4 Conclusions
This paper has examined the joint role of the elasticity of taxable income (which refers to the behavioural effect on taxable income of a marginal tax rate rise) and the revenue elasticity (which reflects the structural effect on revenue of a change in taxable income) in influencing the revenue effects of tax rate changes. Traditionally, the revenue elasticity has been the central concept in examining fiscal drag, and obtaining local measures of tax progressivity. But it has an additional role in the context of the revenue effects of tax changes when incomes respond to rate changes. This separate effect has not previously been discussed explicitly, even though 'mechanical' and behavioural effects have long been distinguished in the literature. The elasticity of tax revenue with respect to a rate change was examined at both the individual and aggregate level.
When a single marginal tax rate in a multi-rate income tax structure is changed, those in the relevant tax bracket adjust their incomes in accordance with the elasticity of taxable income, and this affects the tax paid via the revenue elasticity. There is also a revenue effect on those individuals who are in higher tax brackets, since marginal rate changes in lower tax brackets imply a change in their effective income threshold. But there are no incentive effects on higher-rate taxpayers because only their average tax rate changes. Only if there were no incentive effects would an equal proportional change in all marginal tax rates produce the same proportional increase in total revenue.
Illustrations were provided using the New Zealand income tax structures before and after the 2010 Budget. This reduced all rates while leaving income thresholds unchanged and, in particular, reduced the top marginal rate substantially. The elasticity of total tax revenue with respect to a single tax rate change was found to be particularly sensitive to the elasticity of taxable income in the top two tax brackets. In the pre-Budget structure, an elasticity of taxable income in excess of about 0.6 was found to produce a negative tax response to an increase in the top two marginal rates. When these rates are lower, as in the post-Budget structure, the elasticity of taxable income needs to be over 0.8 before tax revenue in the highest tax bracket is expected to fall in response to an increase in the marginal rate. However, recent estimates of the elasticity of taxable income in the top tax bracket in New Zealand are in the range (with some estimates in excess of 1) where tax revenue may fall. For New Zealand in particular, these results therefore suggest that further detailed empirical investigation of the elasticity of taxable income for taxpayers at different income levels may be warranted to assess whether cuts in some marginal tax rates are likely to be revenue-enhancing.
