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3 Tax revenue modelling

The Ball-Creedy (2012) analysis is a deterministic projection model of personal income tax (PIT) and GST revenue and personal income growth for a specified set of hypothesised values for labour force participation, population age structure, and so on. In addition to specifying the basic income tax structure (based on 2012 settings), the model is based on estimated gender-specific age-income profiles for employment and self-employment income. Using pooled Household Economic Survey (HES) data for five years, 2007-11, BC obtain average single-year-of-age values for individuals aged between 20 and 65. Combining the average wage for each individual with average hours worked by the relevant cohort then yields taxable labour incomes.

Fitted age-income profiles for males and females (for income from wages, salaries and self employment) are shown in Figure 11. This reveals the usual hump-shaped pattern of male earning with age, with female age-income profiles behaving similarly except that a downturn in average female earnings beyond 40-45 years in the labour force is not evident. However, the BC profiles are adjusted for variations in hours worked, using individuals' wage rates and average hours.

Figure 12 illustrates the resulting process of overtaking whereby the average real income of a given birth cohort is higher at each age for more recent cohorts. Hence someone joining the labour force at age 15 in 2010, though he/she has lower average real earnings that a 25-year-old in 2010, he or she will have higher average real earnings in 2020 than did the previous 25-year-old in 2010. As a result, though the ageing process involves some slowing of earnings growth (and downturn in the case of males), over time, average earnings are rising due to the “overtaking,” reflecting the tendency for productivity growth over succeeding cohorts to be reflected in average wage rates.

Figure 11 – Male and female age-income profiles
Figure 11 – Male and female age-income profiles
Figure 12 – Time profile of average incomes by age cohort: males
Figure 12 – Time profile of average incomes by age cohort: males

The BC model incorporates age-specific and gender-specific average benefit income, measured net of tax, which is added to average disposable income. Furthermore, the model uses age-profiles of average capital income (for those with positive capital income), along with profiles of the proportion of each age and gender group receiving some positive capital income, to obtain the average capital income for each cohort for each projection year. A capital income tax rate of 30% was applied to this income, and the resulting net income was added to average disposable income for each cohort and gender in each year. Finally, applying an age-profile of saving (and, for those in older age groups, dis-saving) rates gives expenditure and hence GST for each cohort and gender in each year.

Tax simulations combine employment/self-employment and capital income data with the 2010/11 income tax structure, and 2010 income distribution data to obtain income tax revenue projections, which also assume 2% annual price inflation, 1.5% annual real wage growth. Simulations can be obtained based on no indexation of income tax thresholds or indexation of thresholds to prices or nominal incomes. Indexation to nominal incomes effectively removes all fiscal drag from projections.

Income tax threshold adjustment in the simulation model is a vital policy choice. New Zealand income tax legislation does not specify automatic adjustment of thresholds in association with either price inflation or nominal income growth. However, with non-indexed thresholds, typically observed rates of inflation of 2%-3% per year, and average real income growth of around 1.5% per year (equivalent to 3.5%-4.5% nominal income growth) can readily lead to all taxpayers being on the top marginal tax rate (MTR) within a 50-year projection period. Historical evidence suggests that New Zealand governments tend to adjust income tax thresholds from time to time, which serves to counteract partially, but not to reverse completely, nominal fiscal drag. Without full (nominal) indexation of thresholds, average income tax rates rise over time in association with income growth even though the existing marginal rate structure is unaltered.

To simulate GST revenues, the BC model adjusts the simulated disposable incomes (gross incomes less income tax) described above for age-related savings, and dis-savings, rates (estimated from HES data) to obtain individuals' expenditures.[6] Applying the current GST rate of 15% yields individuals' and aggregate GST payments.[7]

A merit of the BC model is that it allows average PIT and GST rates to be projected over time, for different assumptions about the tax structure, alongside a decomposition of the tax paid by each overlapping cohort. This allows, for example, estimates of the distribution of the tax burden between age groups such as between the under-65s and over-65s, or NZS-recipients and non-NZS recipients. In addition, both the tax and social expenditure models can accommodate a variety of policy-change scenarios, such as changing the age of eligibility for NZ Superannuation, whilst allowing for any flow-on effects to labour force participation rates, etc.

The starting point for tax simulations is the 2011 HES; hence the one-year later start date compared with social expenditure simulations. This allows various average tax rate (ATR ) measures to be constructed. To compare projected changes in ATRs with changes in social expenditure/GDP ratios also requires a suitable personal income/GDP ratio. For example, for 2010, Inland Revenue personal taxable income data, and Treasury LTFM data on GDP suggest a ratio of taxable income to GDP of around 0.63.[8] Hence a given ATR (say, 0.3) can be converted to a tax revenue-to-GDP ratio by multiplying by 0.63, to give 0.19, under the assumption that the taxable income/GDP ratio remains unchanged.

Table 1 shows projections of ATRs for PIT and GST combined in 2011, 2031 and 2061 under three PIT threshold indexation assumptions: none; indexation to prices; and indexation to nominal incomes. Indexation to nominal incomes effectively removes the fiscal drag effect on income tax revenue and Table 1 reveals that the combined PIT+GST ATR rises from 27.2% in 2011 to 28.3% in 2061 for this indexation case. This 1.1 percentage point increase cannot therefore arise from fiscal drag, but rather reflects a larger fraction of taxable income becoming liable to GST as an ageing population dis-saves relative to 2010 values.

