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Milligan and Smart: Provincial Taxation of High Incomes Page 1 of 22

Provincial Taxation of High Incomes: What are the Impacts on


Equity and Tax Revenue?

Kevin Milligan
Vancouver School of Economics
University of British Columbia


Michael Smart
Department of Economics
University of Toronto


IRPP-CLSRN Conference Inequality in Canada
Ottawa: February, 2014

Comments welcome

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Should redistribution happen centrally or locally?


Traditional public finance / fiscal federalism advice:

(E.g. Oates CJE 1968; Musgrave 1971)

With mobile factors, horizontal tax competition limits ability of local
governments to redistribute.

Less mobility of factors out of whole country, so central redistribution more
efficient.

But: Recent Canadian experience shows 4 (or 5) provinces increasing top
rates; not federal government. No sign any federal party is going to.



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Recent Canadian experience: Provinces take the lead

Notes: Shown are the highest personal marginal tax rate by province in 2014. The five provinces
with recent increases in their top rates are shown, with the year of the increase indicated to the right
of the bar.

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Our question:

What are the implications of provincial taxation of higher incomes?

Implications for equity

Implications for tax revenues


Plan for talk:

Estimates of responsiveness of taxable income to provincial tax rates

Simulations of a counterfactual: each province adds a high-income tax
bracket
o Present impact on equity, revenues.


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Provincial income taxation in Canada:

Under the Constitution Act, Section 91 / 92 allocate power for direct taxation to
both federal and provincial levels. Base is co-occupied.


Tax Collection Agreements:

Since 1962, in all provinces except Quebec.

Agreeing provinces must use federal tax base.

Since 2000/2001, provinces free to set own brackets and rates.



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Figure 1: Provincial Top Tax Rates, 2000 to 2014

Notes: Shown are the highest personal marginal tax rate by province by year from 2000 to 2014.
The source is the Canadian Tax and Credit Simulator.

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What impact do taxes have on reported income?

See recent survey by Saez, Slemrod, and Giertz (2012 J. Economic Literature)

1980s focus: real responses

Adjustment of labour supply, consumption / savings / investment,
residency.

Q: Do hyper-competitive top lawyers and hedge fund workers really cut
hours worked in response to taxes?

More recent focus: Shifting / avoidance

Look at reported income, not hours etc.

Responses: timing, accounting, form
o Assisted by expensive advice, specialized financial structures.


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Figure 2: Provincial Top Income Shares vs. Top Tax Rates, 1988 to 2011

Notes: The graph plots the top one percent income share against the top combined federal-provincial marginal tax
rate by province for the years 1998-2011. The income shares use total incomes (excluding capital gains). The
source is CANSIM table 204-0002. The tax rates are from the Canadian Tax and Credit Simulator.

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Estimation: How do taxes affect reported income of top 1%?

Use CANSIM high income database 204-0002 to estimate:

Share of income going to the top 1%


Top tax rate in province p in year t.


Total income in province p in year t.


Provincial fixed effects.


Year fixed effects.



Object of interest: Elasticity of taxable income


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Table 1: Regression Results


(2) (3) (4)
Sample P99 P95-P99 P99.9
Observations 240 240 190
R-squared 0.970 0.926 0.952

Tax elasticity 0.664** -0.004 1.414*

[0.270] [0.111] [0.615]
Log Income 0.633*** 0.0986** 0.843***
[0.0785] [0.0336] [0.183]

Notes: Reported are coefficients from regressions of the log share of top percentile income on the net
of tax rate and controls on provincial level data from 1988 to 2011. Each column contains the results
of a different regression. All specifications include year and province fixed effects. The income
fractile used for each column is listed in the sample row. Other details can be found in the main
text.

(See Milligan and Smart 2014 for more)

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How to interpret the elasticity:

The elasticity of 0.664 means that a 10% decrease in (

) leads to a 6.64%
decrease in the top 1% income share.


How does this compare to literature?

Milligan and Smart (2014) use same data; find similar robust result.
Department of Finance (2010) finds e=0.62 with similar approach.
SSG (2012) conclude that 0.25 is middle of range of estimates for US.

Why different from SSG (2012)?

Existing evidence may be confounded by time series trends.
e is a function of particular tax base. CanadaUS
Using provincial variation, some income may leak horizontally to other
provinces, so parameter may be different federally/provincially.


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A Counterfactual: Each province introduces top tax bracket


Consider the following exercise:

Take the tax system in 2011.

Institute a top tax bracket in every province at that provinces 1% threshold.

Rate for new bracket is +5% over the current top rate.




