What is bracket creep and how can it reduce your take-home pay?

The federal government says its revised stage three tax cuts will reduce bracket creep for the average Australian. Here's everything you need to know.

The federal government has promised its revised stage three tax cuts will address bracket creep. Source: Getty / Asadnz/iStockphoto

The term "bracket creep" has come up a lot in recent days amid discussions about the federal government's revised stage three tax cuts.

Treasurer Jim Chalmers says the changes will more evenly distribute bracket creep to make things fairer for "middle Australia".

But what does that mean and what impact can it have on your take-home pay?

What is bracket creep?

Australia currently has five income tax brackets:

• $0 to $18,200 - taxed 0 per cent
• $18,201 to $45,000 - taxed at 19 per cent
• $45,001 to $120,000 - taxed at 32.5 per cent
• $120,001 to $180,000 - taxed at 37 per cent
• $180,000+ - taxed at 45 per cent

Rather than being indexed to keep pace with inflation, the federal government adjusts the tax brackets on an "ad hoc" basis, associate professor Ben Phillips, an economic and social researcher at Australian National University, said.

"If you keep the current tax thresholds as they are, people will naturally tend to move into higher brackets as their wages increase and as prices increase," he said.

This results in bracket creep — where workers end up paying an increasing proportion of their income in tax, leaving them worse off.

How can bracket creep affect your take-home pay?

For example, if you earn the median Australian salary of $67,600 before tax, you pay:

• 0 per cent tax on your first $18,200
• 19 per cent tax on your next $26,800
• 32.5 per cent tax on the remaining $22,600

That means you'll be taxed $12,437, reducing your pay after tax to $55,163 (not including the Medicare levy or any other deductions) and giving you an average tax rate of 18.4 per cent.

If you get a pay increase of 4.1 per cent to match the current rate of inflation, your salary will rise to $70,371.60 before tax.

In that scenario, you'd be taxed $13,337.77, reducing your pay after tax to $57,033.83 (not including the Medicare levy or any other deductions) and raising your average tax rate of 18.95 per cent.

So although your pre-tax pay rose by 4.1 per cent to keep pace with inflation, after tax, your income only increased by 3.55 per cent, meaning your real wage has decreased.

How could the stage three tax cuts address bracket creep?

Bracket creep has a greater impact on those on low and middle incomes as they experience a faster growth in their average tax rate as their pay increases, Greg Jericho, chief economist at think tank the Australia Institute, said.

"When we talk about trying to fix bracket creep, it's generally about increasing the tax brackets or lowering the tax rates so that people are not worse off just because they've got a wage rise to keep pace with inflation," he said.

Assuming the revised stage three tax cuts pass parliament, they will change from 1 July 2024 to:

• $0 to $18,200 - taxed 0 per cent 
• $18,201 to $45,000 - taxed at 16 per cent 
• $45,001 to $135,000 - taxed at 30 per cent 
• $135,001 to $180,000 - taxed at 37 per cent 
• $190,000+ - taxed at 45 per cent

Credit: Kenneth Macleod

With a salary of $70,371.60 before tax, you would pay:

• 0 per cent tax on your first $18,200
• 16 per cent tax on your next $26,800
• 30 per cent tax on the remaining $25,371.60

That means you'll be taxed $11,899.48, reducing your pay after tax to $58,472.12 (not including the Medicare levy or any other deductions), and giving you an average tax rate of 16.9 per cent.

Therefore, you will take home $1,438.29 more after tax than before the changes were implemented.

Your average tax rate will also be 2.05 per cent lower.

The revised stage three tax cuts are expected to be debated in federal parliament next week.

Additional reporting by Ewa Staszewska