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The Built-in Flexibility of Income and Consumption Taxes in New Zealand - WP 03/05

2.2  Estimates of individual revenue elasticities

Individual elasticities can identify those taxpayers likely to experience the greatest change in tax liabilities as their incomes, or fiscal parameters, change. They therefore also provide local measures of tax progressivity. This subsection shows how individual revenue elasticities can be expected to vary across income levels in New Zealand.

Using information on the New Zealand income tax structure in 2001 to calculate effective allowances, estimates of the income tax revenue elasticity in (3) can readily be obtained for a range of individual income levels. Income tax rates of 0.15, 0.21, 0.33, 0.39 between income thresholds of (NZ$) 0, 9500, 38000, and 60000 were used. These are the effective rates and thresholds, allowing for the existence of the Low-Income Rebate. For New Zealand, with no initial tax-free allowance and virtually no deductions, tax thresholds do not change with individuals’ incomes, so it is reasonable to assume in (3). This simplifies income tax revenue elasticity calculations.

Consumption tax revenue elasticity calculations require estimates of the ad valorum-equivalent indirect tax rates. Most goods are taxed at the 12.5 per cent GST rate. However some expenditures are exempt from GST (for example, rent and overseas travel) while a number of excises produce very different effective tax rates on goods such as fuel, alcohol and tobacco. The consumption tax rates used are given in the Appendix.

It is necessary to have total expenditure elasticities of goods taxed at different rates. For this reason it is not possible, even if separate income unit data from budget studies were available, to produce precise individual values since estimates must be based on the cross-sectional variation in budget shares as total expenditure varies within specified groups (defined say by location or demographic characteristics). The estimates reported here are based on total expenditure elasticities for all households combined, and were obtained from published average expenditures from the 2000-2001 Household Expenditure Survey; further details of the method used are discussed in the Appendix.

Finally, consumption function parameters, and in (13) are required. In view of the considerable difficulty in obtaining reliable information about savings functions, three consumption function cases were examined. These are: the no savings case, ; the proportional savings case, ; and the non-proportional case, , . The proportional case assumes that 95 per cent of disposable income is spent, while the non-proportional case implies an average propensity to consume of 0.95 at NZ$30,000, which is around the arithmetic mean income level.

Figure 1 shows how the income and consumption tax revenue elasticity (all goods) varies across income levels. The income tax elasticity generally declines as income rises, with discrete jumps taking place as individuals cross the tax thresholds, reflecting the sharp increase in the marginal rate of income tax.

Figure 1 – Individual tax revenue elasticities
Figure 1 – Individual tax revenue elasticities.

For the consumption tax elasticity, two examples of the proportional and non-proportional cases are shown. As shown in subsection 1, the shapes of these profiles reflect the three combined effects of the progressivity of the income tax, saving habits and differing expenditure elasticities across goods (combined with their associated ad valorem rates). Income tax progressivity tends to induce a ‘mirror image’ effect in the consumption tax profile via changes in disposable incomes. For example, discrete declines are evident in the consumption tax elasticity profiles in Figure 1 at the income tax thresholds and, at higher income levels, elasticities tend to rise.

However, at lower income levels consumption tax revenue elasticities also decline, rather than showing a mirror image of the decline in the income tax elasticity. This arises because of the dominant effect of declines in the tax-share weighted expenditure elasticities. For example, examination of these elasticities in Figure 2 reveals substantial declines in tax-share weighted expenditure elasticities for vehicles (mainly fuel) and tobacco as incomes increase from relatively low levels. Since these expenditures face especially high tax rates, changes in these tax-share weighted elasticities dominate changes in the weighted average at low income levels. Figure 1 also reveals that the elasticities produced by the non-proportional consumption function relationship are generally slightly lower, by about 0.1 - 0.2 percentage points, than the proportional equivalents.

Figure 2 – Tax-share weighted total expenditure elasticities
Figure 2 – Tax-share weighted total expenditure elasticities.
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