2 Tax Revenue and Population Ageing
This section discusses the main determinants of the variation in tax revenue and in particular the influence of population ageing. It describes the components which a tax revenue projection model must have. Tax revenue in any year is the sum of tax raised from many overlapping cohorts of different ages. Hence income and expenditure variations over the life cycle are of central importance. Population ageing, to the extent that it shifts more people into retirement, changes the balance between the tax bases for income tax and GST. The possible overall effect on tax revenue can only be evaluated with the use of a projection model that captures all the components discussed here.
2.1 Income Taxation
A crucial requirement of any analysis of income tax revenue changes over time is the ability to project the changing distribution of income over time for each cohort. Income projections must be in nominal, rather than real, terms because the income tax system is not automatically indexed. Within a single cohort (of individuals of the same age), the distribution of income varies over time as the members of the cohort age and as they move through calendar time: there are separate ‘age' and ‘time' effects. The systematic variation with age is such that mean incomes typically follow a ‘hump' shape, reaching a maximum in late middle age (although the precise pattern differs for males and females). Furthermore, the dispersion of incomes generally increases with age. For projection purposes it is useful to have a model that is capable of describing these variations with relatively few parameters which can be estimated from available data.
Two strong assumption in what follows are, first, that the variations associated purely with age do not vary among cohorts (that is, there are no ‘cohort effects' on earning, for example, associated with the size of cohorts) and, second, that the ‘time' effect arises simply from the general growth of incomes, arising from productivity changes and inflation, which affects all age groups and cohorts similarly. The existence of general wage growth has two implications. First, for each cohort it delays the age at which average incomes reach a maximum over the life cycle. Second, it gives rise to an ‘overtaking' effect whereby the incomes of succeeding cohorts are higher, at comparable ages, than earlier cohorts. Both of these effects imply an increasing tax base over time. The basic structure of age-income profiles is relatively stable over time, although the aggregate relationship may change if there are substantial changes in the occupational composition of the labour force over time and if the profiles for specific occupations differ in their shapes. However, the general growth of wages and productivity can undergo short term variations which are less easy to predict: the projections assume a constant rate of growth over the whole of the projection period.
However, changes in the tax base do not depend only on the nature of age-income profiles. Importantly, the base is influenced by the changing age distribution of workers over time. That is, at any time, it depends on the age distribution of workers alive at that time (strictly on the age and gender distribution of workers). In turn the age distribution of workers results from the combined effect of the age-and-gender distribution of the population and age-and-gender-specific labour force participation rates. It is possible for changes in participation rates over time (that is, among cohorts) to compensate for, or modify to some extent, the changes arising from population age structure changes. Income tax revenue changes therefore depend crucially on detailed projections of the labour force. While there can be some confidence about population projections, labour force participation changes can undergo unforeseen changes.
The effects of a systematic increase in the average age of workers does not have obvious a priori implications for tax revenue changes. Clearly population ageing means that there are more people in retirement and hence in receipt of much lower taxable incomes. However, to the extent that ageing implies that relatively more people move to the age groups for which incomes are at their life-cycle peak, tax revenue is higher. And, in addition, higher general growth of incomes shifts the peak of the age-income profiles to a higher age. If the average age of workers moves from shortly before, to shortly after, the age of peak incomes, there may be very little effect on revenue.
The general shape of the age-income profile implies that individuals typically move into higher income tax brackets, and hence face higher marginal and average tax rates, as they approach the peak of incomes. A crucial factor in projecting income tax revenue is thus the extent to which the income thresholds in the multi-rate tax structure are adjusted over time. A lack of full indexation implies, through ‘fiscal drag', a substantially higher revenue compared with indexation. Furthermore, the extent to which fiscal drag results in higher revenues when nominal incomes increase is determined by the degree of marginal rate progression in the system (which influences the difference between the average and the marginal tax rate at any income level, and in aggregate).
