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A microsimulation analysis of marginal welfare-improving income tax reforms for New Zealand

Abstract

This paper examines the direction of welfare-improving income tax reforms in the context of New Zealand, which recently reduced its top marginal income tax rate to one of the lowest in the OECD. A behavioural microsimulation model is used, in which social welfare functions are defined in terms of either money metric utility or net income. The model allows for labour supply responses to tax changes, in which a high degree of population heterogeneity is represented along with the details of the highly complex income tax and transfer system. The implications of the results for specific combinations of tax rate or threshold changes that are both revenue neutral and welfare improving are explored in detail, recognising the role of distributional value judgements. Results suggest, under a wide range of parameter values and assumptions, that raising the highest income tax rate and/or threshold would be part of a welfare-improving reform package.

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Notes

  1. 1.

    On microsimulation modelling, see Creedy and Kalb (2005, 2006). Examples are in Decoster and Haan (2015), Dagsvik et al. (2014), Thoresen (2004) Thoresen and Vattø (2015) and Capéau et al. (2016). When using such models, it is nevertheless important to be aware of their limitations. In particular, they deal only with the supply side of the labour market and, despite modelling labour supply, have no genuine dynamic element. Furthermore, they deal only with financial incentive effects rather than administrative behaviour and monitoring features designed to reduce moral hazard.

  2. 2.

    Examining the direction of welfare-improving reforms in Australia using the MITTS behavioural microsimulation model, Creedy and Hérault (2012) report that, for a range of social welfare assumptions, a welfare-improving reform involves a reduction in the top marginal rate, which was around 47 per cent (in 2003/04).

  3. 3.

    Certain groups are not included in the labour supply analysis, and in simulations their hours and gross incomes are held fixed. These include full-time students, disabled, retired and self-employed.

  4. 4.

    Optimal income tax models maximise a social welfare function, subject to a government budget constraint. The partial equilibrium environment usually consists of individuals with identical preferences but different abilities (reflected in exogenous wage rates), and the welfare function is specified as a variant of the basic utilitarian form, allowing for inequality aversion. The welfare metric is thus utility, which is necessarily considered to be cardinal and interpersonally comparable.

  5. 5.

    Even a minimum requirement of homotheticity is not satisfied by the types of direct utility function used in practical labour supply analyses. This has led to the adoption of non-welfarist approaches, such as that proposed by Fleurbaey and Maniquet (1999).

  6. 6.

    Blundell and Shephard (2009) simply adopt a social welfare function based on a common (isoelastic) utility transformation.

  7. 7.

    Any analysis of marginal reforms must recognise the possibility that there may be multiple local optima, despite the fact that standard optimal tax models (which reflect very little heterogeneity) produce a single optimal structure.

  8. 8.

    For an early treatment of welfare changes in discrete models, see Hanemann (1983).

  9. 9.

    On abbreviated forms, see, for example, Lambert (1993).

  10. 10.

    The tolerance for leaks clearly depends on the assumed ratio of incomes of transferor and transferee. For example, if \(y_{2}/y_{1}=3\), then when \( \varepsilon =0.1\), \(\Delta y_{1}=0.90\) and a leak of 10 cents is tolerated, and if \(\varepsilon =0.2\), \(\Delta y_{1}=0.80\) and the maximum leak tolerated is 20 cents. Some surveys have found an average inequality aversion in the context of the Atkinson inequality measure of about 0.2; see Amiel et al. (1999).

  11. 11.

    Indeed, with \(\varepsilon =3\), the leak tolerated is 99.9 cents, virtually the whole of the $1 taken from person 2.

  12. 12.

    This kind of situation is discussed further in the New Zealand context by Creedy and Mok (2018).

  13. 13.

    Other changes are included in responses described by the concept of the elasticity of taxable income (ETI). An extended version of this paper, Creedy and Mok (2018), examines how far \(\left| \Delta W/\Delta R\right| \) results based only on labour supply changes for top rate taxpayers can be extended to incorporate taxable income responses.

  14. 14.

    However, it is important to distinguish rate progression from progressivity. The former refers to the schedule of marginal tax rates, whereas the latter refers to the extent of redistribution arising from the structure and depends on a wide range of further considerations.

  15. 15.

    A zero aversion is of course consistent with a redistributive tax and transfer policy on ‘efficiency’ grounds, but it does not necessarily imply rate progression (that is, increasing marginal rates).

  16. 16.

    Instead of changing each threshold in turn, a policy of simultaneously raising all income thresholds by $1k was examined. In each case (that is, for both money metric utility and net income as the welfare metric, and each equivalent adult scale parameter), it was found that the welfare benefit per dollar of revenue reduction was not as high as when a single threshold was raised.

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Acknowledgements

This paper is part of a larger project on ‘Improving New Zealand’s Tax Policy via International Tax Transfer Model Benchmarking’, funded by an Endeavour Research Grant from the Ministry of Business, Innovation and Employment (MBIE). Access to the data used in this paper was provided by Statistics New Zealand in accordance with security and confidentiality provisions of the Statistics Act 1975. The results presented in this study are the work of the authors, not Statistics New Zealand. We have benefited from comments by the referees and participants at the Microsimulation Workshop in Wellington, March 2018, and the CPF Public Economics Research Day, Wellington, April 2018.

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Creedy, J., Gemmell, N., Hérault, N. et al. A microsimulation analysis of marginal welfare-improving income tax reforms for New Zealand. Int Tax Public Finance 27, 409–434 (2020). https://doi.org/10.1007/s10797-019-09558-5

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Keywords

  • Optimal taxation
  • Tax reform
  • Behavioural microsimulation
  • Social welfare function
  • Money metric utility

JEL Classification

  • D63
  • H21
  • H31
  • I31
  • J22