The basics of income tax

(Note: This article quotes tax rates from the 2006/07 tax year.) 

In Australia, like many countries, we have a tax system that applies increasing tax rates the higher your taxable income. Unlike a country that applies a flat tax rate of, say, 30% of every dollar you earn, the Australian system is designed to make high income individuals pay a higher rate of tax than low income individuals.

The top marginal tax rate, which kicks in on your first dollar after your income exceeds $150,000pa is 45%, though there is an additional 1.5% on the whole amount called the Medicare levy, and for many tax payers that do not have any private health insurance there is also an extra 1% called the Medicare Levy Surcharge. If you are a high income earner it would pay to buy a health insurance policy because the policy could well be cheaper than the surcharge.

It needs to be clarified that being on a 46.5% (including Medicare levy) marginal tax rate does not mean you pay 46.5% of your income out as tax. You are taxed at lower rates on your first $150,000 of income just like other tax payers. If you earned $170,000 last year you would not pay $79,050 in tax, you would instead pay around $54,000 in tax and $2,550 Medicare levy for a total liability of $56,550. This is much less than what a flat 46.5% tax would be.

A common belief by many people is that when you are on the top marginal tax rate there is no point in working to earn money because, "it all just goes in tax." If you do overtime and you have already earned more than $150,000, you will pay 46.5% on the extra money you earn, but never 100%. For all the money you earn to go on tax would require a 100% marginal tax rate, and such a thing does not exist. Ok, after taking out taxes your actual hourly rate drops by almost half, but it doesn't drop to nothing.

A second point of confusion is about tax deductions. Just as there is no 100% tax rate, there is no 100% tax refund for claiming a tax deduction on an item. Just as silly as the, "it all goes on tax" statement is, "don't worry, it's tax deductible so I'll claim it back." If you earned $170,000 and claimed $1,000 tax deductions, your tax bill would be reduced by only $465, not the full thousand. So in most cases instead of making phone calls on your mobile that you bought for work, or buying a new computer that you don't need just for the tax deductions you should go for a more frugal approach of not spending money unnecessarily.

I expand on the subject of tax deductions in another article in the Tax FAQ, "Tax rebates vs deductions".

A simple formula describes the amount of taxable income you have:

    Taxable income = Assessable income minus allowable deductions

Your taxable income is then taxed at each marginal tax rate up till the highest one that applies to you, then any tax rebates that apply are credited against your tax liability. Some income, such as foreign employment income is exempt from Australian tax, this is called, funnily enough, exempt income.

Medicare Levy applies is normally 1.5% of your income, but it may be lower if your income is lower.  An easy way to estimate it is to use the ATO's Medicare Levy estimation calculator .

An additional 1% of total taxable income is charged for the Medicare Levy Surcharge, for all individuals with a reportable income plus reportable fringe benefits in excess of $50,000 and for families with income over $100,000 plus $1500 for each child after the first.

To avoid paying the Medicare Levy Surcharge taxpayers can obtain private medical insurance, though please note that there are certain requirements about the level of cover you must buy to get the exemption. It may not be enough to take out a very inexpensive policy with a huge excess and long wait periods etc, there are specific rules about buying super cheap policies that you don't intend to use just to dodge the medicare levy surcharge.