Income tax basics

Income tax has a reputation for being complicated. The core maths is not. It runs on two ideas: a slice of income that is not taxed at all, and rising rates on the slices above it. Once you can do one worked example, you can estimate anyone's tax.

The tax free threshold

For Australian residents, the first $18,200 you earn in a year is completely tax free. This is the tax free threshold, and it matters enormously for students: a casual job earning less than $18,200 across the whole year owes no income tax at all. Whatever gets withheld from your pay during the year comes back as a refund when you lodge your return.

The brackets for residents

• Nothing on the first $18,200.
• 16 cents in each dollar from $18,201 to $45,000.
• 30 cents in each dollar from $45,001 to $135,000.
• 37 cents in each dollar from $135,001 to $190,000.
• 45 cents in each dollar above $190,000.

The crucial word is each. The rates apply to the dollars inside each bracket, not to your whole income. Earning your way into a higher bracket only changes the tax on the extra dollars. Nobody has ever lost money by getting a pay rise into a new bracket, despite what someone's uncle insists at every barbecue.

A worked example: $50,000

Take someone earning $50,000 a year. The first $18,200 is tax free. The slice from $18,201 to $45,000 is $26,800, taxed at 16%, which is $4,288. The slice from $45,001 to $50,000 is $5,000, taxed at 30%, which is $1,500. Total income tax: $5,788, or about 11.6% of the whole $50,000, even though they sit in the 30% bracket. The rate on the top slice is the marginal rate. The rate on the whole income is the average rate, and it is always lower.

The Medicare levy

On top of income tax, most taxpayers pay the Medicare levy, 2% of income, which helps fund the public health system. Low income earners pay a reduced levy or none at all, so it will not touch a small casual income. On $50,000 it adds $1,000 to the bill.

A second example: $80,000

Run the same method on a higher income to see the gap between the two rates widen. On $80,000 the first $18,200 is tax free, the slice from $18,201 to $45,000 is $26,800 taxed at 16% for $4,288, and the slice from $45,001 to $80,000 is $35,000 taxed at 30% for $10,500. That is $14,788 of income tax, plus a 2% Medicare levy of $1,600, for $16,388 all up. The marginal rate is still 30%, because the last dollar sat in the 30% bracket, but the average rate on the whole $80,000 is about 18.5%. This is an illustrative case using the resident rates, and once you can run it twice you can estimate almost anyone's tax on the back of a receipt.

What the marginal rate is good for

The marginal rate matters because it tells you the tax on your next dollar, not your average dollar, and the next dollar is the one you decide about. When you weigh up an extra weekend shift, a bit of overtime or a small pay rise, the marginal rate is the fraction of that extra money the ATO will take, so a worker in the 30% bracket keeps 70 cents of every additional dollar earned. That is still a clear gain, which is the whole point: because only the extra dollars are taxed at the higher rate, more work and more pay always leave you ahead, and the barbecue theory that a raise can push you backwards is simply wrong.