New research by Associate Professor Cagri Kumru from The Australian National University (ANU) College of Business and Economics (CBE) reveals that raising taxes on high-income earners increases government revenue more than increasing the overall progressivity of the tax system.
Cagri recently joined forces with PhD student Jiu Lian (ANU), Professor Ayşe İmrohoroğlu (University of Southern California) and Assistant Professor Arm Nakornthab (Khon Kaen University) to provide new evidence on the government revenue implications of different tax policy innovations.
More specifically, the team developed a life cycle model of the United States’ (U.S.) economy to understand what improves government revenues the most: raising the tax rate payable by the richest one per cent of the population; or, increasing the overall progressivity of the tax system—in other words, increasing taxation rates in parallel with the taxpayer’s income.
“Our model reproduces wealth and income distributions correctly, allowing us to analyse various tax reforms as realistically as possible,” Cagri says.
“A key aspect of our research is the inclusion of entrepreneurs, who are pivotal to our study. In the U.S., nearly 50 per cent of the top income earners are entrepreneurs, taking home an 18.2 per cent of the national income.”
Drawing on the accuracy of their comprehensive model, Cagri shows that increasing tax progressivity is not as effective as the proposed alternative.
“When altering overall progressivity, the tax burden on middle and upper-middle income groups increases. Accordingly, individuals in this bracket may reduce their working hours and/or savings to avoid higher taxes, moving to lower-income groups,” Cagri explains.
“When these behavioural changes occur at the individual level, the gross domestic product is adversely affected.”
In contrast, the way taxes impact high-income earners is, overall, less disruptive and more lenient on a country’s GDP.
The impact of taxes on high-income earners depends on totally different factors, such as who the rich people are, why they are rich, and the level of tax rates they are facing.
“A majority of rich individuals don’t react much to tax reforms. They keep working and saving even with tax rates being high.”
Could we say the key to the tax puzzle is to continually increase
taxes on the rich?
For Cagri, the answer to this question is more intricate than it seems at first glance.
“Previous research indicates that taxing top incomes could be a good idea to maximise revenue up to a certain level, but if the rates are too high, there is a risk of losing talent to tax havens,” he cautions.
“For example, entrepreneurs are very responsive to tax reforms and setting the tax rate at excessively high levels could prove detrimental as they may adjust their saving and labour supply decisions in response.”
As a result, due to the significant impact tax changes can have on economic behaviour, Cagri stresses governments must employ ‘delicate’ modelling to determine the optimal tax rate—one that maximises revenue whilst ensuring economic stability.
As a first of its kind, Cagri’s highly innovative research has already sparked the interest of other academics in his field and is setting the stage for substantial policy reforms worldwide.
“Proper taxation of top income is relevant to all advanced economies, and, while we calibrated our study to the U.S. economy, it can be easily adjusted to other countries, including Australia,” he says.
The research is particularly timely given the Albanese government’s recent announcement of stage three tax cuts that will see Australia’s low and middle-income earners receiving a bigger tax relief than their higher paid contemporaries.
Shifting the future tax cut from the top earners to the middle-income earners is in line with the findings of our research, meaning we can expect the decrease in tax revenues to be significantly lower with the new stage three cuts rate.
Importantly, Cagri notes that his work has implications far beyond the tax area.
“Several papers have already extended the applications of our model, as it has proven to be adaptable not only to tax analyses, but also to transfers, pensions and social insurance studies.”
Read more about Cagri’s research, published in the Review of Economic Dynamics.
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Featured expert
Associate Professor of Economics Cagri Kumru
Cagri Kumru is an Associate Professor of Economics, an Associate Investigator at the Centre of Excellence in Population Ageing Research and a Research Associate at the ANU Centre for Applied Macroeconomic Analysis. His research spans macroeconomics, public economics and behavioral economics. Cagri is mainly interested in the macroeconomic implications of various tax and social insurance programs.