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This note is the first in a two-part series that seeks to improve our understanding of effective average tax rates (EATRs) in New Zealand. EATRs measure the net effect of taxes and transfers as a proportion of a taxpayer’s income. Measuring EATRs can provide insight into some important questions with implications for the fairness and efficiency of the tax and transfer system:
- Who pays tax and who receives transfer payments?
- How much do they pay or receive?
- Where might taxes and transfers distort decisions to save and invest?
This series focusses on the first two questions and what EATRs can tell us about progressivity (defined as having higher tax rates and lower transfer rates for higher levels of income or wealth). Measuring EATRs can also help us to identify tax distortions caused by the inconsistent tax treatment of different types of income. Such distortions can create allocative inefficiencies and reduce productivity. The objectives of the tax system are outlined in Box A.
This note seeks to:
- Explain why considering more comprehensive EATRs is valuable, and why microsimulation modelling is useful.
- Present our method for estimating more comprehensive EATRs, which uses a prototype-extension to the Tax and Welfare Analysis (TAWA) microsimulation model that can measure the effect of multiple tax and transfer types against broad definitions of income.
One of the challenges with measuring EATRs is deciding which taxes and transfers to consider and what to count as ‘income’. EATRs are often narrowly defined as the average tax rate for a single tax (eg, income tax) against a statutory tax base (eg, taxable income). We build on traditional EATR measures by gradually combining multiple different tax and transfer types and assessing them against increasingly broad definitions of income, to estimate a more comprehensive measure.
The scenarios in this note show that taxpayers with equal taxable income can have very different EATRs when we include the effects of transfer payments and untaxed sources of economic income, such as capital gains and imputed rents (the benefit of home ownership or the notional rents that owner-occupiers pay to themselves to live in their own house). These scenarios do not demonstrate the effect of combining GST with income tax and other taxes, which is also expected to be significant for the distribution of EATRs.
TAWA microsimulation modelling, employing the experimental methods described in this note, is required to understand how these more comprehensive EATR measures may alter progressivity across the income and wealth distributions. The results from our prototype-extension to the TAWA microsimulation model are presented in part two of the series (Ching, Reid, & Symes, 2023).
-  The TAWA microsimulation model applies policy settings to individuals in its input data, and then scales up and aggregates the results so that they are representative of the New Zealand population. Further information about TAWA is available here: treasury.govt.nz/information-and-services/financial-management-and-advice/revenue-expenditure/tax-and-welfare-analysis-tawa-model