The welfare cost of taxation in New Zealand following major tax reforms

Abstract

The welfare cost of taxation of labour income is the economic loss to employees over and above the taxation revenue acquired by the government. This article estimates total welfare cost in 1986 and 1988 in New Zealand, and also estimates marginal welfare cost and related measures of marginal excess burden for a hypothetical marginal tax reform prior to and following the major discrete reforms of 1986. Estimated welfare costs are generally higher in the post-reform period despite a significant reduction in the progressivity of the statutory personal income tax schedule, the effect of the uniform goods and services tax introduced at that time serving to raise the weighted average effective marginal tax rate. As with recent estimates for the U.S., estimated welfare costs for New Zealand are sensitive to labour supply elasticity parameters, and are higher than for the U.S. Part of this difference, however, is shown to depend on our use of disaggregated income data.

Measuring Welfare Changes and the Excess Burden of Taxation*

“…They used elasticities based on averages quoted from other studies, but applied them to individuals in microdatasets, grouping the results into income deciles. McKeown and Woodfield (1995) also used a somewhat more disaggregated approach. 26…”

Price stability: Somecostsand benefits in New Zealand

“…To obtain the welfare effect of this tax revenue loss, we need to multiply these values by some estimates of the dead-weight cost of taxation. As already anticipated, we use two values of λ: 0.14 from Diewert and Lawrence (1994) and 0.65 from McKeown and Woodfield (1995). The resulting welfare effect varies from -0.04 percent to -0.42 percent of GDP.…”

“…The distortionary effect of offsetting taxation is summarised by the parameter λ (corresponding to the deadweight loss per one dollar of additional taxes). The estimates of this parameter for New Zealand range from 0.14 (Diewert and Lawrence, 1994) to 0.65 (McKeown and Woodfield, 1995). Due to the uncertainty surrounding this parameter, we present two sets of results for each of these values.…”

The marginal welfare cost of personal income taxation in New Zealand

“…7 McKeown and Woodfield (1995) examined welfare costs of income taxation, using an approach based on the standard approximation to the excess burden, in terms of the equivalent variation. Assuming a linear compensated demand curve for leisure, the excess burden arising from a small tax change is known to be equal to half the product of the compensated demand elasticity (here the demand for leisure) in the new position, the net wage income and the square of the tax-inclusive income tax rate.…”

“…Assuming a linear compensated demand curve for leisure, the excess burden arising from a small tax change is known to be equal to half the product of the compensated demand elasticity (here the demand for leisure) in the new position, the net wage income and the square of the tax-inclusive income tax rate. 8 Although McKeown and Woodfield (1995) looked at a range of income levels, they used a common tax rate obtained as an income-weighted arithmetic mean marginal tax rate (over the multi-rate income tax schedule, and including indirect taxation).…”