Behavioral Responses to Payroll and Income Taxes in the UK

36 Pages Posted: 19 Nov 2015  

Alisa Tazhitdinova

McMaster University, Department of Economics

Date Written: November 12, 2015

Abstract

I study behavioral responses to changes in marginal tax rates of social security and income taxes. I find that responses depend on individual’s employment status: whether a worker is a wage earner, self-employed, or a proprietor. In line with the existing literature I document weak (but statistically significant) bunching at kink points of the tax schedule among wage earners. Starting from 1999, wage earners accumulate pension credits when they exceed a certain threshold, however, no contributions are due until earnings reach a second, higher threshold. Even 10 years after this reform I find no bunching to the right of the eligibility threshold, suggesting that individuals do not assign a high value to pension benefits. Lack of bunching is persistent across age groups and unlikely to be explained by friction costs as individuals are able to bunch at other kink points. I find strong responses to tax incentives among the self-employed but the responses differ by the type of kink. I find sharp bunching at the first kink, medium bunching at the top kink and weak bunching at the middle kink. Comparing responses before and after a tax reform that changed the magnitude of kinks I find that self-employed individuals aggressively reduce earnings to bunch at the lower, more salient kink points. Finally, I document large income shifting by proprietors: many firm owners report most of income as dividends thus avoiding social security taxes. Nevertheless many proprietors choose to pay themselves sub-optimally high wages thus incurring an unnecessarily high tax liability. I show that some of these proprietors pay multiples of £5,000 or £6,000.

Keywords: Payroll Tax, Income Tax, Earnings Elasticity, Income Shifting

JEL Classification: H20, H24, H31, J21, J26

Suggested Citation

Tazhitdinova, Alisa, Behavioral Responses to Payroll and Income Taxes in the UK (November 12, 2015). Available at SSRN: https://ssrn.com/abstract=2689879 or http://dx.doi.org/10.2139/ssrn.2689879

Alisa Tazhitdinova (Contact Author)

McMaster University, Department of Economics ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

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