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5 Is tax change desirable?

Faced with population ageing and other factors that are expected to create pressures for increased public expenditure over the next 40-50 years, the question of whether automatic average tax rate rises are preferred to discretionary tax policy changes is complex and requires careful analysis. It cannot be adequately addressed in this paper: on the desirability of fiscal drag, the Tax Working Group Report (2010) has argued forcefully, “It is doubtful whether such a process is politically sustainable over several decades.” It would also reverse, to some extent, the recent shift in the tax mix towards GST and away from income tax, recommended by the Working Group. Clearly, the evaluation of any policy change cannot escape the role of value judgements. This section addresses some of the issues that any evaluation of the desirability of long-term tax increases would need to take into account.

First, the government budget can be described as a “closed system,” summarised by the government budget constraint. This is an identity linking aggregate levels of tax revenue, public expenditure and budget deficits. Any change in one element of that constraint must involve an equal and opposite change in one or more other components. As a result, no individual tax revenue change, whether due to automatic factors or discretionary policy change, can be evaluated without simultaneously considering the other fiscal changes that will either adjust automatically or would need discretionary action. Similarly, a proposed increase in one public spending category, financed by a specified tax increase, must be evaluated in comparison with alternative uses of the relevant expenditures or tax revenues.

These various alternatives are likely to have complex and potentially quite different interaction, or general equilibrium, effects and hence require a suitably comprehensive evaluation framework. Analyses may be of the “political economy” type, in which different voting rules are applied, or they may be of the “welfare economics” form. In the latter case, economists often work with a form of evaluation, or welfare, function which involves an explicit description of value judgements imposed by a hypothetical decision-maker or independent judge.[13] Whatever framework is adopted, tax changes to finance an increase in social expenditure such as those that may arise from population ageing must be evaluated against, for example, counteracting public expenditure decreases, different tax changes, or a change in the extent of deficit financing.

Second, many evaluations of alternative tax proposals take a given revenue requirement and compare the impacts of each policy. In the present context this can be thought of as first deciding on the level of public expenditure to be financed and then considering the merits of alternative tax revenue-raising options. This in turn would imply first considering whether age-related increases in NZS, health or other social spending, expected in the absence of policy change, should be counteracted by countervailing policy change, such as changing the age of eligibility for NZS. This would then determine the level of total spending to be financed. However, such an approach ignores the likelihood that the choice of optimal expenditure levels may be conditional on the costs of raising different levels of tax revenue. For example, if the welfare costs of higher income tax or GST revenues are thought to be small, the case for compensating cuts in public spending would be weaker.

Third, on the specifics of alternative tax-financing options, allowing fiscal drag to raise average income tax rates slowly over time may be compared with a number of options such as discretionary changes to particular income tax rates and/or thresholds, changing the rates or structure of GST, extending the income tax base, or introducing new tax bases.

An argument often made against higher income tax rates is that these have especially high disincentive or other adverse welfare costs, for example, by discouraging labour supply or encouraging the diversion of income into tax-favoured forms, or overseas. Some economic literature suggests possible adverse effects of high income tax rates on GDP growth rates, investment or household savings. These often relate to high marginal tax rates, but in the case of location decisions involving, for example, investment or labour migration, average rates of income tax are potentially more relevant.

In comparing the alternative tax increases canvassed above, an important advantage of the real fiscal drag option, based on the current income tax structure, is that it does not involve a general increase in marginal tax rates. Some taxpayers, by moving into higher tax brackets as their incomes rise, do face higher marginal rates, but the highest marginal rate remains at 33%. In addition, where taxpayers do experience an increase in their MTRs via moving across tax brackets, this simply implies that when a lower income taxpayer today obtains the same (higher) real income levels experienced by a high income earner today, the former will face the same MTR as the latter. On average, of course, taxpayers are paying higher marginal tax rates, but these never exceed 33%.

By contrast, raising the top income tax rate (to yield similar revenue increases as the fiscal-drag option), would raise marginal tax rates for a substantial group of taxpayers above those currently experienced. Raising the rate of GST effectively raises the marginal tax rate on labour income for all taxpayers. A GST increase effectively taxes existing wealth when accumulated savings are spent. This involves differential impacts on different generations, which may be compared with implicit intergenerational transfers involved in pay-as-you-go financing of NZS.[14] However, as shown by the BC model, many wealthy current and future retirees are expected to have significant capital income which would be subject to the income tax regime.[15] Hence evaluating the merits of different tax-financing options would require a careful analysis of these and other factors that are likely to affect taxpayers.

Notes

  • [13]Recognising that several dimensions are usually involved and trade-offs must be specified explicitly, the New Zealand Treasury (2011) has recently proposed a “Living Standards Framework,” which encourages quantification of a number of criteria against which to evaluate the outcomes of a policy change; see Karacaoglu (2012).
  • [14]For more on these intergenerational aspects of tax and retirement income policy, see Coleman (2012).
  • [15]For example, the BC model projects a rise in the ratio of capital income tax revenue to taxable income from 1.1% in 2011 to 3.1% by 2060.
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