Taxes can be progressive, proportional, or regressive.
If high-income earners pay a larger proportion of their income in tax than low-income earners, that’s progressive.
Say, for example, a person on $100,000 has to pay $25,000 in tax (25 per cent of their income), while a person on $50,000 a year has to pay $8,000 in tax (16 per cent of their income). That’s a progressive tax, because the high-income earner hands over a larger share of their income to the tax office.
But if the person on $100,000 had to pay $16,000, that would be a proportional tax, because their tax rate (16 per cent) is the same as the lower-income earner’s rate.
And if the higher income earner is taxed at a lower rate, that’s a regressive tax.
How can we measure progressivity?
Measuring progressivity is a bit harder in an economy like Australia’s, with many millions of taxpayers, than it is in a simple example with just two people in it.
To get a rough idea of progressivity, we can look at the share of tax paid by people at different points in the income distribution – the top and bottom 10 per cent, for example. But that won’t give us a complete answer about progressivity of the system over the whole range of incomes.
That’s where a couple of commonly used indexes come in. First is the ‘Suits index’, named after the economist Daniel Suits, who created it in the 1970s.
The Suits index ranges from -1, for a regressive tax where the poorest person pays all the tax, to 1 for a progressive tax where the richest person pays it all. In a proportional tax system, where everyone paid the same share of their income in tax, the Suits index would be 0.
The second is the Reynolds-Smolensky index, also created in the 1970s and also named after its creators.
The Reynolds-Smolensky index measures the difference in income inequality before and after taxes are paid.1
With both the Reynolds-Smolensky and Suits indexes, the main thing to remember is that the higher the number, the more progressive the system.
What happens under the Coalition’s plan?
Using the Grattan Institute’s grattax model of the tax system, we can project what will happen to the progressivity of income tax if the Coalition’s full plan is implemented. With the grattax model, we take detailed historical data from the Australian Tax Office on what Australians earn, and project that data forward, using plausible assumptions about wages and employment growth. We then apply a set of tax rules – in this case, the Coalition’s policy – to the projected income distribution. This allows us to calculate the share of tax that will be paid by particular groups in future, and to calculate measures of progressivity such as the Reynolds-Smolensky and Suits indexes. Our approach is very similar to those used by the Commonwealth Treasury and researchers at the Australian National University and at the National Centre for Social and Economic Modelling (NATSEM) at the University of Canberra – and it gives similar results.
We project that under the Coalition’s plan, the personal income tax system will become a little more progressive next year. This is largely because of the boost in the low- and middle-income tax offset. After that, as bracket creep takes its toll, the progressivity of the system will start to slide, as shown in previous Grattan Institute work.
If Stage Three of the Coalition’s plan is implemented as scheduled in 2024-25, the progressivity of the system will take a big step down. That’s the stage that involves eliminating the second-highest marginal tax bracket and lifting the threshold for the top bracket.
If the plan is implemented as outlined in the recent budget papers, and there are no further policy changes to the end of next decade, Australia’s personal income tax will be the least progressive it has been in years. Still progressive, but much less so. And, as this chart shows, the Suits and Reynolds-Smolensky indexes both tell much the same story.
1. Income inequality is measured using the so-called Gini coefficient, which ranges from 0 (if everyone has the same income) to 1 (if all income is concentrated in one person’s hands).If the Gini of pre-tax income is 0.48, and the Gini of post-tax income is 0.42, the tax has reduced inequality by 0.06 Gini points, so the tax system is at least somewhat progressive.