Effective tax rates

I just spotted in the news that the New Zealand IRD and Treasury “effective tax rate” reports have been released. The IRD report is here and the Treasury report is here. I also see that OliverShaw slipped out a report a week prior.

I will read both policy reports in the future. I know both the policy teams well, they are smart, have integrity, and provide genuinely useful insights. And my interactions with OliverShaw have always been reasonable, so I’m sure that report is of interest also. As a result, I don’t have much interest in giving a knee-jerk reaction to anything until I’ve had a chance to read the work and to educate myself a bit.

The headline results from all the reports sound pretty plausible – my key concern is that people who aren’t the researchers might start talking about them without understanding what the numbers mean. And man, I don’t want to be one of those people!

How can I say all these different results sound plausible when they are all quite different?

Well, how about we chat about effective tax rates a little bit first to discuss how there are different measures – and why they are different!

I’m pretty into the topic (i.e. my studies, my hobbies) and for those who know me I have a more respectable brother who arguably gets even more excited when he hears about this topic. So it is something I enjoy thinking about and chatting about. Lets have a go.

Note: I have not read any of the reports that are online yet – so please don’t read these as comments about any of the work, as it will be out of context. They are comments about me being a nerd.

What is an effective tax rate?

What is a tax rate? People in the media will talk about how I’ll pay a tax rate of 39% if I’m earning over $180,000 per year – but is that the right number? What about tax I pay when I spend at the shops? What about when I pay local govt rates? What am I even paying 39% of?

Well, this 39% is called a marginal tax rate as it refers to the proportion of an additional dollar of income I would pay directly in income tax.

So it doesn’t count other types of taxes I’d pay. And it doesn’t tell me how much tax I’d pay on the first $180,000 earned during that year.

Now what does it look like when I consider the tax I paid during a year from some measure of the income I earned – that tax paid divided by the income earned is the average tax rate. If I was earning $180,000pa at work my average tax rate would be way lower than 39% – in fact using this neat tool it looks like it looks like it would be 28%.

An effective tax rate takes these two concepts and runs with them – it takes into account other bits and bobs of tax, and importantly it will count “government transfers” in some way – either as income or as a negative tax. Look we’ll come back to this point.

What is income, what is tax?

So what is income? Well that’s a pretty hard topic – income is, in principle, going to refer to what “people can contribute from” on the basis of the means they have. There are legitimate debates about people’s ability to contribute from some things that are called income – and personally I find it easier just to think about these topics in terms of consumption. But we have an income tax system, and so these debates are key!

Lets ignore them!

So we are thinking about contributions to government from some amount of income. There are three types of broad income concepts I want to think about here.

  • Market income: The income people generate before they receive anything directly from government, or get taxed.
  • Gross income: The income people are sitting around with before they get taxed.
  • Disposable income: The income people are left sitting with after they’ve paid tax.

There are other terms, taxable income, adjusted gross income, capital income, labour income, imputed income. But for our purposes, who cares.

The first two (market and gross) are a base that we can build tax measures from. One thing that people get minced up on is that they hear “tax rate” and they think there is one measure to rule them all. But for different questions the relevant rate is completely different!

  • Intensive work margin: Hey, I am thinking about work a slightly longer shift this week – what is my tax rate?
  • Extensive work margin: I’ve been out of the workforce looking after my young child and I’m thinking about jumping into work – what is my tax rate?
  • Redistribution of income: I’m worried about inequality in our society, and I wanted to understand how taxes and government spending is reducing this? Can I do this with a distribution of tax rates?
  • Earnings period: I’m taking a big risk going out and building up my hairdressing business – and with COVID coming in and out my profits are going to jump around a lot – how does my tax rate compare to one of the hairdressers I hire over the 30 years I run the business?

Effective rates and the choice to do something … usually work

The first two are “financial disincentives to work” – the first one is a “marginal” tax rate (the effective marginal tax rate, or EMTR), the second is an average or participation tax rate (the EATR, or ETR).

For this we want to start with what people are receiving in the starting circumstance (their gross income) and talk about how much is taken away as a contribution (the difference between gross and disposable income). In the first case the person is working and works a tiny bit more, in the second case they aren’t working and jump to work a number of hours. We care about the two measures as they are refering to two different “choices” related to work – the decision to work a little bit more (intensive margin) vs the decision to move from not working to working (the extensive or participation margin).

The tax here refers to more than just the tangible tax contribution. It also includes any abatement of government support – or in english, the amount your benefits are reduced as you earn more income.

Here the tax rate is the ratio of (tax + benefit removed) divided by gross income. This is because this is the proportion of gross income that is sacrificed when you decide to undertake this other choice – or in english, if your boss pays you a given amount more, how much of that amount goes back to the government.

These types of disincentives can also be considered for a much wider range of behaviours – saving, investment, reporting of income – but work incentives are just a great example of how we’d use such a measure!

Effective tax rates and “fairness” – redistribution

The third is a wildly different rate – we aren’t asking about people’s incentives to work, but instead how taxes and transfers transform market income to disposable income. This one is more about “fairness” more generally. It doesn’t tell us what is fair (redistribution is a value-laden issue), but if we coherently want to talk about people paying their “fair share” we want to be building this measure – not the measures of financial disincentives to work.

