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The Marginal Welfare Cost of Personal Income Taxation in New Zealand

2 Previous Estimates for New Zealand

The earliest estimates of marginal welfare costs of taxation in New Zealand were produced by Diewert and Lawrence (1994, 1995), using a small general equilibrium model in which a representative individual allocates expenditure over four groups (motor vehicles, housing, leisure and ‘general consumption').[6] They found marginal welfare cost values for income tax and general consumption tax of about 18 and 14 cents per extra dollar of revenue respectively for the early 1990s.[7]

McKeown and Woodfield (1995) examined welfare costs of income taxation, using an approach based on the standard approximation to the excess burden, in terms of the equivalent variation. Assuming a linear compensated demand curve for leisure, the excess burden arising from a small tax change is known to be equal to half the product of the compensated demand elasticity (here the demand for leisure) in the new position, the net wage income and the square of the tax-inclusive income tax rate.[8] Although McKeown and Woodfield (1995) looked at a range of income levels, they used a common tax rate obtained as an income-weighted arithmetic mean marginal tax rate (over the multi-rate income tax schedule, and including indirect taxation).[9] Using a tax reform consisting of a one percentage point increase in all marginal rates, and values of the compensated demand elasticity in the range 0.2 to 0.6, their illustrative calculations produced marginal welfare costs much higher than those obtained by Diewert and Lawrence (1994) and, as expected, they were substantially higher for the higher elasticities; see McKeown and Woodfield (1995, Table 3).

The next contribution to measuring welfare costs of income taxation was by Thomas (2007).[10] He based results on his estimate of the elasticity of taxable income, using information relating to the 1986 tax reform in NZ. These results are necessarily for a very high level of aggregation. The rapidly growing literature on the elasticity of taxable income, ETI, following Feldstein (1999), had established that, for those in the top income tax bracket and in the absence of income effects, the marginal welfare cost can be obtained as a simple function of the elasticity, the tax-exclusive income tax rate and a term equal to the ratio of average income in the top bracket to the excess of that average over the income threshold.[11]

Using estimates of the elasticity of taxable income obtained for the 2001 tax reform, Claus et al. (2012, p. 301) later reported a range of marginal welfare cost values for alternative assumptions about the extent to which taxable income is shifted to lower-taxed sources rather than being evaded.[12] However, a serious problem with this approach is that the results are very sensitive indeed to the value of the elasticity of taxable income, a term that has been very difficult to estimate with sufficient precision.

There have been fewer studies of the welfare costs of indirect taxes. As mentioned above, there are the highly aggregative estimates of Diewert and Lawrence (1994) for the broad groups of housing, vehicles and ‘general consumption'. Creedy (2004b), using a partial equilibrium model allowing for extensive heterogeneity, computed marginal welfare costs of a simulated increase in the petrol excise tax, and these ranged between 35 and 55 cents per dollar of additional revenue, depending on the household type. Welfare costs arising from the Goods and Services Tax (GST) and other excise taxes in New Zealand were obtained by Creedy and Sleeman (2005) for a wide range of household types and income groups. As a broad-based tax, the GST was found to give rise to relatively low welfare costs for most household types.[13]

Notes

  • [6]See also Diewert et al. (1998). They referred to the ‘marginal deadweight cost’ or ‘marginal excess burden’ which they expressed in percentage terms, rather than per dollar of net revenue.
  • [7]A helpful summary of their approach is found in Small (2012) who found, using bootstrap methods and various modifications to the Diewert and Lawrence model, that the values were typically not significantly different from zero. Other attempts to measure excess burdens, including the present paper, have not obtained confidence intervals.
  • [8]They refer (1995, p. 48) to the excess burden in some places as the ‘total welfare cost’. They also write the formulae in terms of the gross income (the pre-tax wage multiplied by hours worked), rather than net income, so that their tax term is written as m2/(1-m), where m is the tax-exclusive rate. The tax-inclusive rate is m/(1-m). For the approximation based on the compensating variation, the appropriate tax rate is the tax-exclusive rate, and elasticities and net incomes are pre-change values. The expression described above corresponds to the more common idea of the excess burden depending on the square of a tax rate (either the tax-inclusive or exclusive rate). Here net income is the product of hours worked and the gross wage rate multiplied by (1-m). For more details of EV and CV approximations in consumption and income tax contexts, see Creedy (2004a).
  • [9]This meant that they used a rate for the post-1980s-reform period that was higher than for the pre-reform period, particularly given the role of built-in flexibility.
  • [10]In the published version of his paper, Thomas (2012) omitted estimates of the marginal welfare cost.
  • [11]The standard specification rules out income effects, and thereby considerably simplifies welfare measures. This result was extended to deal with all tax brackets, with numerical illustrations, by Creedy (2010).
  • [12]Examples were also produced by Gemmell (2009) for the Victoria University of Wellington Tax Working Group.
  • [13]In their analysis the effects of eliminating GST on food, Ball et al. (2016, p. 122) report values of the ratio of the change in tax to the equivalent variation, for a range of household types, from which the marginal welfare cost can easily be obtained. However, their policy change was designed to be revenue neutral in aggregate, so for some groups considered, the revenue change was found to exceed the welfare change.
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