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Challenges and Choices: Modelling New Zealand’s Long-term Fiscal Position

5.2  Projecting source deductions tax

Source deductions tax is grown with drivers related to employment and earned income, because it predominantly stems from tax on wages and salaries. An added complication is the fact that it is levied via progressively higher tax rates on tiered thresholds, making it subject to fiscal drag.

Fiscal drag refers to the phenomenon that tax grows faster than the income it is levied on because, as a person's income grows, an increasing proportion of it is taxed at a higher rate. The term “fiscal drag” comes from this reduction in aggregate demand by a rising average tax rate on personal income.

Other income-driven taxes are not modelled with fiscal drag applied to their drivers, because their annual volatility is much larger than that of GDP. For example, the income stream of a self-employed person such as a farmer or a real estate agent, compared with that of a wage/salary earner such as a teacher or a nurse. The variability in the incomes of the former, from year to year, tends to be much larger than in those of the latter. Finding a long-term ratio of GDP to apply to other persons or FBT is difficult and the volatility in these tax types over history means no significant fiscal drag component can be discerned. For salary and wage earners, on the other hand, it is not difficult to extract a fiscal drag elasticity estimate from historical data, allowing for tax rate and threshold changes.

The modelling of source deductions is as follows:

where:

t = the fiscal year

SDt = source deductions tax revenue

ELFgt = the annual growth in the employed labour force, where the employed labour force is calculated as (aggregate labour force) x (1 - unemployment rate)

ε = the aggregate fiscal drag elasticity estimate for the New Zealand personal tax regime

lpgt = the annual labour productivity growth, which is the proxy for the annual growth of the average real wage in the economy, and

πt = inflation, as measured by annual growth in CPI, which turns real wage growth into nominal wage growth.

Therefore, the source deductions total in any projected year is derived from its preceding year's value by multiplying it by a demographic driver, which is the growth of the employed labour force, and an indexation driver, which is the growth of nominal wages in the economy. The latter is supplemented by a fiscal drag elasticity, reflecting that as nominal wages grow, a higher percentage becomes subject to higher tax rates.

The 2009 Statement projections are based on the end-of-forecast values, which are themselves based on the personal tax regime introduced on 1 April 2009. The fiscal drag elasticity used in the modelling relates to that tax regime. It is estimated to be 1.35, as an average value in the first decade of projections. If, for example, nominal wages are assumed to be growing by 3.5% each year, the average tax on the aggregate wages will be growing annually by about 4.7%.

Assuming that fiscal drag will be allowed to go unchecked for a decade is realistic, given the recent history of the New Zealand tax system. However, an assumption that fiscal drag would be allowed to continue for 40 years without change seems fanciful. It effectively means the tax rates and thresholds currently applying would continue to do so, with no allowance for the inflation of incomes. Over a 40-year horizon, even the incomes of those currently on the lowest personal tax rate of 12.5% would grow with inflation to levels that were taxed at 33%.

Consequently, the modelling in the 2009 Statement does not assume ongoing fiscal drag lifting source deductions as a ratio of nominal GDP. Rather, we assume that the fiscal drag effect will continue for a decade out to the year ending June 2023, in line with the source deductions tax projection modelling in the Budget 2009 Fiscal Strategy Report.

Figure 5.1 - Source deductions tax revenue
Figure 5.1 - Source deductions tax revenue.
Source: The Treasury

After 2023, we assume some form of changes would be applied to the personal tax regime in order to return source deductions, as a ratio of nominal GDP, to a value more in line with its historical average over the last 20 years. The path of source deductions to nominal GDP in history, the Budget 2009 forecast and the 2009 Statement projection, is depicted above in Figure 5.1.

Even the peak of source deductions as a percentage of GDP, reached in 2023, is not out above values reached in the recent past. Following 2023, the long-term projection is reduced at a rate of 0.2% of nominal GDP per year until it attains a level in line with the historical average over the last 20 years.

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