Estimating the Elasticity of Taxable Income in New Zealand

Simon Carey, John Creedy, Norman Gemmell and Josh Teng

The Economic Record, 2015, vol. 91, issue 292, 54-78

Abstract: type="main" xml:id="ecor12151-abs-0001">

This paper produces regression estimates of the elasticity of taxable income in New Zealand using two new instruments applied to a substantial tax reform ‘experiment’. Instrumental variable methods are required to deal with endogeneity of the tax rate and taxable income in a non-linear tax structure. However, in the New Zealand context, the ‘standard’ regression instrument is found to be unable to accommodate the substantial observed exogenous (non-tax-induced) changes in taxable income. Two new tax rate instruments are proposed, which use information on taxable income dynamics, for a panel of taxpayers over a period that involves no tax changes, to derive taxpayers’ counterfactual post-reform incomes and tax rates expected in the absence of reform. The two instruments respectively measure, for each taxpayer, the tax rate associated with expected mean income, and the expected tax rate associated with the individual's expected conditional distribution of income. Applying these instruments to the 2001 New Zealand tax changes yields plausible estimates of the elasticity of taxable income around 0.5–0.7. Elasticities are found to be substantially higher for taxpayers with non-wage-and-salary income compared with wage and salary only taxpayers. Results also confirm that non-wage-and-salary income was especially responsive to the tax changes.

Date: 2015
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