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1  Introduction

This paper provides estimates of the built-in flexibility, or revenue elasticity, of income and consumption taxes (GST and excise taxes) in New Zealand. It is important for the design of tax policy to be able to measure reliably the income elasticity of tax revenues both for a tax system and its component taxes. For example, given some revenue target, the need for discretionary changes tax rates and thresholds depends on the expected automatic revenue growth generated by the system’s built-in flexibility. The extent to which the aggregate effective tax rate changes when total income changes depends on a range of factors, including consumption patterns and the distribution of individual relative income changes associated with the aggregate change. Furthermore, elasticity and progressivity are closely related, so that tax changes designed to affect progressivity may have unforeseen consequences for elasticity, and vice versa.

Elasticity values at individual and aggregate levels are reported. These are obtained using convenient analytical expressions which have the advantage that they can be evaluated readily from relatively little information about the tax structure, income distribution and budget shares. Furthermore, the main factors affecting the size of the elasticities can be identified, using meaningful and easily interpreted decompositions of the revenue elasticities.[1]

Detailed official forecasts of tax revenues in New Zealand are of course frequently made, though for various reasons these do not always involve the explicit calculation of revenue elasticities. Few independent estimates for New Zealand appear to have been published; however, various elasticities are given by van den Noord (2000) for OECD countries.

This neglect may reflect the perception that, in the presence of lower rates of inflation in recent years, a flattening of the income tax structure, and a broad based consumption tax, fiscal drag is no longer significant. However, as the analysis below shows, the issue is more complex than this simple view would suggest. It is also useful to identify the various influences on the size of New Zealand tax revenue elasticities.

Section 2 sets out the relevant conceptual expressions for income and consumption tax revenue elasticities at the individual level; subsection 2 provides some estimates based on the 2001 tax structure. Section 3 defines aggregate revenue elasticity expressions, with empirical estimates in subsection 2. These estimates use the standard assumption that all incomes increase by the same proportion from year to year. Subsection 3 models the more realistic case of non-equiproportional income changes, and allows for a simple process of regression towards the geometric mean income.

In producing aggregate values directly from individual values, the question arises of the level of disaggregation to be used, particularly regarding the budget shares. The estimates reported here are based on an overall distribution of taxable income and use published budget shares for all households combined, rather than considering different household types separately; however, the methods could be applied to more disagreggated data. Section 4 draws some conclusions.

Notes

  • [1]The approach, involving explicit modelling of the tax structure, contrasts with the use of regression analyses, of time series data on tax revenues and income, which are sometimes used to produce aggregate elasticities. Some comparisons of aggregate income tax revenue elasticities based both on regressions and on tax-share weighted individual values are given in Giorno et al. (1995), although they do not include New Zealand.
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