‘Side by Side’ Global Tax Deal Tests Pillar Two’s Staying Power

Dangerous love affair with personal income tax will leave us poorer

Revenue from individuals forms our biggest tax base, but there are risks if we overload it. It’s time for a national conversation about comprehensive tax reform.

Melissa Bray Economist

Jan 27, 2026 

Personal income tax is the single largest revenue source for the Australian government, and since the 1970s, it’s been responsible for about half the government’s tax revenue. In its medium-term budget outlook released last year, the independent Parliamentary Budget Office said it expects this proportion to increase from 48 per cent of total revenue this financial year to 53 per cent in 2035-36.

Australia is more reliant on personal income tax than other OECD countries. In fact, the OECD’s 2025 revenue statistics show us occupying second position for the proportion of revenue we receive from personal income tax, behind Denmark.

When people’s income increases through wage inflation, they can be pushed onto higher tax rates, resulting in bracket-creep. 

Is this becoming a problem? Yes, it is. Inflation is pushing individuals into higher tax brackets. And complexities in the system mean people’s decisions are being distorted. It would be terrible to get into a situation as we have with tobacco excise, where applying tax at a higher rate to a smaller group of taxpayers has led to a significant increase in illegal behaviour as well as a significant reduction in the revenue being collected.

In theory, taxes aim to raise revenue in the most efficient, equitable and simplest way possible. Economists favour taxes that apply to a broad base because you can raise the same revenue with a less distortionary effect. Narrow bases with high rates are more complex, and they provide opportunities for tax planning and income shifting.

While Australia’s personal income tax does have a broad base for labour income, it provides concessional treatment for most forms of savings (including superannuation) and business income (including CGT concessions for small business). These differences can operate to provide incentives for people to structure their affairs to minimise tax.

In addition, interactions between the personal income tax and means-tested transfer payments like JobKeeper and Austudy can lead to extra money that is earned being lost due to both higher taxes and reduced government benefits. The result of these interactions is known as high effective marginal tax rates (EMTRs), and they provide a disincentive to work, particularly for lower-income earners.

Offsets, including the low-income tax offset (or LITO) and levies like the Medicare levy, also work to obscure the true tax rates faced by individuals and add to the complexity of the tax system. LITO effectively increases the tax-free threshold and EMTRs; and the Medicare levy generally adds 2 percentage points to individuals’ marginal income tax rates.

“Historically, governments have provided tax cuts to return a proportion of this bracket creep. While this is generally popular with the electorate, this is not real tax reform.”

A concern voiced by some individuals is that broad-based low-rate taxes are regressive. However, we achieve progressivity not just through the tax system but also through the transfer system.

On the tax side, personal income tax is applied on a progressive rate scale, so the more you earn, the higher the rate of tax you pay.

The tax-free threshold is currently set at $18,200, below which no tax is payable. Above the threshold, 16¢ in tax applies for each $1, and then there are increasing tax rates at subsequent thresholds until at $190,000, 45¢ is payable for each dollar earned over that. On July 1 this year, that 16¢ rate will drop to 15¢ and then to 14¢ from July 1, 2027.

The dollar thresholds are not indexed though, so when people’s income increases through wage-inflation, they can be pushed onto higher tax rates, resulting in bracket-creep. This has the effect of reducing the progressivity of the tax over time, as well as discouraging participation and encouraging planning to minimise tax.

Historically, governments have provided tax cuts to return a proportion of this bracket creep. While this is generally popular with the electorate, this is not real tax reform.

The Parliamentary Budget Office has flagged continued reliance on personal income tax as a structural risk to the budget. Despite the tax cuts that were announced in last year’s budget, it says, “there is a continued risk of increased dependence on personal income tax driving the intergenerational challenge as well as raising issues around equity and efficiency of the tax-base more broadly”.

The OECD’s economic survey of Australia, released on Thursday, recommended indexing the thresholds.

In his book on the mixed fortunes of tax reform in Australia, Paul Tilley has highlighted another issue. The demographic pressures of our ageing population and the tax concessions associated with retirement incomes mean that, in future, personal income tax will apply to a shrinking proportion of the working-age population.

It’s now been 16 years since Australia’s last comprehensive tax review was released. The Henry review suggested that to ensure sustainability, personal income tax needs to be perceived by the community to be fair. Its recommendations included: a higher tax-free threshold; a constant marginal rate for most people; exempting income support and supplementary payments; largely incorporating (i.e. scrapping) the Medicare levy and structural offsets, including LITO; and providing a standard deduction for work-related expenses.

Deloitte Access Economics has recently modelled its proposal to index thresholds at 2.5 per cent per year, increase the tax-free threshold to $33,000 and then have a single marginal tax rate of 33 per cent applying to income between $33,000 and $330,000 and a rate of 45 per cent above that. They flag how this would significantly simplify the system, but come at a cost to the budget of $54 billion per year after 10 years.

The Parliamentary Budget Office has developed a Build Your Own Budget tool that lets anyone test a range of economic scenarios and policy changes (it’s a great tool for tax, policy and budget nerds). It shows the cost of just indexing the thresholds at CPI coming in at about $29 billion over the forward estimates period.

The Parliamentary Budget Office has also released a paper on Australia’s tax mix that considers scenarios that would raise the same amount of revenue. One of them involves shifting the tax mix from income tax to consumption tax. They highlight how decreasing personal income tax and increasing the GST – which is a more efficient and less distortionary tax – would increase economic efficiency, decrease average complexity in the tax system and make it more responsive to economic shocks.

Personal income tax is our biggest tax base, but there are risks if we overload it. It’s time we had a national conversation about comprehensive tax reform, including how it interacts with the transfer system.