In sticking with tax cuts divorced from reality, Labor is left with a hard choice

The big question prior to Treasurer Jim Chalmers delivering the Albanese government’s first budget on October 26 has been whether it will seek to modify the “stage 3” tax cuts legislated by the Morrison government, with Labor’s support.

The cuts, set to come into effect in 2024, reduce the marginal tax paid on incomes between $45,000 and $200,000 to 30% (instead of the 32.5% now paid up to $120,000, 37% between $120,000 and $180,000, and 45% after that).

Labor promised before the election it would implement the cuts, but over the past few weeks it has encouraged a debate about abandoning this position, given changed circumstances. Nevertheless, it now appears the tax cuts will go ahead as legislated.

Read more: Grattan on Friday: Should Anthony Albanese keep his word on the Stage 3 tax cuts?

It’s worth considering that debate – and the comparisons drawn to the United Kingdom, where new Prime Minister Liz Truss announced a radical package of tax cuts, including reduced marginal rates for high income earners.

Within a matter of weeks she has been forced to scrap central elements of the package. She has now sacked her Chancellor of the Exchequer (treasurer) Kwasi Kwarteng, with whom she designed and announced the package. It looks like a doomed attempt to save her prime ministership.

Her backdown emboldened those calling for a similar policy shift in Australia. The parallels aren’t exact, but there are plenty of similarities between the economic and political difficulties faced by the UK and Australian governments.

What made the UK cuts different?

In both countries, the response to the COVID pandemic was broadly successful in keeping unemployment down and allowing for a rapid return to the pre-pandemic growth path.

High inflation, rising interest rates and sharp increases in energy costs now threaten to derail this recovery. The UK also faces extra challenges of its own making, with the mismanagement of Britain’s exit from the European Union disrupting exports to Europe and creating labour shortages.

Under previous prime minister Boris Johnson, the UK government’s economic response was more or less similar to that of other countries – with a modest increase to national insurance contributions and cost-of-living increase to welfare payments.

After replacing Johnson, Truss announced a radical package combining a massive fuel subsidy with equally massive tax cuts mostly benefiting corporations and high-income earners.

No offsetting savings were announced, although it was hinted that welfare benefits would not be raised in line with inflation. Estimates of the cost were £100 billion to £150 billion (7-10% of Britain’s annual national income), of which about half was associated with the tax package.

The public reaction was swift and hostile. But what mattered more was the response of financial markets.

Fears of inflation, which would reduce the real value of government bonds, led to holders of those bonds selling them off. Since market interest rates – that is, the return demanded by bond holders – move in the opposite direction to bond prices, these rates rose sharply.

The pound plummeted in value, as traders expected its real value to decline. Major pension funds, which employed complex strategies to manage their holdings of bonds, faced collapse. The Bank of England was forced to intervene by stepping in to inflate demand for government bonds.

Truss backed down on scrapping the top marginal tax rate of 45%, paid on income in excess of £150,000 (about A$250,000). This saved about £2 billion. In a second backdown late last week, Truss accepted a previously announced increase in corporate tax rates, which she had planned to cancel, would go ahead after all. But the equally regressive cut in national insurance contributions remains, along with a range of business handouts.

Projections now bear no relation to reality

Truss’s tax package was ideologically extreme. But it was, at least, designed as a response to current conditions.

By contrast, Australia’s stage 3 tax cuts were planned and legislated in 2018, on the basis of economic projections that now bear no relation to reality.

As their name implies, they followed two previous rounds of tax cuts. Stages 1 and 2, which came into effect in 2018-19 and 2020-21 respectively, were smaller and largely designed with the political goal of smoothing the path for stage 3.

Because of the unexpected acceleration of inflation, most of the tax relief these cuts provided for low- and middle-income earners will be eroded by bracket creep – the process by which inflation pushes incomes into higher tax brackets, even with no change in the real value of those incomes.

Read more: That $243 billion 'saving' from axing the Stage 3 tax cut is more mirage than reality

Moreover, some of the stage 1 cuts are temporary – implemented by then treasurer Scott Morrison as the so-called Low and Middle Income Offset (LMITO) rather than as a permanent change in tax rates.

This measure was originally due to expire in 2020-21, but Morrison extended it to 2021-22. Unless Chalmers extends it again, many Australians on modest incomes will face a tax increase this financial year, as their wealthier compatriots look forward to a cut.

As with the Truss tax measures, stage 3 massively favours high earners, with 70% of the benefits going to the 10% of taxpayers who earn more than $120,000 a year.

Let debt grow or cut services?

The macroeconomic impacts of the stage 3 cuts remain to be seen. But no one now can see them as a sensible response to economic difficulties likely to worsen over the next couple of years.

One idea that emerged from the past few weeks of debate was to maintain part of the cuts, by reducing the 32.5% marginal tax rate on incomes between $45,000 and $120,000 to 30%, while scrapping or scaling back the cuts for incomes between $120,000 and $180,000.

But with the tax cuts going ahead exactly as they were legislated in 2018, the Albanese government is left the same dilemma as in the UK: a choice between growing debt and cutting expenditure on vital services.

At a time when wages are failing to keep pace with inflation, while profits are booming, it’s not the kind of choice any government would normally like to make.