3. Fifteen Lessons from Tax Analysis
3.5 Minimise ‘Kinks’ and Avoid ‘Notches’ in Tax Schedules
It is self-evidence that different taxpayers facing different tax rates for the same type of tax (for example income tax rates at different income levels), or the same taxpayer facing different tax rates across different taxes for which they are liable, have incentives to shift tax burdens wherever
possible towards the lower-taxed regimes. However, since equity objectives often motivate some rate progression in tax schedules, preventing ‘income shifting’ becomes potentially important.
Such income shifting is more likely (and more rewarding to the taxpayer) where there are large, discrete changes in marginal tax rates, MTRs (‘kinks’), and especially where there are large discrete changes in average tax rates, ATRs, (‘notches’) in the tax schedule.
Wherever possible, those kinks and notches should be avoided or minimised. ‘Tax kinks’ refer to kinks (slope changes) in the taxpayer’s budget constraint due to changes in the MTR that they face, while ‘tax notches’ refer to tax-induced discontinuities in the budget constraint. Personal income taxes commonly give rise to kinks due to a set of (usually increasing) MTRs as incomes rise across various tax thresholds or brackets. Decreasing MTRs are also common where the income tax and transfer systems interact, mainly at lower income levels.
Notches are more often found in welfare benefit system, corporate income taxes or property transaction taxes where, for example, if the property sale price exceeds $100,000 the property tax rate rises from 1% to 2% on the total sale price, not the increment above $100,000. As a result, the tax rate is 2% ($200) for a property that sells for $100,001 but 1% ($100) for a sale price of
$100,000. A characteristic of a notch, therefore, is that the increase in price which (as usual) makes the taxpayer better-off before tax, makes him or her worse-off after-tax. A tax kink, on the other hand, merely results in a smaller fraction of any increment in before-tax income being retained after-tax.
Tax notches sometimes also occur with indirect taxes such as GST or VAT, where ‘small business’ thresholds are commonplace – that is, where businesses only become required to register for GST above a threshold level of firm sales or turnover. In New Zealand this is set at $60,000.
As a result, as a firm’s annual turnover rises from just below, to just above, $60,000, a new GST liability at 15% of their value added will result even though their value added, or gross profit, may have remained unchanged.
Example 1:
An example of a ‘kink’ in an income tax schedule is given in Figure 6. This shows marginal and average tax rates of the NZ personal income tax in 2020. As with most multi-step income taxes marginal rates rise discretely at various income levels (in this case $14,000, $48,000 and $70,000) and with MTRs rising from the lowest rate of 10.5% to a top rate of 33%. These MTRs are charged on income earned above each threshold, As a result, the associated average tax rate increases regularly with no such discontinuities. Rather the ATR begins to rise somewhat more steeply when income increases above each MTR threshold. It is the discrete MTR ‘jumps’ that give rise to ‘tax kink bunching’ described below.
Figure 6 The NZ Income Tax Schedule
Example 2:
The UK’s Stamp Duty Land Tax is levied on the transactions value of residential property when it changes ownership (as recorded by the UK’s Land Registry), at various percentage rates of the sale price, depending on value, with the percentages rising across several ‘price bands’. Until December 2014, these percentage rates were charged on the full sale price, not on the price above each threshold in the schedule.37
The stamp duty schedule for 2012-13 is shown in Figure 7, where it can be seen that the absolute amount (in £s) jumps at each tax rate threshold as the tax liability increases in five steps from 0%
below £125,000 to 7% over £2 million. These jumps imply that the after-tax receipts are lower for a house sold, for example, for £250,001 compared to one sold for £250,000 due to the tripling of the tax payment from £2,500 to £7,500.
37 This ‘notch’ condition was removed in 2014 such that, thereafter higher rates of tax were payable on the amount of the property value received in excess of each threshold. This represents one of very few changes in recent UK tax policy that unambiguously replaced a less efficient, with a more efficient, tax structure.
Figure 7 The UK Stamp Duty Schedule
Source: Best and Kleven (2018, p. 166)
The expected effects of such tax kinks and notches on behaviour are illustrated in Figures 8A and 8B respectively. These show the distribution of earnings before tax (in black, dashed), and the equivalent distributions (in blue) after a tax kink has been imposed in the form of a higher MTR above an income threshold, z*, in 8A, or above a tax notch in 8B.
Figure 8A shows that the tax kink encourages taxpayers above z* to shift to the left, with the result that some taxpayers bunch up against the threshold z* from above. Those previously in the region z*+z, now bunch instead at z*, while some of those previously above z*+z also move down (reduce their incomes) to replace some of those that are bunching at z*. Of course, in practice such bunching is never so precise and taxpayer ‘spikes’ in the income distribution are usually observed around the tax thresholds.38
Figure 8B shows that the notch case is somewhat different. The key difference is that no-one is expected to locate in the segment just above the threshold (labelled ‘density hole’) – the income levels where they would be worse-off after tax – and instead bunch just below. As with kinks, various ‘frictions’ that limit taxpayer movement may lead to some taxpayers observed in the
38 For evidence on income tax kink bunching, see Alinaghi et al. (2019, 2020) for New Zealand, Chetty et al. (2013) for the US and Chetty et al. (2011) for Denmark.
‘density hole’ but this segment could be expected to have more ‘missing mass’ compared to a tax kink case (with correspondingly more individuals below the threshold). Kleven and Waseem (2013) provide examples of this for income tax paid by the self-employed in Pakistan.
Figure 8 Impact of Tax Kinks & Notches on Earnings Distribution
8A – Tax Kink 8B – Tax Notch
Source: 8A: Kleven (2016, p.439); 8B: Kleven and Waseem (2013, p.675)
3.6 Avoid Taxing Income Differently when Earned Through Different Legal Forms