New Research- The Wage Response to a Reduction in Income Tax Rates: The 2003–09 Tax Reform in Israel
- In 2003–09, reform in Israel reduced the marginal income tax rate on individuals by 7–17 percentage points.
- The marginal income tax reduced by different extent along the wage distribution, therefore making it possible to estimate the tax reform effect on wages, by comparing the change in wages reported by individuals who benefited from a marked reduction in marginal tax rate to the change in wages of similar individuals who benefited from a smaller reduction.
- The research indicates that in response to an increase in the net-of-tax rate (one minus the effective marginal direct tax rate) by 10 percent, the individual’s wages will increase by approximately 1 percent (elasticity of about 0.1). This finding is within the range of estimates worldwide.
- Based on the estimate, it is possible to conclude that the tax reform increased total gross wage payments in the business sector by 1.1 percent.
- The three lowest wage quintiles showed no response to the reduction in tax rates, but the response increased with wage, reaching elasticity of 0.4 in the upper decile. Public sector employees did not react to the reform.
In 2003–09, the marginal tax rate for individuals was reduced by 7–17 percentage points. This was one of the most major economic reforms carried out in recent decades. Supporters of reduction in tax rates claim that it will increase labor supply, provide an incentive for economic growth, and possibly even yield additional tax revenues. Those who oppose it claim that high tax rates do not adversely impact labor supply to a significant extent, and are a necessity for a society that wants broad government expenditures and a reduction in economic inequality.
The research literature indicates that a reduction of marginal tax on labor income is likely to lead to several behavioral reactions from individuals—including joining the labor force, increasing the number of work hours, increasing labor productivity, reducing tax maneuvers and tax evasion. These reactions are ultimately reflected in an increase in gross reported income from labor, and thus the empirical literature examines how direct tax rates impact on reported income from work.
Research conducted at the Bank of Israel by Sophia Igdalov, Roni Frish and Noam Zussman estimated the impact of the reduction of direct marginal tax rates (income tax, national insurance payments, and health tax) on gross wages reported to the Israel Tax Authority. The research focused on the years 1998–2010, employees in the prime working ages, and the business sector.
The research relied on a rich database. It includes the individuals sampled in the Labor Force Surveys conducted by Israel’s Central Bureau of Statistics between 2001 and 2010, and those individuals’ demographic/socioeconomic characteristics. These individuals make up a representative sample of working age residents. Each individual was matched against employee files of the Israel Tax Authority that include gross wage and obligatory payments, which make it possible to independently calculate the direct tax obligation. In all, the research population contained approximately 100,000 individuals who worked as employees in at least one of the research years.
As the marginal direct tax was not reduced by the same rate among all tax brackets (see figure) within the framework of the reform, it is possible to estimate the impact of the reform by comparing the change in wages reported by individuals who benefited from a marked reduction in marginal tax to the change in wages of similar individuals who benefited from a smaller reduction.
As accepted in the literature, the real change in gross reported wages (for all pairs of years separated by 3 years) was estimated as a function of the change in marginal direct tax rates, the demographic/socioeconomic characteristic of the individuals, their wages, and more.
The research findings indicate that in the business sector, the gross reported wage elasticity in regard to the net-of-tax rate (one minus the effective marginal direct tax rate) is approximately 0.1, meaning that when the net of tax rate increases by 10 percent, the wage increases by about 1 percent. This value is within the range of elasticities found by similar research in Western countries. Between 2002 and 2009, the net of tax rate increased by approximately 13 percent; based on the elasticity estimated, it may be concluded that the gross reported wage in the business sector increased by 1.1 percent (assuming that the capital stock adjusted itself to the increase in labor supply). The reported gross wage of the lowest three wage quintiles did not respond at all to the reduction in tax rates, but the elasticity increased with the wage, reaching 0.4 in the upper decile. No statistically significant differences were found in the elasticity between men and women, Jews and Arabs, and those with high education and those with low level of education. It was also found that employees in the public sector did not respond to the reform, probably because the limited employment elasticity in the public sector (compared with the business sector) reduces the ability of employees in the sector to react to tax reductions, for example by increasing overtime hours.
Marginal income tax ratesa, 2002 and 2010 (percent)
SOURCE: Based on Israel Tax Authority and Central Bureau of Statistics.
a The effective marginal income tax rates imposed on income subject to regular tax rates. The figure refers to employees who held one post, worked the entire year, did not live in localities where a tax benefit is granted, and did not receive a tax credit for shift work.Each point in the figure represents one or more employees.