7 Conclusion
This paper has examined estimation of the elasticity of taxable income using instrumental variable regression methods. It has argued that the 'standard instrument' for the net-of-tax rate - the rate that would be applicable post-reform but with unchanged income levels - is unsatisfactory in contexts where there are large numbers of taxpayers with exogenous changes in their taxable income. Two alternative tax rate instruments were proposed, based on estimates of the dynamics of taxable income for a panel of taxpayers over a period that involved no tax changes.
The parameters derived from that procedure were then used to construct hypothetical (or counterfactual) post-reform incomes that would be expected in the absence of reform. The first method is based on the tax rate each individual would face if their income were equal to 'expected income', conditional on income in two periods before the tax change. The second alternative uses the form of the conditional distribution of income for each taxpayer to obtain an instrument based on their 'expected tax rate'.
These methods were applied to the 2001 tax reform in New Zealand. This 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 examined taxpayer responses in terms of observed correlations between income change and changes in the actual and instrumented tax rates. Secondly, instrumental variable regressions were examined. Thirdly, these results were 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 the standard approach, of assuming unchanged income levels after reform, performed poorly. Instruments that are based on a model of income dynamics, estimated using extraneous information on incomes over a three-year period without any tax structure changes, performed much better, particularly the instrument based on an expected tax rate for each individual. Applying these instruments to analyses of income tax changes in other countries provides an interesting avenue for future research.
