four years and delivered a tax cut of $315 to the roughly two-and-quarter million taxpayers earning over $87,000. Was the government, for example, to raise the next lowest threshold from $37,000 to $40,000, it would mean a $405 tax cut to the around seven-and-half million people earning over $37,000.

So these things get expensive very quickly.

And in an environment where the government is already basing its return to surplus on very optimistic wage-growth predictions, being able to keep to that path while simultaneously reducing the amount of revenue it will raise via income tax is not maths that adds up.

At the very least the government would need to either cut government services or payments, or raise the money elsewhere.

So while it is a nice little sentence in a speech that gets the desired headlines, it is unlikely to become anything close to reality until at least after 2020-21. And it is worth remembering that the reality will also contain the other side of the equation. You can either cut taxes and increase the deficit, or you can cut taxes while also cutting spending or raising other taxes in order to keep the budget unaffected. You cannot do both.