The Treasury today published further research on the elasticity of taxable income under its Working Papers series.
The paper, The Elasticity of Taxable Income in New Zealand, by Dr Iris Claus, Professor John Creedy and Josh Teng, provides estimates of the extent to which reported taxable incomes change as a result of people responding to changes in the marginal income tax rates that they face.
People may respond to income tax rate increases in a variety of ways. For example, they may reduce their working hours, shift some of their income into sources (corporations, family trusts) which face lower tax rates, or take other steps to conceal some income.
Economists combine all the possible responses into one measure, the 'elasticity of taxable income', which measures the percentage change in taxable income resulting from a 1 per cent change in the net-of-tax rate (that is, the amount retained from a dollar increase in income).
This Working Paper uses a random sample of administrative data collected by the Inland Revenue Department to estimate the size of this elasticity, using two methods.
First, the year 2001 saw the introduction of a top marginal income tax rate of 39 per cent for higher income earners who had previously faced a 33 per cent marginal rate, while corporate and trust rates remained unchanged. An elasticity was obtained by comparing the income shares of those who were affected by the tax change and those who were not affected.
Secondly, there was subsequently a relatively long period during which there were no changes in the income thresholds or the marginal tax rates. The resulting 'fiscal drag' (the movement of individuals into higher-rate brackets as a result of income growth) permits an estimate to be made of responses over a wider range of the income distribution.
The authors found that the elasticity of taxable income was estimated to be substantially higher for the highest income groups, at around 0.5. Changes in the timing of income flows for the higher income recipients were found to be an important response to the announcement of a new higher rate bracket. The marginal welfare costs of personal income taxation were found to be relatively small for all but the higher tax brackets. For the top marginal rate bracket of 39 per cent, the welfare cost of raising an extra dollar of tax revenue was estimated to be well in excess of a dollar.
The implications of the findings are that the disincentive effects of high top marginal rates can be substantial even when labour supply responses are small; the welfare costs of increases in top marginal tax rates can be high and; announcement effects of tax policy changes can lead to considerable income shifting between time periods.
This follows other recent research involving senior Treasury analysts, including a Treasury Working Paper entitled Tax Rates and Revenue Changes: Behavioural and Structural Factors, published late last year which examined how changes to marginal income tax rates flow through to the Crown's tax revenue - that is, the elasticity of tax revenue following changes to marginal tax rates.
The views, opinions, findings, and conclusions or recommendations expressed in Treasury research working papers are strictly those of the authors and do necessarily reflect the views of the Treasury.