6.3 Regression Results

The results of applying the three alternative instruments to the sample described above are reported in Table 6. Each regression takes the form in (11) above and includes, in addition to the relevant instrument and the age terms, log income in 1999, the lagged change in log income and the 'other income’ dummy described above. The resulting estimated elasticity using the standard instrument is a large negative number, -175 with a huge standard error (t-value = -0.11), so that it is obviously not significantly different from zero. Also, none of the coefficients on the age and income variables is significantly different from zero.

Introducing the first of the alternative instruments, the tax rate associated with expected income in 2002, in Table 6, radically changes the parameter estimates. In particular, using the expected income instrument, the estimate of the elasticity of taxable income becomes 0.575, (t-value = 1.99) and all variables are significantly different from zero at standard levels of significance.[19]

Using the expected tax rate instrument has a modest impact on the point estimate of the elasticity of taxable income (0.676 compared with 0.575) but more than halves the standard error, resulting in a t-value of 5.4. Similarly all variables in the regression now have higher coefficient t-values. The use of the expected tax rate instrument therefore appears to substantially improve the robustness of the estimated marginal tax rate effect on taxable income, with a plausible mean value. This is confirmed when using both the expected tax rate and expected income variables as instruments in the first stage regression. Using both instruments (not shown in Table 6) yields a parameter on Δlog (1 - τ) of 0.673 (t-ratio = 5.38); that is, adding the expected income instrument has a negligible effect on the estimated elasticity of taxable income. This reinforces the results of the previous subsection.

The specification in Table 6 only includes an intercept shift dummy, allowing for observed income changes to differ for taxpayers with other income from those with only wage and salary income. However, it cannot capture the potential for different tax rate responsiveness by those with other income; for example, if other income is easier to shift, re-classify or evade for tax purposes. To allow for the possibility that the elasticity coefficient on Δlog (1 - τ) depends on the composition of income, Table 7 adds an interaction term equal to the product of the dummy variable and Δlog (1 - τ).[20]

The results suggest that the elasticity for those without other income is smaller, at 0.414 (t-ratio = 2.39) , while the coefficient on the interaction term is 0.495 and significantly different from zero (t-ratio = 2.13). That is, the estimated elasticity of taxable income for those who have only wage and salary income, at 0.414, is around half of the value for those who have income from other sources, at 0.909 (= 0.414 + 0.495). This latter value is similar to values found by Claus et al. (2012). for the higher income groups. It is consistent with the findings for the US by Saez (2004) that taxpayers' non-salary income appears to be especially responsive, via income shifting, to marginal tax rates and other tax parameters.[21] However, Saez (2004) shows evidence for the 1986 US tax reform was less clear regarding whether the observed growth of wage and salary income after reform represented a tax response.

To test this aspect further, the total sample was decomposed into taxpayers with and without at least one of the categories of non-wage-or-salary income sources (dividends, trust income and so on). If it is either easier to alter other income than salary income, or taxpayers have a greater propensity to do so, in response to tax changes, then it might be expected that those taxpayers with non-salary income would demonstrate a larger elasticity than taxpayers with no other income. Secondly, among the subset of taxpayers with other income, the responsiveness of their other income to a change in marginal tax rates might be expected to be greater than the equivalent response for salary income.

This is likely to be important in the case of New Zealand's 2001 reform. Though all types of personal income (salary, dividends and so on) above the new $60,000 threshold after the reform were taxed at 39 per cent, rather than 33 per cent, income received by trusts and companies continued to be taxed at 33 per cent. Diversion of income to trusts, and incorporation, is relatively easy (with a low cost) in New Zealand, and the new 6 percentage point gap provided a strong incentive to shift income away from the personal tax code to those alternatives. This can be expected to have induced further reductions in other income received by individual taxpayers in the current sample in response to the tax rise.[22]

Table 8 shows the regression parameters on Δlog (1 - τ) for the specification in Table 6 but for those taxpayer/income sub-samples.[23] The estimate for all taxpayers (0.676) is repeated from Table 6. Splitting the sample into taxpayers who had other income in at least one of the three years (1998, 1999, 2002), and those with only salary income gives a much larger parameter estimate of 0.514 for those with other income compared with the estimate of 0.19 for those with no other income. Only the former is statistically significant at conventional levels with much more noise associated with the 0.19 estimate.

Testing the sub-set of taxpayers with non-salary income both before and after reform (1999 and 2002), Table 8 confirms that the responsiveness of other income is substantially greater, with a parameter estimate on Δlog (1 - τ) of 2.48 (t-ratio = 7.28) for other income, compared with 0.22 (t-ratio = 1.53) for salary income.

The importance of the other income component of total taxable income, and its response to the 2001 reform, can be seen in Figure 3. This shows the percentage distribution of all other income across ($5000) income bands both in 1999 and 2002.

Figure 3: The Distribution of Other Income

The first point to note is that 'other income' is not especially concentrated among taxpayers with high taxable incomes; the bulk of other income is received by taxpayers in the $30-70k taxable income range. This tends to suggest that the estimate above of high responsiveness of other income to tax rate changes is not exclusively a high-income earner phenomenon. Secondly, the clearest difference between the 1999 and 2002 distributions of other income is the new large spike in 2002 around the new $60k threshold introduced in the 2001 reform. That is, a much larger fraction of other income in 2002 is accounted for by taxpayers with income around $60k than was the case in 1999, with a compensating decrease in other income received by taxpayers with taxable incomes around $25-35k.[24]