This week, my ECONS102 class covered inequality, and social security. Which is timely, because I have been meaning to blog about this Treasury Analytical Note from 2024, by Tod Wright and Hien Nguyen, for some time. Wright and Nguyen look at the distributional impact of taxes, transfers, and government spending (on healthcare and education).
Importantly, they distinguish between three conceptions of household income: (1) market income, which includes taxable income (including wages, income from self-employment and from investments) and non-taxable income (such as gifts and inheritances) [*]; (2) disposable income, which adjusts market income by subtracting direct taxes (such as income tax) and adding in transfers from government (such as income support payments); and (3) final income, which adjusts disposable income by subtracting indirect taxes (such as GST and excise taxes), and adding estimates of the government spending on health and education services that the household receives in kind. Looking at the difference in the income distribution (and measures on inequality) between market income, disposable income, and final income, gives a sense of how redistributive the tax and transfer system is.
I'm not going to get deep into the weeds on the methods. However, it is worth noting that the analysis is for the 2018/19 tax year, and makes use of Treasury's TAWA (Tax and Welfare Analysis) model, supplemented by data on indirect taxes paid by households from the Household Expenditure Survey (HES) The TAWA model is constructed from administrative data from Stats NZ's Integrated Data Infrastructure. For health and education spending:
We estimate education spending received by children and students based on their reported enrolment in educational institutions in HES. Health spending amounts are distributed over all individuals in HES in proportions determined by the Ministry of Health’s (MoH) Person-Based Funding Formula (PBFF) model... which assigns expected healthcare costs to a person based on their demographic characteristics.
The resulting income distributions are summarised in Figure 2 in the note, which shows the average income (under each of the three conceptions of income) for each income decile:
Notice that, for households in the bottom deciles, market income is low, disposable income is higher, and final income is highest. This reflects that they receive net transfers from the government (they receive more in transfers than they pay in direct taxes), so that disposable income is higher than market income. They also receive more in in-kind government spending (on health and education) than they pay in indirect taxes, so that final income is higher than disposable income. For high-income households, the pattern for market vs. disposable income is reversed (they pay more in direct taxes than they receive in transfers). However, only for the very top decile (the highest income households) does the payment of indirect taxes exceed the benefits received from in-kind transfers, so that final income is less than disposable income.
Overall, the distributions in Figure 2 show that taxes and transfers reduce inequality - there is less inequality in disposable income than market income, and less inequality in final income than disposable income. The effects of the different components of the tax and transfer system in reducing inequality is demonstrated in Figure 9 in the paper:
The coloured parts of the columns show the components that add to income (transfers, or income support, in orange; and in-kind benefits, in blue) and subtract from income (direct taxes, in grey; and indirect taxes, in yellow). The black point estimates in the centre of each column show the combined effect on income within that income decile. Income support declines by income decile, as you would expect, while in-kind benefits are fairly consistent. Direct and indirect taxes both grow with income. Overall, the bottom five quintiles (making up half of all households) receive more in transfers and in-kind benefits than they pay in taxes, while the top four quintiles (and especially the top quintile) pay more in taxes than they receive in transfers and in-kind benefits.
Finally, Wright and Nugyen show the effect on inequality, measured by the Gini Index, where:
...including income support benefits in the calculation results in the lowering of the Gini coefficient from its value of 45.6 ± 1.5 for market incomes to 35.8 ± 1.6 for gross incomes. The inclusion of direct taxes to form disposable incomes further reduces the Gini coefficient to 33.1 ± 1.5. The equalising effects of these contributions are partially offset by the inclusion of indirect taxes, which lead to a post-tax income Gini coefficient of 34.9 ± 1.6 – ie, whereas direct taxes reduce income inequality as quantified by the Gini coefficient, indirect taxes increase it. However, the inclusion of in-kind benefits in the final household income calculation has a significant redistributive impact, resulting in a drop in the Gini coefficient to 28.1 ± 1.4.
As you would expect given the data from the figures, the tax and transfer system substantially reduces measured inequality. That is exactly what it is expected to do, in a country with progressive income tax, a social safety net, and universal access to healthcare and education. There is far more detail in the analytical note, so if you are interested in how taxes and transfers affect the income distribution (or how they affect the distribution for retired and non-retired households separately), I encourage you to dig into it further.
[HT: Inside Government, and Offsetting Behaviour, both last year]
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[*] One major caveat for this analysis is that the non-taxable income excludes capital gains. It also includes imputed rent on owner-occupied dwellings, which should be included to better capture the distributional effects of home ownership.
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