This third one involves subtracting benefits from tax, and not including benefits in income to start with – so the “tax” is the net payment by the individual to government (tax – benefits) while the “income” base should be the “initial” market income in the absense of taxes and benefits.

The rationale is that this measure of the tax rate is representing the way the tax and transfer system transforms your market income which relates to how much is changes relative to that income.

The difference between disposable and market income is benefit minus taxes, and so the system has generated this by adding benefits to your income, and taking away tax. You “contribute” in a fiscal sense when taxes paid exceed benefits received, and you are “contributing” from the private/market income that is generated from transactions without the imposition of the tax-transfer system.

In terms of “contribution” it may be that many people are not net contributors, but that is by design – “market” incomes are not the demarcation of fairness, and the real question is then whether policy does enough (or too much) to address inequities that do exist in this distribution. In other words, there is no substitute for actually talking about the actual incomes and opportunities that people face and the trade-offs involved.

Furthermore there is a huge wrinkle in these definitions – behaviour. The market income distribution would look very different without taxes and transfers, and in this definition we’ve assumed it wouldn’t change. As a result, it is normally a bit more accurate to say that “the individuals involved in the transactions that lead to market income are contributing” rather than the sole individual who is paying the tax (to capture the idea of tax incidence) – but even then there are shortcomings related to behaviour and counterfactual activities. So we gotta be careful!

How do we get to this fairness measure?

Actually, this is a fun topic – so I’m going to dive into it a little bit.

Now there is a lot of debate about fairness and ETRs in the literature – and the literature often goes in a different direction. By definition the progressivity of the tax system is just a measure of tax paid from an income base, and gross income is a legitimate base to ask how progressive taxes are.

But this isn’t fairness.

If our questions are about whether government policy is “fair” we should be looking at all government policies together, and the way this redistributes income – any half measure of this just doesn’t really tell us anything useful. Yes you’ve stopped a bunch of people having a negative infinitey tax rate when you draw a graph – but you’ve also made your measure treat a dollar paid to someone and a dollar taken from the same person not equivalent!

Ok I need to explain this. Imagine we have a person earning $10. We then tax them $5 and given it back to them. What is their tax rate? If we only looked at taxes on market income it is 50%. If we added benefits in to get gross income it is now $5/$15, or 33%. But their situation – and any view about their contribution – is exactly the same as if there is no tax!!

Fairness is about asking about the change in an individuals situation due to the redistribution tax-transfer system – we then debate if this redistribution meets our “principles of fairness”. Looking at only one part of the system and ignoring the rest to make fairness claims is incoherent.

A “fair” system will redistribute between people based on a set of values – and so if we are using the tax rate to describe this we would want to treat circumstances where the individuals situation is unchanged in an equivalent way. This measure does not and so will give us different numbers for two policies that are exactly the same!

Now, if the goal is to try to look at taxes and benefits in isolation and talk about relative effects, then playing with a variety of income bases is sort of interesting! And if the goal is to comment on distortions in behaviour, and the $5 payment is happening regardless, then this is the damned right measure (hence why I’m using a similar definition here).

I’d even concede that we might have fairness concerns about sharp benefit abatement and poverty traps- which may be easier to understand by looking at the financial disincentive measure.

But if the goal is to comment comprehensively about fariness of the overall tax-transfer system through redistribution, we want to use market income as the denominator and subtract transfers from tax, to ensure we compare policies consistently – by looking at the net amount redistributed to the individual/family as a proportion of the initial (market) income. Anyway, if you are interested read this cool paper (Herault and Azpitarte 2015).

And before anyone swings to the extreme of saying “over 50% of people aren’t net contributors, that is unfair, lets cut taxes” let me give a clear response – yawn. In a world where significant value is generated from the technology and the knowledge we share, it could easily be the case that the “fair” distribution involves even more people being net contributors – and the argument you are making is as incoherent as the situation described above.

To do a fairness comparison we really need to ask “how does the observed contribution compare with how it should be according to our fairness principles”? For this it makes more sense to actually report the distribution of income, and counterfactual distribution if policy was different – what are the outcomes and opportunities for people on the basis of a tangible policy change.

Lifetime contributions

The fourth could be about either incentives or fairness as the person didn’t tell us – but we would want to think about it in a lifetime basis. In New Zealand we don’t tax capital gains (meaning there is income that doesn’t get taxed for the owner in so far as they spend their own time building up the business and goodwill) but we also have a progressive tax scale which taxes “variable” incomes more.

So here, should we be taxing capital gains? If so what part, do we tax inflation? Do we tax the “risk-free return”? If profits are taxed in the future are we double taxing now? Or are we just taxing the bit that is hidden labour income and economic rents?

Hells if I know – the main thing is that if we have a lifetime perspective of the net contribution to government from market income, some of this will wash out, and some important parts will not.

As a result, any discussion on effective tax rates – especially at the top end with a lot of “capital income” – will need to have a discussion of this time dimension. This is where stuff gets super fun – and where we’ll leave todays yarn!

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  1. […] do I read these without going through this excessively long blog post? The effective marginal tax rate (EMTR) noted here tells us that, if someone worked for an extra […]

  2. […] leave out the idea of whether we consider government transfers as income – because we already chatted about this here. Cliff notes – if we are talking about the “progressivity of the tax system” they […]

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