Elasticity of Taxable Income: Evidence from Changes in Municipal Income Tax Rates in Finland

• Date: 01 July 2018
• DOI: http://doi.org/10.1111/sjoe.12236
• Published date: 01 July 2018

©The editors of The Scandinavian Journal of Economics 2017.

Scand. J. of Economics 120(3), 943–973, 2018

DOI: 10.1111/sjoe.12236

Elasticity of Taxable Income: Evidence from

Changes in Municipal Income Tax Rates in

Finland*

Tuomas Matikka

VATT Institute for Economic Research, FI-00101 Helsinki, Finland

tuomas.matikka@vatt.fi

Abstract

The elasticity of taxable income (ETI) is a key parameter in income tax analysis, in

terms of both efficiency and tax revenue. In this paper, I use Finnish data to analyze

the ETI. I use changes in flat municipal income tax rates as an instrument for overall

changes in marginal tax rates. This instrument is not a function of individual income,

and thus the ETI estimates are less susceptible to bias caused by differential trends

across the income distribution. In general, instruments used in previous studies do not

have this feature. My preferred estimate for the average ETI is 0.21.

Keywords: Behavioral response; income taxation; labor supply

JEL classification:H21; H24; J22

I. Introduction

The elasticity of taxable income (ETI) with respect to the net-of-tax rate

(one minus the marginal income tax rate) is a key tax policy parameter

and an important element in the efficiency analysis of income taxation.

The practical significance of the ETI is straightforward. It measures how a

1 percent change in the net-of-tax rate affects taxable income. Intuitively,

the more elastic taxable income is, the larger the behavioral response to

a tax reform will be, in terms of a change in the tax base. Therefore,

good knowledge of the ETI is essential when deciding on national tax

reforms.

Furthermore, the ETI measures the overall marginal excess burden of

income taxation, including various behavioral margins in which individuals

can respond to income taxes (Feldstein, 1995, 1999; Saez et al., 2012).

*I thank Jarkko Harju, Markus J ¨antti, Tuomas Kosonen, Claus Kreiner, Teemu Lyytik¨ainen,

Jukka Pirttil¨a, Marja Riihel ¨a, Friedrich Schneider, H˚akan Selin, Jeffrey Smith, Roope Uusitalo,

Trine Vattø, and the referees for their useful comments and suggestions. Funding from the

Academy of Finland, the Finnish Cultural Foundation, the Nordic Tax Research Council,

the Emil Aaltonen Foundation, and the OP-Pohjola Group Research Foundation is gratefully

acknowledged.

944 Elasticity of taxable income

In addition to labor-supply responses, the ETI covers other decisions in

response to income taxation, such as effort and productivity, deduction

behavior, tax evasion, and tax avoidance. All behavioral responses reflect

the inefficiency of the income tax, and thus different behavioral margins

are all important when considering the overall efficiency of the income

tax system.

In this paper, I study the ETI using Finnish register data for 1995–

2007. I use changes in flat municipal income tax rates as an instrument

for the changes in overall net-of-tax rates. This instrument is not based

on individual income, and thus the instrumental variable estimates are

less susceptible to bias caused by differential income trends across

the income distribution. In contrast, previously published ETI studies

typically use instruments that are a function of taxable income. The

recent body of literature highlights that these so-called predicted net-of-

tax rate instruments are not necessarily exogenous (Blomquist and Selin,

2010; Weber, 2014; Burns and Ziliak, 2016). In this paper, I propose an

alternative strategy of utilizing institutional features of the tax system to

derive an instrument for individual tax rate changes. To my knowledge,

this paper is the first to use this type of approach to identify the ETI.

In general, variation in tax rates and the endogeneity of the net-of-tax

rate variable are the main issues to focus on when estimating the ETI using

panel data. Identification of the ETI requires variation in tax rates that is

different for individuals with otherwise similar income trends. In addition,

due to the progressive income tax rate schedule, a valid instrument for

the net-of-tax rate is necessary to derive a consistent elasticity estimator.

In this study, I use variation in municipal-level income tax rates for both

purposes.

Finnish municipal income taxation has appealing features from the point

of view of empirical analysis. First, the municipal income tax rate is flat,

which means that it is independent of individual income level. This is the

basis for using changes in municipal tax rates as an instrument for changes

in individual net-of-tax rates. Second, differential tax rate variation caused

by municipal tax rate changes covers the entire income distribution. This

improves identification of the average ETI while avoiding some of the

typical difficulties in the earlier studies, such as non-tax-related changes

in the shape of the income distribution and the mean reversion of income.

Third, there is limited tax rate variation available for individuals at different

income levels in Finland. This indicates that changes in municipal tax

rates provide the main source of identifying variation to estimate the ETI

in Finland.

However, although municipal tax rate changes do not depend on

individual income, changes in municipal income tax rates are not randomly

assigned to individuals. Municipalities might change their tax rates based

©The editors of The Scandinavian Journal of Economics 2017.