Tax thresholds are everywhere in Australia’s tax system. They often seem well intentioned—simplifying administration or shielding smaller businesses from complex tax obligations. But thresholds also introduce abrupt jumps in effective tax rates, and these jumps can distort economic decisions in ways that reduce efficiency and introduce deadweight costs.
Our recent modelling work examines this issue in the context of corporate taxation. The results suggest that turnover thresholds—while well-intentioned—can impose measurable costs on the economy by encouraging firms to operate below their most efficient size.
The lesson extends well beyond company tax. Similar threshold effects appear across many Australian taxes, including payroll tax and state land taxes, where sharp thresholds create steep effective tax schedules as firms or landholdings grow.
Why thresholds matter
The basic economic mechanism is straightforward.
When tax liabilities jump sharply once a threshold is crossed, firms close to that threshold face a choice. They can expand production and incur the higher tax rate, or they can scale back activity to remain below the threshold. If firms choose the second option, the economy ends up with businesses operating below their most efficient scale. Labour and capital are used less productively, and the cost of producing each unit of output rises.
Economists describe this loss as a deadweight cost of taxation—additional resources are used to produce the same level of output due to the presence of a tax threshold. Our modelling focuses on this problem in the context of corporate income taxation, building on previous work by our colleagues, Profs. Peter Dixon and Maureen Rimmer, together with Dr Mark Picton, who studied payroll tax thresholds.
A turnover threshold in the corporate tax system
Because corporate tax ultimately applies to profits rather than turnover, this threshold corresponds to about A$400 million in capital income, assuming typical national factor shares in production for Australia.
Firms are assumed to produce using labour and capital, with production costs increasing when output moves away from the firm’s most efficient scale.
Two market structures are considered:
- Perfect competition, where firms operate at minimum cost. In such markets, each firm is too small to affect prices, and competition drives down production costs and output prices.
- Monopolistic competition, where firms face downward-sloping demand and operate below efficient scale. In such markets, firms have some price-setting power, which leads to higher prices and less efficient production.
These two cases matter because the degree of competition affects how firms respond to tax incentives, and thus the deadweight costs of the tax threshold.
Uniform taxes versus thresholds
Before introducing thresholds, it is useful to consider how firms behave under simpler tax structures. If there is no corporate tax surcharge, firms choose their production scale purely based on technology and market conditions. If instead a uniform corporate tax surcharge applies to all firms, the tax raises costs but does not distort firm size decisions. Firms still operate at the same scale as before; the tax simply increases prices and reduces profits.
The key point is that increases in taxes that are uniform across all firms change costs, but not firm size decisions. Thresholds are different. Once a tax applies only above a certain turnover level, firms near that threshold have an incentive to reduce output to avoid crossing it.
Firms shrinking to avoid tax thresholds
Our model illustrates how this behaviour emerges.
Under perfect competition, our calculations suggest that production could fall by about 10 per cent relative to efficient scale for firms with turnovers near the threshold, when compared to a non-tax baseline. This fall in output is partly a reflection of the rise in tax load on the firm. To measure the efficiency cost of the threshold, we need to compare average production costs at the previous level of output (before the tax threshold was introduced), to average costs at the new level of output (after the tax threshold is introduced). Under perfect competition, where average cost curves are relatively flat, average costs of production rise but only by a small amount, about 0.07%. This is the efficiency loss: each unit of output has become more expensive to produce due to the threshold.
To estimate the broader economic impact and generalise our cost calculations to reflect more reasonable assumptions about the degree of competitiveness in Australian industry, we constructed a detailed distribution of firm sizes across the Australian economy, and simulated how all these different sized firms respond when a threshold is introduced.
The economy-wide impact
The modelling compares two scenarios:
- A uniform corporate tax surcharge applied to all firms.
- A threshold-based surcharge, where the surcharge applies only above A$1 billion in turnover.
To isolate the effect of the threshold itself, total tax revenue is held constant between the two scenarios.
The results show a clear pattern. As shown in Figure 1, firms cluster just below the threshold, while the number of firms just above it declines. In other words, firms reduce output to remain under the tax cutoff.
Because average cost curves are downward sloping, these reductions in output levels drive average costs of production higher. Resource costs per unit output rise; this is a deadweight cost caused by the threshold.
Aggregating the cumulative effect of many firms altering output levels in this way, we find the deadweight cost of the threshold is A$1.7 billion under the core scenario. Relative to the size of the Australian economy, this corresponds to a deadweight cost of about 0.07 per cent of GDP.
Thresholds across the Australian tax system
While this analysis focuses on corporate taxation, the underlying mechanism appears throughout Australia’s tax system.
Take payroll tax, which is levied by the states and territories. Employers pay payroll tax only once their wage bill exceeds a threshold that varies by jurisdiction. For example, in 2025–26 the payroll tax threshold is about $900,000 in Victoria and $1.2 million in New South Wales, with tax applied to wages above those levels.
These thresholds were designed to protect smaller businesses from the tax. But they also create strong incentives for firms close to the cutoff to limit hiring or restructure their operations to remain below it. A naïve read of this policy may conclude that lower effective tax rates imply lower deadweight costs of taxation: in reality, one deadweight cost is traded for another, so-called threshold effects discussed herein.
A similar pattern arises in state land taxes, where tax-free thresholds mean that landowners pay little or no tax until their landholdings exceed a certain value. For example, in New South Wales land tax applies only once land values exceed about $1.075 million, after which a marginal rate of 1.6% applies to the value above the threshold.
Across all of these cases, the same economic logic applies: discrete jumps in tax liability create incentives for taxpayers to remain just below the threshold.
Implications for tax design
None of this means thresholds are always bad policy. They can reduce compliance burdens and target relief to smaller businesses or property owners. But it is important to understand that thresholds come with their own trade-offs. By introducing discontinuities into tax schedules, decisions about hiring, investment, production, and asset ownership are distorted. The modelling presented in our paper suggests that even a single threshold in the corporate tax system could impose measurable efficiency costs across the economy. Australia’s ongoing debates about corporate tax, payroll tax, and property taxes often focus on tax rates. But the structure of the tax schedule—the presence or absence of thresholds—can matter just as much for economic efficiency.
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