What is notional tax?
The ATO writes it as “estimated (notional) tax”, and that phrasing is the whole definition. It is an estimate, not an assessment. The ATO builds it from the last tax return you lodged, and it stands for the tax it expects your business and investment income to attract this year.
The word notional does the work. Nothing is owed because of it and nothing is payable on it. It is an internal working figure, which is why it never appears on the statement it drives. What you see is the result: a percentage at label T2, or a dollar figure at label T7.
How notional tax sets your instalment rate
The ATO publishes the formula exactly as follows: the instalment rate is (estimated (notional) tax ÷ instalment income) × 100. Both inputs come from the same lodged return, so the rate captures the relationship between your gross income and your tax in that year, and then gets applied to this year's takings.
Two consequences follow, and both explain complaints people have about their notices. The rate is an average rate, not your marginal bracket, so it always reads lower than the top rate you pay. And it lags, because it was built from a return covering a year that has already finished.
As an illustration on 2026-27 resident rates: a sole trader whose only income is $90,000 of business profit pays about $19,320 in income tax and Medicare levy, an equivalent rate near 21.5%. A real notice derives the percentage from your own lodged figures. Run your own numbers on the PAYG instalment calculator, and see instalment income for what belongs in the denominator.
The GDP adjustment, and what it does not touch
The ATO uplifts the instalment amount to allow for likely income growth, using a factor based on changes in Australia's gross domestic product over the previous two calendar years. The GDP adjustment for the 2026-27 income year is 5%, and it applies to taxpayers whose quarter starts on or after 1 April 2026.
The uplift does not apply to the rate method. The ATO states the GDP adjustment factor “does not affect you if you work out your own instalments (using the rate method) or pay annually”. It moves the pre-filled dollar amount under option 1. If you multiply your own quarterly income by the rate at T2 under option 2, no GDP factor is in that number.
This is the distinction most explanations of notional tax get wrong, and it matters because the two options behave differently when your income moves. The amount option carries last year's tax plus a flat 5% guess at growth. The rate option tracks your actual income quarter by quarter, which is why it suits a business with an uneven year. The PAYG instalments guide works through choosing between them.
When the rate comes out too high
Because the rate is built from a single past return, anything that inflated the tax in that return inflates the rate. The ATO names four causes:
- Income from an employee share scheme
- A compulsory study loan repayment in your last return, covering HECS-HELP, SFSS, AASL, SSL, ABSTUDY SSL or VSL debts
- Income reported at the wrong label in your last return
- A return amended to include excess superannuation contributions
The study loan case is the one that catches sole traders. A compulsory repayment is not income tax, but it is collected through the same assessment, so it lifts the total the rate is derived from and every quarter of the following year carries that lift. The HECS repayment calculator shows what the compulsory repayment on your income actually is, and why your PAYG is too high covers what to do about an instalment that overshoots.
The reasonable rate ceiling
The ATO caps the result. If the calculated rate exceeds the highest income tax rate for your entity type, it is automatically reduced to what the ATO calls a reasonable rate, and the reduced figure is what prints on your statement.
| Entity type | Reasonable rate |
|---|---|
| Individuals (including sole traders) | 55% |
| Trusts | 55% |
| Superannuation funds and SMSFs | 45% |
| Corporate tax entities | 30% |
Notional tax vs the tax on your return
These are different figures and they are meant to be. The tax on your assessment is worked out on taxable income, which is gross income after deductions. Notional tax is an estimate designed to sit over instalment income, which is gross business and investment income before deductions.
The gap between them is the reason instalments almost never land exactly on the final bill. A year with heavy expenses over-collects, a lean-cost year under-collects, and the correction happens at assessment where every instalment already paid is credited against the tax actually owed. If this year looks nothing like the return the estimate came from, varying your instalments is the mechanism, and withholding vs instalments explains why salary earners never meet this figure at all.
Frequently asked questions
What is notional tax?
How is notional tax used to work out my instalment rate?
Is notional tax the same as the tax on my return?
Does the GDP adjustment change my notional tax?
Why is my instalment rate higher than I expected?
Is there a cap on the instalment rate?
Can I change the rate if notional tax is wrong for this year?
Where does notional tax appear on my activity statement?
Sources
- ATO: How we calculate your PAYG instalment amount or rate (QC68098). Source of the rate formula, the 5% GDP adjustment for 2026-27, the reasonable rate table and the four causes of an inflated rate.
- ATO: PAYG instalments overview