Econ 3007 Economic Policy Analysis Reforming the Tax System Lecture I: The Taxation of Earnings October 2009 Richard Blundell University College London http://www.ifs.org.uk/mirrleesReview
Lecture I: The Taxation of Earnings 1.Why reform earnings taxation? 2. What is earnings taxation? 3. Taxing the rich 4.Taxing lower income families http://www.ifs.org.uk/mirrleesReview
Why reform earnings taxation? • Changes in employment patterns, in earnings inequalities and in population trends • New empirical findings on labour supply elasticities • New insights from optimal tax design • A need to look at the whole income tax/benefit system • Key chapter (in Mirrlees Review): Brewer, Saez and Shephard (2008), http://www.ifs.org.uk/mirrleesReview/publications • Commentaries by Moffitt, by Laroque and by Hoynes
Changes in the changed economic environment • Changes in employment patterns – growth of female labour supply – changes in youth employment – changes in ‘early retirement’ behaviour • Changes in population – growth in single person & single parent households – growth in migration • growth in earnings and wealth inequalities – change in nature of income and earnings risks
Increased empirical knowledge • labour supply responses for individuals and families • at the intensive and extensive margins – extensive margin elasticities generally higher than intensive margin • by age and demographic structure – labour supply elasticities higher for mothers with younger children and for pre-retirement adults • taxable income elasticities – top of the income distribution using tax return information
What is earnings taxation? • The earnings tax schedule describes the total amount of taxes paid, or transfers received, by an individual for different levels of his or her labour earnings. • It determines the difference between the amount income an individual worker has to spend or to save and the wage cost of that worker to an employer. • In most developed economies this schedule is far from simple - not just because of the income tax system but through interactions between income taxes, benefits and social security. • As a rule, the earning tax schedule is complex and will differ according to family composition and by the level of other income in the family unit.
Budget Constraint: Lone Parents UK
The taxation of income from earnings • I want to take a holistic view of the way taxes and benefits impact on family income as individual earnings vary. • Simple tax schedules are not necessarily the best from either an economic efficiency standpoint or from a position of fairness. • However, to be effective an earnings tax system has to be understandable to employees and employers. To quote the Nobel prizewinner Herb Simon ‘..a wealth of information creates a poverty of attention’. • There is a therefore a balance to be struck between what maybe considered ‘over’-complexity resulting from an economic and fairness point of view and a need for a clear, comprehensible tax code.
The taxation of income from earnings • There are certain key margins where tax rates impinge on earnings decisions. • For many male workers this is at the beginning and at the end of their working lives. These are the schooling-work margins and the early retirement margins. • Indeed much of the difference in male employment across OECD countries occurs at these points in the life-cycle.
Male employment by age – US, FR and UK 2005 1 0.9 US FR 0.8 UK 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
Male employment by age – US, FR and UK 1975 1 0.9 US FR 0.8 UK 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
Male Hours by age – US, FR and UK 2005 2400 2200 US 2000 FR 1800 UK 1600 1400 1200 1000 800 600 400 200 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
The taxation of income from earnings • For women earnings are influenced by taxes and benefits not only at these margins but also when there are young children in the family. • For women with younger children it is not usually just an employment decision that is important it is also whether to work part-time or full-time. • Often the employment margin is referred to as the extensive margin of work and the part-time or hours of work decisions more generally as the intensive margin.
Female Employment by age – US, FR and UK 1975 1 0.9 US FR 0.8 UK 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
Female Employment by age – US, FR and UK 2005 1 0.9 US FR 0.8 UK 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
Female Hours by age – US, FR and UK 2005 2400 2200 US 2000 FR 1800 UK 1600 1400 1200 1000 800 600 400 200 0 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78
The taxation of income from earnings • It is essential to assemble all the components of the tax schedule and examine the system as a whole. • One way to achieve this and to capture the complete picture of the tax rate schedule is through the calculation of effective marginal tax rates and participation tax rates. • The ‘effective marginal tax rate’ is the proportion of an £1 of extra earnings retained in the tax and benefit system. This will include all employer taxes and contributions as well as the full set of taxes and benefits. It typically varies widely. • By contrast the ‘participation tax rate’ is the net loss, through taxes and benefits, of earnings in work relative to being out of work.
The taxation of income from earnings • If someone who did not work had an income from a benefit programme of £60 a week, and would earn £250 in gross earnings, but pay £40 of that in income tax if they were to work, then the PTR is given by 1 - (210-60)/250, or 40%. • The higher the PTR, the more the tax and benefit system reduces the financial gain to work. • A PTR in excess of 1 means the individual would be worse off in work than not working; a PTR equal to 1 means that there is no financial reward to work; a PTR of zero means that the financial reward to work is equal to gross earnings; • Negative PTRs are possible where benefits are conditional on being in work or having positive earnings.
Participation tax rates: Lone Parents UK
The taxation of income from earnings • The higher the METR, the more the tax and benefit system reduces the gain to earning a bit more: • a METR in excess of 1 means that an individual would be worse off if they earned a bit more; • a METR of 1 means that an individual would be unaffected by any small change in earnings; • a METR of zero means that the individual is keeping all of any small rise in earnings. • A negative METR means that an individual's net income increases by more than a small change in earnings.
Effective marginal tax rates: Lone Parents UK
Labour supply and taxation • Taxes and means tested transfers affect the returns to work, often in complicated ways. A key purpose of a labour supply model is to provide a framework for understanding and measuring the way that tax and welfare systems affect incentives. • In particular take a decrease in the marginal tax rate at different points in the system. Two cases: • The tax rate being changed relates to earnings higher than those earned by the individual. In this case the tax rate change has no impact on her optimal hours of work. • The tax rate being changed is precisely the one faced by the individual. In this case the effect on labour supply comes about because both the marginal wage and the effective non-labour income changes: the decrease in the tax rate increases the slope of the budget constraint (the incentive effect of the wage rate) and reduces its intercept, as if the individual had less non-labour income.
Labour supply and taxation
Labour supply and taxation
Allowing for welfare benefits • The UK has a complex system of welfare benefits and tax credits, mostly means-tested, resulting in potentially large transfers to individuals. Their aim is to provide a safety net against poverty and sometimes to provide work incentives at the same time, such as the Working tax credit programme in the UK (and the Earned Income Tax Credit in the US). • Suppose an individual receives a means-tested transfer. When earnings increase, some of the transfer will be taken away. This is equivalent to an additional tax on these earnings on top of any regular income tax they pay. • The UK (as well as the US) system leads to a non-convex budget set.
Allowing for welfare benefits The interaction of taxes and benefits in the UK £300.00 £250.00 £200.00 Working Tax Credit Income Support £150.00 Net earnings Other income £100.00 £50.00 £0.00 0 4 8 12 16 20 24 28 32 36 40 44 48 weekly hours of work
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