1 Introduction

This paper reports new estimates for New Zealand of the elasticity of taxable income with respect to the marginal net-of-tax rate. This elasticity aims to capture, in a reduced-form relationship, all potential responses to income taxation in a single elasticity measure, without the need to specify the structural nature of the various adjustment processes involved; early contributions are by Lindsey (1987) and Feldstein (1995, 1999). These adjustments include, as well as labour supply changes, income shifting between sources which are taxed at different rates, and tax evasion through non-declaration of income. The elasticity of taxable income has the added attraction that, under certain assumptions, it can easily be used to obtain a measure of the excess burden of income taxation. The only previous estimates for New Zealand, produced by Thomas (2007), relate to the 1986 tax changes.

Given the difficulty of constructing and estimating structural models dealing with the different types of adjustment, along with the data requirements, the popularity of the elasticity of taxable income is not surprising. The widespread use of the measure is indicated by the fact that a recent survey of estimates, by Saez, Slemrod and Giertz (2012), includes 111 references. However, it must be recognised that this ability to 'cut through' considerable complexity is not without significant costs. In particular, the strong – and usually untested – assumption is usually made that there are no income effects of tax changes, since this considerably simplifies the calculation of welfare costs. This implies a special quasi-linear form of the utility function: for an introduction to the basic analytics, see Creedy (2010).[1] It means, for example, that a change in the marginal tax rate in a lower tax bracket than the one occupied by an individual has no effect on taxable income. Furthermore, a simple constant elasticity specification of the relationship between taxable income and the net-of-tax rate is typically used, as in the present paper. Furthermore, in obtaining empirical estimates there is the ever-present danger of attributing changes in income to changes in the marginal net-of-tax rate, when they may have arisen for other unobserved reasons as part of a general process of relative income dynamics. In addition, the elasticity is in practice affected by, for example, the costs of income shifting between sources and time periods, along with detailed tax regulations other than simply the marginal rates. These influences cannot be captured in a reduced-form approach. Hence, any estimates must be treated with caution.

Despite these problems, the more recent New Zealand tax structure provides a good context for attempting to estimate an elasticity. The estimates are obtained using a special dataset, constructed using a random sample of administrative data collected by the New Zealand Inland Revenue. The details of the sample method and the variables obtained are provided in Appendix A. In 2001 there was a change involving only a single tax rate change: this was the introduction of a top marginal income tax rate of 39 per cent for higher-income earners who previously faced a 33 per cent rate, and corporate and trust rates remained unchanged. An elasticity can thus be obtained by comparing the income shares of those who were affected by the tax change and those who were not affected. This necessarily relates only to those at the top end of the income distribution. There was subsequently a relatively long period during which there were no changes in the income thresholds or the marginal tax rates. The existence of fiscal drag makes it possible to apply a difference-in-difference approach, by distinguishing treatment and control groups respectively in terms of those individuals who were sufficiently close to an upper income threshold that they moved into a higher tax rate bracket, and those who remained in the same bracket. This approach can therefore be extended to relatively lower income ranges. A feature of the results presented here, shared by a number of studies for other countries, is that they indicate quite substantial values (in excess of 0.5) of the elasticity of taxable income for high-income individuals. This finding clearly contrasts with those studies which have concentrated on estimating labour supply elasticities. Hence disincentive effects on high-income groups of tax rate increases cannot easily be dismissed.

The basic concept is introduced in Section 2, which describes the estimation methods used in later sections. Section 3 briefly discusses the marginal rate structure of New Zealand's income tax system. This has remained relatively stable since the middle 1990s. A major change was made in 2001, when a new top marginal rate was introduced. From 2001 until 2008, no threshold or marginal rate changes took place. Hence, a policy change and the existence of fiscal drag provide two alternative approaches to estimating the elasticity. Section 4 concentrates on estimates obtained by considering the introduction of the 39 per cent rate, and Section 5 examines the implications of fiscal drag, whereby some individuals experience a change in their marginal rate on moving into a higher tax bracket. Brief comparisons with other estimates are made in Section 6. Welfare effects are considered in Section 7. Further background details regarding welfare effects for all tax brackets are given in Appendix B. Brief conclusions are in Section 8.