Governments often fail to account for the behavioural effects spurred by its personal income tax rate hikes
The Alberta government recently abandoned the province’s single 10 per cent tax rate on personal income in favour of a five-bracket system with a top rate of 15 per cent – a move that will reduce Alberta’s competitiveness and cause undue harm on an already struggling economy.
While increasing tax rates on upper-income earners might seem like an easy way to bring in more revenue, the government will receive much less than expected if it fails to recognize that increasing tax rates causes people to alter their behaviour.
There is broad agreement in economic literature that increasing tax rates – particularly on upper income earners – leads people to change their behaviour in ways that mitigate the impact of the tax increases. This can come in many forms: taking more leisure time, accepting more compensation as tax-favourable fringe benefits, incorporating as a business to take advantage of lower tax rates, and shifting income to, or perhaps even moving to, a lower tax jurisdiction.
Upper-income earners, in particular, are better positioned to take advantage of a variety of tax-saving mechanisms already available in the tax code. This is why a 2010 federal Department of Finance study found that tax filers in the top 1 per cent reduced their reported incomes by 0.72 per cent for every 1 per cent increase in income taxes.
For a prominent real-life example of tax rate hikes failing to generate the expected amount of additional revenue, consider the United Kingdom experience. In 2010, the government increased the top marginal income tax rate to 50 per cent, but later found that while the rate increase was initially projected to bring in £2.5 billion, it actually raised less than £1 billion, prompting the government to reduce the rate.
It’s critical to understand that tax revenue depends on two components: the base, which is the income derived from the activity being taxed, and the rate. Multiplying the two together gives us the “tax take” or the revenue the government receives from a specific tax.
Unfortunately, pundits and politicians often fail to realize that the base and the rate aren’t entirely independent of each other. Tax rate increases change people’s behaviour, which can reduce the tax base. Multiplying a lower tax base by a higher tax rate won’t necessarily lead to an overall increase in revenue – or it could generate less additional revenue than expected.
A recent Fraser Institute study estimates how much revenue the Alberta government can reasonably expect from its tax rate hikes. The study compares two forecasting models: one that accounts for behavioural changes and one that does not – the method most often employed by governments.
In the latter model – where it’s assumed taxes from revenues will increase in exact proportion to tax rate increases – the Alberta government might expect an additional $6.7 billion from 2016 to 2020. But when behavioural responses are appropriately accounted for, the government will likely take in $5 billion in new revenue – a difference of $1.7 billion over the period. By 2025, the cumulative gap between the two models is estimated to grow to $5.1 billion.
Put simply, if government fail to account for the behavioural effects spurred by its personal income tax rate hikes, they could be in for larger deficits and more debt than already planned.
By Steve Lafleur & Charles Lammam
Steve Lafleur is a senior policy analyst and Charles Lammam is the director of fiscal studies at the Fraser Institute. The study, Alberta’s Personal Income Tax Increases Likely to Yield Less Revenue than Expected, is available at www.fraserinstitute.org.