Executive Summary
The 'elasticity of taxable income' (ETI) measures the response of taxable income to variations in the net-of-tax rate (one minus the marginal tax rate). It captures the combined impact of various economic responses to changes in marginal income tax rates. It is thus a crucial component of any investigation of the potential revenue effects of proposed income tax changes.
The estimation of the elasticity uses information about individuals' taxable incomes before and after a tax reform. This is complicated by the fact that, with an income tax schedule having several marginal rates, changes in many individuals' incomes can lead to changes in the actual marginal tax rate they face. These changes occur as well as the potential taxable income responses to tax rate changes that are of primary interest here. Furthermore, substantial income changes may take place that are unrelated to tax structure changes. To minimise these problems many investigators use the method of 'instrumental variables' but, as in most contexts, the choice of 'instrument' is not straightforward.
In this paper, two new tax rate instruments are proposed. The approach advocated here involves estimating the dynamics of taxable income for a panel of taxpayers, using data over a period that involves no tax changes. Instruments based on the expected income, and the expected tax rate, of each individual are constructed.
The proposed new instruments are used to estimate the elasticity of taxable income in New Zealand, using information about taxable incomes for a sample of taxpayers before and after the income tax rate changes in 2001. This reform provides an especially useful context in which to examine the performance of the three instruments, given the nature of that reform and the availability of suitable data to estimate income dynamics. The reform involved a convenient mix of marginal tax rate increases, decreases and no change across a wide range of incomes.
Comparing taxable incomes in 1999 and 2002, the paper first examines taxpayer responses in terms of observed correlations between income change and changes in the actual and instrumented tax rates. Secondly, instrumental variable regressions are examined. Thirdly, these results are compared with observed and predicted changes in key parts of the taxable income distribution between 1999 and 2002. All three approaches suggest that observed income changes after reform reflect the causal behavioural responses to tax reform predicted by the elasticity of taxable income literature. However, an instrument based on a standard approach of assuming unchanged income levels after reform is found to perform poorly. The new instruments, based on a model of income dynamics estimated using extraneous information on incomes over a three-year period without any tax structure changes, perform much better, particularly the instrument based on an expected tax rate for each individual.
The expected tax rate instrument produces an aggregate estimate of the elasticity of taxable income of 0.676 for all sources of income combined. The estimated elasticity of taxable income for those who have only wage and salary income is 0.414. This is around half of the value for those who have income from other sources, at 0.909. This latter value is similar to values found for the higher income groups by previous researchers and is consistent with the findings for other countries that taxpayers' non-salary income appears to be especially responsive, via income shifting, to marginal tax rates and other tax parameters. The results have important implications for the design of the income tax structure, since elasticities of this size can imply high welfare losses from taxation as well as constraining the ability to increase revenue.