The Elasticity of Taxable Income and the Tax Revenue Elasticity

Abstract

This paper examines the joint role of the elasticity of taxable income (the effect on taxable income of a tax rise) and the revenue elasticity (the effect on revenue of a change in taxable income) in influencing the revenue effects of tax rate changes. Traditionally, the revenue elasticity has been the central concept in examining fiscal drag, or obtaining local measures of tax progressivity. But it has an additional role in the context of the revenue effects of tax changes when incomes respond to rate changes. The elasticity of tax revenue with respect to a rate change is examined at both the individual and aggregate level. If there were no incentive effects, an equal proportional change in all marginal tax rates would produce the same proportional increase in total revenue — the elasticity is unity. This rapidly falls, at a linear rate, as the elasticity of taxable income increases. Illustrations are provided using the New Zealand income tax structures before and after the 2010 Budget, which reduced all rates while leaving income thresholds unchanged and, in particular, reduced the top marginal rate substantially.