Progressive tax systems are usually implemented through several tax brackets with increasing rates. For example, in Australia, a resident individual does not pay tax on their income up to the ‘tax‑free threshold’, currently $18,200, but only on income that exceeds this amount. As a result, an individual with an income of $40,000 in 2021‑22 (just above the current full-time minimum wage) pays no tax on their first $18,200, and 19 per cent tax on their next $21,800, around $4,000 in total, or 10 per cent of their income.3
Australia’s personal tax system has four tax thresholds for the 2021-22 year. The range of income between two thresholds is called a ‘tax bracket’, and a higher tax rate applies to individuals as their income moves into the higher tax brackets. Someone with an income of $150,000, for example, will pay no tax on their first $18,200, 19 per cent tax on the next $26,800, 32.5 per cent on the next $75,000, and finally 37 per cent on the last $30,000 (the marginal tax rate). This results in a total tax of just over $40,000, around 27 per cent of their total income (the average tax rate).
There are two important concepts to understand here – marginal tax rates and average tax rates.
As outlined in the example above, an individual’s marginal tax rate is the amount of tax they would pay on an additional dollar of income they earn – if an individual’s marginal tax rate is 37 per cent and they earn one more dollar, they would pay an additional 37 cents of tax. This differs from the average tax rate, which is an individual’s total tax as a proportion of their total taxable income. Taxable income is the measure of income used to calculate how much tax an individual needs to pay, which may be less than an individual’s gross income if, for example, deductions can be made.
The ‘bracket structure’ of Australia’s personal tax system means that two individuals on very different incomes can face the same marginal tax rate yet face very different average tax rates. Box 1 shows such an example.
Figure 1 shows that the marginal tax rate is higher than the average tax rate in 2021‑22 at all income levels where tax is greater than zero. Marginal and average tax rates would only be the same in a system that applied a flat rate of tax to all income.4
Figure 1: Marginal tax rates exceed average rates in Australia’s tax system
Tax rates, 2021-22
Note: Excludes levies and offsets for illustrative purposes.
Source: PBO analysis.
For taxable incomes well beyond the highest tax threshold of $180,000, the average tax rate gradually converges to the highest marginal tax rate of 45 per cent. An individual with $1 million in taxable income, for instance, will pay an average tax rate of 42 per cent, reflecting that more than 80 per cent of their income is taxed at the highest rate of 45 per cent.
Income growth only results in an individual paying a higher marginal tax rate if their income is pushed into the next tax bracket. But, as Figure 1 shows, any increase in an individual’s taxable income will result in an increase in the average tax rate, with the exception being those still earning below the tax-free threshold. This means that everybody who pays tax will be affected by bracket creep if their income increases, regardless of whether they are pushed into the next tax bracket.5
Box 1: Individuals can face the same marginal tax rate but pay very different average tax rates
Figure 2 provides an illustrative example showing that two income earners, Suzy and Justin, face the same marginal tax rate but different average tax rates. Suzy earns $90,000 and Justin earns $60,000, so both face a marginal tax rate of 32.5 per cent. Half of Suzy’s income is taxed at the higher rate of 32.5 per cent, while only a quarter of Justin’s income is taxed at this rate.
While Suzy earns 50 per cent more than Justin, she pays around twice as much tax (around $20,000 compared to around $10,000 for Justin), resulting in a higher average tax rate. Suzy’s average tax rate is 21.9 per cent, compared to 16.6 per cent for Justin.
If their incomes grow at the same rate, bracket creep will have a larger impact on Justin. This is because there is a larger difference between the marginal tax rate of 32.5 per cent that will apply to the increase in income and Justin’s current average tax rate, relative to Suzy’s.
Figure 2: Two individuals facing the same marginal rate can pay a very different average tax rate
Note: Calculations exclude levies and offsets. When levies and offsets are included, Justin’s average tax rate remains at 16.6 per cent, while Suzy’s average tax rate increases to 22.7 per cent.
Source: PBO analysis.