Table 1 - Average PIT and GST rates over time
Thresholds adjusted: No with prices with incomes
2011 27.2 27.2 27.2
2031 30.7 28.2 27.7
2061 34.9 31.6 28.3
Difference 2061 - 2011 +7.7 +4.4 +1.1

Table 1 shows that allowing for some fiscal drag has a noticeable impact on projected ATRs. By 2060, indexation to prices (that is, keeping real thresholds constant) generates a 4.4 percentage point rise in the ATR to 31.6%, while no threshold indexation at all generates a 7.7 percentage point rise in the ATR to 34.9%. Whether average tax rate increases of these orders of magnitude are likely to be acceptable in some sense is unknown. Since in the price-indexation case income tax has no impact on real after-income-tax living standards, such a policy might be acceptable to taxpayers, especially as real incomes rise over the next 50 years. However, these real income rises mean an increasing fraction of taxpayers moving into higher ATR brackets, as a consequence of their higher real incomes.

To see how far “real bracket creep” (with price indexation) may affect taxpayers in future, Inland Revenue data on taxable incomes in 2010 can be projected forward at the rate of real annual income growth assumed in the projection model (1.5%). In 2011, approximately 27% of taxpayers, representing 15% of taxable income, faced a marginal PIT rate of 10.5%. At the other end of the income scale, 10% of taxpayers (with 39% of taxable income) faced a 33% marginal tax rate. Average taxable income was around $34,000. By 2061, after allowing for 1.5% real income growth for all taxpayers over 50 years, average real income approximately doubles to $72,000. This implies that the share of taxpayers in tax brackets below the highest all fall, while the top rate (33%) bracket would contain around 34% of taxpayers, representing 75% of all taxable incomes.

The question arises of whether this is feasible. There is obviously no definitive answer, but with all taxpayers' ATRs rising over the 50 years, no taxpayer faces an MTR greater than 33%, which is relatively low by current OECD standards. Around 25% of taxpayers in 2061 would face marginal PIT rates of between 18% and 30%. Given the much higher real incomes experienced by all taxpayers in this scenario, it does not seem unduly optimistic to believe that such average and marginal PIT rates could be acceptable to voters. As discussed further below, even if feasible, it does not necessarily follow that it would be desirable to let ATRs rise in this manner.

The acceptability or otherwise to taxpayers of projected changes in ATRs is likely to be a function of how the burden of any ATR rise is shared across the population. In particular, with an ageing population, where older individuals may have different labour and capital income-earning and spending characteristics compared with younger individuals (who comprise a declining share), the age-distribution of tax burdens may become an important influence on policy preferences.

The increases in ATRs reported in Table 1 represent the combined effects of fiscal drag, where relevant, the ageing process and the assumed participation rate changes over time. Decomposing the ATR change into those three components reveals that only a small fraction is due to the ageing and participation effects. For example, turning off the ageing aspect of the BC model, by holding the age structure constant at 2011 values, leads to a small reduction in the 2061 ATR in the no-indexation case, from the 34.9% value shown in Table 1 to 34.1%; that is, 0.8 percentage points lower. Thus, the 2011-61 rise in the ATR becomes +6.9 percentage points instead of +7.7 percentage points. If, instead, labour force participation rates are held constant at 2011 values, this leads to a 2061 ATR of 35.5% instead of 34.9%; that is, 0.7 percentage points higher. For the price indexation case, these ageing and participation effects are commensurately smaller, producing a difference from the 2011-61 benchmark increase of +4.4 percentage points, of around ±0.4 percentage points. These results suggest that most of the increasing income tax and GST revenues are due to the fiscal drag and other properties of the tax structures rather than ageing per se, or the assumed, though plausible, increase in labour force participation over the next 50 years. In this sense, the tax revenue projections are not primarily age-driven, and would be expected even in the absence of the anticipated demographic ageing.

The age-related components of the BC model also allow changes in the age distribution of the tax burden over time to be investigated. An example is given in Figure 13, which shows the percentage of total income tax revenue paid by age for females in 2011, 2031 and 2051 (the male profiles look similar - see Ball and Creedy, 2012). This reveals that in 2011 the “peak” ages for payment of income tax are around 40-55, with steady increases and decreases leading up to, and beyond, those ages respectively. At ages 40-55 each annual cohort pays around 3%-3.5% of the total PIT burden; that is up to around 50% of the total (15 years x 3.5%). The (female) over-65s pay around 3.3% of total PIT revenues in 2011.

Figure 13 – Proportion of PIT by age (females): 2011, 2031, 2051
Figure 13 – Proportion of PIT by age (females): 2011, 2031, 2051

Projections for 2031 and 2051 show little change in the PIT shares of those under age 35, but a noticeably lower tax share for the 35-55 age group balanced by a higher tax share for the over-55s. Most of this change occurs by 2031. The female over-65s contribute 5.6% of PIT revenue by 2031 and 6.0% by 2051.

The simulations reported in Section 2 indicated that the arithmetic mean social expenditure projections involve a 3-4 percentage points of GDP increase over the next 50 year or so, albeit with large confidence intervals. On tax revenues, results in this section suggest that, with price indexation of income tax thresholds, combined PIT and GST revenues as a percentage of taxable income are projected to rise by around 4-5 percentage points. Using the earlier value of 0.63 for the ratio of taxable income to GDP translates these ATR increases into a tax revenue/GDP ratio rise of between 2.5 and 3.2 percentage points of GDP over the next 50 years. Hence, the two best guesses are not far apart. In judging whether price indexation is politically feasible, it is useful to place the implied tax rates in historical perspective. This is considered in the next section.

Notes

  • [6]The BC model allows for non-taxable income, such as some benefit payments, in estimating disposable income, before calculating expenditures for GST payments.
  • [7]Given the broad base in NZ, GST is treated as a proportional tax on all expenditure in the BC model.
  • [8]See <http://www.ird.govt.nz/aboutir/external-stats/revenue-refunds/inc-dist-of-ind/>(Accessed on 30-01-13)
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