Preface

• This paper shows how the change in income tax revenue - at individual and aggregate levels - as a consequence of a marginal tax rate change can be decomposed into several effects. These effects are measured in terms of elasticities, reflecting the proportional change in one variable expressed as a ratio of the proportional change in another variable. The decomposition is useful for revenue forecasting purposes.

• First, there is the obvious positive revenue effect of a rate rise which arises if all incomes remain unchanged: this is the partial elasticity of revenue with respect to the relevant tax rate. Second, there is a negative effect arising from behavioural responses. This latter effect can itself be divided into two multiplicative influences, as follows.

• There is an adjustment to taxable income, measured by the elasticity of taxable income. It captures the net effect of all incentive effects associated with the marginal rate change, and is measured in terms of the net-of-tax rate (rather than the rate itself). In addition, the tax revenue elasticity - the elasticity of tax revenue with respect to a change in income - determines the consequent effect on revenue of the behavioural response.

• The tax revenue elasticity is concerned only with the nature of the income tax structure itself and, when considering aggregation over individuals, the form of the income distribution. Hence the value of this elasticity can be calculated using relatively little data. The elasticity of taxable income is concerned with a wide range of behavioural adjustments associated with tax rate changes, captured in a single measure. Its estimation therefore presents significant difficulties. There is no direct connection between the two elasticity concepts.

• The paper provides a number of technical analyses which derive the conditions (expressed in terms of the elasticities discussed above) under which the tax revenue increases when a particular marginal tax rate increases. These conditions are derived for individuals and for aggregate revenue. It is found that the elasticity of taxable income (of those in the tax bracket affected by the rate change) must be relatively low for a tax rate increase to produce an increase in total revenue.

• The available evidence suggests that for individuals facing the top marginal tax rate in New Zealand, the elasticity of taxable income is around one half, and is possibly higher for the very high income earners. For example, suppose there is an increase in the marginal tax rate from 33 to 36 per cent. This implies that the net-of-tax rate falls by 4.5 per cent. An elasticity of taxable income of one half means that there would be a reduction of at least 2.25 per cent in taxable income.

• The present paper reports an empirical analysis, based on NZ taxable income distribution data, of the elasticity of tax revenue with respect to a marginal rate change. For the pre-2010 tax structure, it was found that, for an elasticity of taxable income in excess of around 0.6, tax revenue from the top tax bracket could fall as a result of a further tax rate increase. As a result of the 2010 change to the income tax structure, the elasticity of taxable income in the top bracket would need to be in excess of around 0.8 before a tax rate increase would be expected to produce a negative revenue change.