The welfare economic cost of the top tax is underestimated

Type: English
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Danish and international research results show that taxpayers react more strongly toward income taxes than had previously been assumed in the government's calculation conventions. This means that the top tax has very high welfare costs and should be eliminated. Calculating with small behavioural effects is a misunderstood precautionary principle which risks preserving the existing tax system and counteracting reforms. Caution suggests no more than over-financing its elimination, not preserving the top tax.

Everything points toward the fact that a cut of the top tax will finance itself to a greater extent than previously assumed.

The self-finance ratio is not only an expression of how much of the immediate revenue loss will be recovered as a result of behavioural changes after a tax cut. Even more importantly, the self-finance ratio reflects the magnitude of the welfare economic costs of the tax to citizens — on top of what the public sector receives in revenue, it should be noted. With a self-finance ratio of 50 percent (or 0.5), it costs citizens 2 DKK for every 1 DKK received in revenue. With a self-finance ratio of 90 percent, it costs citizens 10 DKK per 1 DKK. With a self-finance ratio of over 100 percent, there are only losses for both sides.

Whether a tax has a self-finance ratio above or below 100 percent is therefore not a deciding factor. Only if the state is considered to be a monopoly, with no interest in the welfare of its citizens, should the self-finance ratio actually reach a level of about 100 percent. Even with self-finance ratios slightly below one, the welfare economic costs are high, and should be considered a red flag.

The self-finance ratio is determined by three factors: 1) the magnitude of the tax rate, 2) the width of the tax base (for the top tax, the size of the tax-free allowance), and 3) the sensitivity of the tax base, expressed from a technical standpoint by its elasticity. The higher the tax rate, the greater the tax-free allowance, and the higher the elasticity, the greater the self-finance ratio will be.

By far, the majority of public revenue comes from taxes with self-finance ratios easily under 100 percent. More than 90 percent of the tax revenue comes from relatively flat taxes: income taxes (aside from top tax), VAT, corporate taxes, and pension fund taxes. But there are some taxes and fees where one or more of those three factors have such a great influence that the self-finance ratio rises above 100 percent. There is good reason to focus on these. According to the government's own evaluations the vehicle registration tax, as well as the taxes on petrol, diesel, alcohol, and tobacco, all have self-finance ratios around 100 percent.

The question is how high the top tax's self-finance ratio is.

Calculating the effective top tax rate and the mass of top tax payers' income under the lower limit is trivial. The central question is the degree of the tax base's elasticity. How much does the top tax base change when the rate is lowered?

From a welfare economic standpoint, whether there are any secondary effects on public spending is not a decisive factor. It is thus important to examine what the elasticity means for the self-finance ratio before spilling over into expenses. I will return to the question about the expenditure side.