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Table 2: Simulated Base and Counterfactual Tax Systems


Base System

+5 System

Bracket

Bracket


Threshold Rate

Threshold Rate
NL $ 63,807 13.3%

$ 168,904 18.3%
PE $ 98,145 18.4%

$ 139,722 23.4%
NS $ 150,000 21.0%

$ 154,588 26.0%
NB $ 120,796 14.3%

$ 147,010 19.3%
QC $ 78,120 24.0%

$ 169,649 29.0%
ON $ 78,361 17.4%

$ 215,316 22.4%
MB $ 67,000 17.4%

$ 161,098 22.4%
SK $ 116,911 15.0%

$ 180,240 20.0%
AB $ - 10.0%

$ 281,096 15.0%
BC $ 100,787 14.7%

$ 190,151 19.7%
Fed $ 128,800 29.0%

$ 128,800 29.0%
Fed-QC $ 128,800 24.2% $ 128,800 24.2%

Notes: shown are the bracket threshold for the base and +5 tax systems used in our simulations. The base
system is from 2011. The federal rate at the bottom of the table is different for Quebec because of the 16.5%
provincial abatement.



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Measuring impact of +5 system on equity

How to measure equity?

Looking at 90-10 ratios for top 1% not useful.
Gini coefficient isnt going to pick up much for a change at top 1%

Our alterative:
Use the Average Tax Rate:






Change in ATR tells us the change in proportion of income individuals have
available to consume.





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Figure 3: Average Provincial Tax Rates under Existing and Counterfactual
Tax Policies

Notes: Plotted are the average tax rates for Quebec, New Brunswick, and Alberta under the 2011 tax system and
under a new tax system featuring a high tax bracket with a rate 5 percent higher. The x-axis indicates the level of
earned income and the y-axis the average tax rate. The tax rates are calculated using the Canadian Tax and Credit
Simulator.

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Results of +5 system on equity

Three ways to view results:

Has no impact for those up to top 1% threshold. Varies by province.

Impact for those over threshold rises slowly

At average income level for top 1%, only a 2.3% change in ATR. (Alberta)

Implication:

Top 1% share in AB has about doubled. Taking back 2.3% isnt much.


To undo changes in inequality would require much larger tax changes.



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Measuring impact of +5% system on provincial revenue

Decompose into two conceptual chunks:

Net Revenue = Mechanical effect - Behavioural effect

Mechanical effect:
How much does revenue go up by applying new rates to existing taxable
income?
Assumes no behavioural response.
In +5% system, varies by province because of strong differences in
provincial income distributions.

Behavioural effect:
Using elasticity of 0.664, how much taxable income vanishes?
Varies by province because of size of existing top tax rate; differing income
distributions.


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Figure 4: Per Tax Filer Mechanical Effect and Net Revenue

Notes: Plotted are the mechanical effect and net revenue per-tax filer of a new five percent tax bracket on incomes
over the top one percent threshold in each province.

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Table 3: Explaining Differences in Revenue Across Provinces


PE AB
Average income of top 1% 203,948 648,475
Threshold to be in top 1% 139,722 281,096
Ratio (inverted Pareto) 1.46 2.31
Mechanical revenue per capita 32 184
Provincial revenue max'ing tax rate 22.8% 32.7%
Actual 2011 top tax rate 18.4% 10.0%
How much of mechanical effect remains 6% 71%


Two drivers of vast PEI-Alberta difference:
Income distribution in AB much more skewed. More income above 1%
threshold.
PEIs 2011 tax rate already near the revenue-maximizing level. Not AB.


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Other impact: Federal tax revenues shrink

Because of co-occupied tax base, there is vertical fiscal externality:
If reported income goes down in response to provincial tax rate, federal
taxable income also affected.
Apply federal tax rates to tax base shrinkage to gauge size of vertical
externality.

Not accounted for here:
Other tax bases could be positively affected.
o Corporate revenues might go up.
o Other province revenues could go up.


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Table 4: Assessing the Vertical Fiscal Externality


NL PE NS NB QC ON MB SK AB BC
Mechanical revenue 24 4 43 30 490 1288 64 64 506 370
Behavioural revenue -12 -3 -34 -17 -379 -651 -38 -32 -146 -162
Net provincial revenue 12 0 9 14 111 637 26 32 360 209
Change in federal
revenue -20 -4 -38 -25 -317 -842 -49 -46 -282 -238
Gains in other tax bases +? +? +? +? +? +? +? +? +? +?

Notes: Reported are results for each province of the simulated revenue impact of a new tax bracket starting at each provinces top one percent income threshold
with a tax rate 5 percent higher than the existing top rate. The simulations are based on 2011 data.


Change in federal revenue is potentially very large
Feds dont get any mechanical effect since they didnt raise rates.
Federal top tax rate is 29%, so loss of taxable income hurts feds more





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Summary

Four main findings:

Provincial taxable income elasticity is high.

Equity: +5% system wouldnt do much to reverse top 1% income surge.

Revenue: Vast provincial differences in revenue potential of new top 1%
bracket.

Negative impact on federal revenues as large as provincial revenue gains.

In future work:

Try to sort out magnitudes of tax avoidance vs. horizontal shifting
Calculate optimal rates that fully account for all vertical and horizontal
externalities.