The Elasticity of Taxable Income: The Case of South Africa

Abstract

A key tax policy parameter that has received much attention in the international literature, but about which there is substantial uncertainty, is the overall elasticity of taxable income. The size of this parameter is central to the formulation of tax and transfer policy, as well as for the study of the welfare implications of tax decisions. This paper uses a panel of individual tax returns for the period 2009–2013 and the phenomenon of “bracket creep” to construct instrumental variable estimates of the sensitivity of income to changes in tax rates. Estimates suggest that the overall elasticity of taxable income is approximately 0.3, while that of broad income is significantly lower. The overall response is primarily driven by the elastic response of taxable income for high‐income earners, who have an elasticity of closer to 0.4. Using the elasticity estimates within an optimal tax framework, it is determined that the optimal marginal tax rate for the top 10% of income earners is broadly in line with the current income tax schedule. However, results also suggest that there is little scope for raising marginal rates on high‐income earners further without inducing a negative revenue response.

Empirical estimates of fiscal multipliers for South Africa

“…Having said that, the estimates in this paper, combined with insights from Kemp (2019Kemp ( , 2020 regarding the individual behavioural response to changing tax rates, suggest that should South African authorities need to embark on a fiscal consolidation drive, policies should be designed in favour of cutting government consumption expenditure as opposed to raising taxes. Unfortunately, this is the exact opposite approach to that followed by the South African government over recent years, with significant personal tax increases bearing the brunt of the responsibility for fiscal consolidation.…”

“…Similarly, the relatively large (negative) tax multipliers might be related to both behavioural and institutional factors. Behavioural factors relate to individual behavioural responses to changing tax rates (see Kemp (2019Kemp ( , 2020 for a discussion on results for South Africa), while institutional factors could be reflective of problems in enforcement and/or collection and tax structure. The latter could include the availability of exemptions and deductions, and the opportunity for tax avoidance/evasion in the face of rising tax rates.…”

Tax research in South Africa

“…As mentioned in the introduction, a key outcome measure is the responsiveness of the personal income tax base, that is, taxable income to changes in the marginal income tax rate. As far as we know, the only study in this area using South African data is the one by Kemp (2017). He uses administrative data provided by SARS and the National Treasury and examines the elasticity of taxable income based on the idea of 'bracket creep' or 'fiscal drag'.…”

“…These findings are in line with international evidence. A caveat, raised by Kemp (2017), the author of this carefully conducted econometric paper, is that the identifying variation used for measuring tax changes would ideally have been greater.…”

The effects of personal income tax reform on employees’ taxable income in Uganda

“…Among these, Kleven and Waseem (2013) use Pakistani tax administrative data to analyse the elasticity of taxable income for wage earners and the self-employed, detecting substantial bunching at notch points. Kemp (2019) uses the bracket creep approach in the South African context, and his preferred elasticity is approximately 0.3, while Tortarolo et al (2020) examine intertemporal labour supply elasticity using Argentinian data.…”