More progressive taxation may increase economic welfare in New Zealand

This week in my ECONS102 class, we've been covering poverty and inequality, as well as redistribution and the economics of social security. It's a lot to cover, but one of the key points is that economics can't directly answer the question of how much redistribution (from rich to poor) is the right amount of redistribution, because that depends on the normative preferences of society (or the normative preferences of the government of the day, if you prefer).

So, I was interested to read this article in The Conversation last month, by Nicolaus Herault (University of Melbourne), John Creedy, and Norman Gemmell (both Victoria University of Wellington). The article discusses how tax rates can be used to increase total welfare in New Zealand:

If we asked people in New Zealand what they think the best income tax reform would be, we would expect a range of responses. People will no doubt have different views about which of the four income tax rates and corresponding income thresholds should be lowered or increased.

In our new study, we examine how tax rates should be changed to improve social welfare in New Zealand.

At 33%, the current highest marginal income tax rate in New Zealand is relatively low compared to other major advanced economies. For instance, it’s 45% in both the UK and Australia.

We find that, under a range of assumptions, lifting the highest income tax rate and using the proceeds to lower one of the two lowest tax rates achieves the greatest improvement to welfare.

The underlying research is available here, published in the journal International Tax and Public Finance (sorry, I don't see an ungated version online). Herault et al. used microsimulation, which involves taking a population at some point in time, making some changes (in this case, changes to the tax system), and simulating how the population would respond (in this case, in terms of their welfare). Microsimulation is a very cool method for investigating how the population will respond, especially if you can account for the fact that not everyone will respond in the same way (one of my PhD students is using microsimulation to look at small-area ethnic population projections for Auckland city).

Herault measure 'social welfare' as a combination of household income and leisure time (I prefer to avoid using the term 'social welfare', since it can easily be confused with social security by the uninitiated, and prefer 'economic welfare' instead). In the sort of model that Herault et al. run, if tax rates go up, people will earn less disposable income, but will work less and therefore have more leisure time. And the reverse occurs if tax rates go down. So, it is ambiguous whether their measure of welfare goes up or down when taxes change. They find that:

...the tax reform that would increase social welfare the most consists of a reduction in one of the two lowest tax rates, funded by an increase in the highest tax rate. Such a reform would lead to more rate progression in the tax system, come at no revenue loss to the government, and increase social welfare. This conclusion applies whether one gives a high or low priority to reduction in inequality.

Many people would argue that we need a tax system that is more progressive, in order to reduce income inequality. If these results are to be believed, then it seems that having a more progressive income tax system would increase economic welfare as well.