7.2 Empirical Results

The results of the previous section, along with Appendix B, enable the marginal welfare cost to be evaluated for any tax bracket, given cross-sectional information about the distribution of taxable income and the relevant value of the elasticity of taxable income. Earlier results have produced a range of values for the elasticity, with lower values in lower income groups and for women compared with men (with the exception of the fiscal drag results for movement into the second highest tax bracket). For this reason computations were carried out for a range of values of η in each tax bracket, thereby also enabling the sensitivity of welfare changes to η to be examined.

Table 9 – Marginal Welfare Costs

Table 10 – Marginal Welfare Costs

Tables 9 and 10 report the marginal welfare costs for each year and tax bracket, for four alternative values of η. A dash in any cell of the table indicates that the tax rate exceeds the revenue-maximising rate for that tax bracket. This occurs in a substantial number of cases, particularly for the top marginal rate groups and the higher elasticity values. The estimates reported above are indeed in those higher ranges. As expected the marginal welfare costs for the lower elasticity values and the lower tax brackets are relatively small, while for the top tax bracket they are large – mostly in excess of unity.[16]

Thus for those top brackets, when the tax rate is below the revenue-maximising value, the welfare cost of raising an extra dollar of revenue is well in excess of a dollar. Furthermore, it can be seen that the welfare costs for the top marginal rate bracket increase substantially after the introduction of the 39 per cent top tax rate. To the extent that a proportion of taxable income is being diverted into other sources which attract lower tax rates, the above estimates overstate the marginal welfare costs.

It is known that the marginal welfare costs can be highly sensitive with respect to the elasticity of taxable income. However, the values reported in these two tables are relatively stable in the lower and middle tax brackets, becoming more sensitive for the higher marginal rates. For the lower tax brackets, where the rates and thresholds remain stable, the welfare costs change very little over time, reflecting the relative stability in the distribution of taxable incomes.

The above calculations all assume that as a result of an increase in any marginal tax rate, taxable income falls as a result of incentive effects or is shifted into an untaxed source. However, one possible response to the introduction in 2001 of an extra income threshold, with a top marginal tax rate of 39 per cent, is to 'convert' some income into trust or corporate income, which continued to be taxed at a rate of 33 per cent. It can be shown that if s denotes the proportion of the reduction in taxable income that attracts a tax rate of t < τ, equation (17) is modified so that the marginal welfare cost becomes:

Table 11 shows the marginal welfare costs for the year 2001 for those in the top income tax bracket, under alternative assumptions about the value of s, with t = 0.33. In view of the relative stability of the income distribution, these are similar for later years. As s increases, the range of values of η, for which the tax rate of is above the revenue-maximising rate, becomes smaller. These results demonstrate yet again the sensitivity of welfare costs to variations in the elasticity of taxable income, as well as the sensitivity to the value of s. For the lower income tax brackets, a less clear assumption can be made about such shifting.[17]

Table 11 – Marginal Welfare Costs 2001: Top Tax Rate with Income Shifting to Lower Tax Rate