appendix e Figure E.1 Employment and earnings elasticities at different levels of earnings 0.40
Employment elasticity Earnings elasticity Distribution of working households
0.35
Elasticities
0.30 0.25 0.20 0.15 0.10 0.05 0.00
£0
£10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000 £80,000 £90,000 £100,000 Household earnings p.a.
The following sections illustrate some of the thinking underpinning the design of an optimal tax and benefits schedule – starting with a simplified assumption of earnings-only elasticity, then looking at employment-only elasticity, and finally combining the two. (See section 10.4 for further discussion.)
E.2 Earnings-only elasticity modelling We will first analyse the social and economic effect of changing MTRs. We do so first, assuming a flat tax rate, and then allowing it to vary as earnings increase. (This model was first discussed in section 10.2 and we refer to it below as the Mirrlees model.) E.2.1 Earnings-Only Elasticity: What happens when the MTR is changed? According to the Mirrlees model, an increase in MTR over a very small band of earnings has three effects on Government tax receipts and welfare: 1. Increased taxes are paid (or lower benefits received) by every household with earnings above the small band (the mechanical effect). 2. This results in a reduction in income for every household with earnings above the small band. 3. The increased MTR will also cause some households in this band to reduce earnings, thus generating a loss in tax revenue. The impact on social welfare from an increase in MTR could be either positive or negative. It can be measured by considering the change in income for those above the affected earnings band, and the net change to tax-take, which, if positive, can pay for other general purposes or be used to raise levels of benefits.
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