Wednesday, 30 March 2011

Income splitting

Canada's Conservative Party seems to be running on a version of income splitting. Consequently, Canada's economics Twitteratti (most notably @kevinmilligan, @MikePMoffatt, and @StephenFGordon) have been mulling over the proposal's merits.

We've been having similar debate in New Zealand, albeit far less prominently. Only Peter Dunne seems to like the idea. New Zealand's Finance and Expenditures Committee deemed the proposal here too costly and full of fishhooks, but worthy in principle.

Kevin Milligan pointed to some of the more important summaries of findings on income splitting: Kleven, Kreiner and Saez's Econometrica piece of 2009 (almost incomprehensible if you're not really into the chicken tracks); Kesselman's IRPP summary on income splitting and fairness; and an IMF summary on Canadian family taxation issues.

Kleven et al work through optimal taxation of a second earner given the existence of a first earner. If a family has two working parents because both parents have high earnings capacity (relative to their home production opportunities), then it might be optimal to tax the second earner relatively more heavily; if the family has two working parents because they're forced to by dire financial straits, then optimal taxation puts less tax burden on the second earner. The neat result is that for high-earning couples, the second earner's optimal tax is high but decreasing with the partner's income; for couples where the second earner's labour force entry is due to poor home production abilities rather than to strong labour market opportunities, the second earner's optimal tax is lower but increasing in the partner's income. I'm not quite sure how these could simultaneously be operationalized.

I'm not a fan of family-based taxation. I'd worked through some of the effects last year. Matt Nolan also argued against the legislation.

Folks who've already decided to be a single-earner family will get a big tax break; folks who've decided to have a two-earner family might see a tax reduction if there's a big difference in marginal tax rates between spouses but are otherwise more likely see a tax increase if the change is kept revenue neutral. Folks on the margin are more likely to choose to keep one parent out of the workforce. Single parents and single persons either see a tax increase or a reduction in services.

Frances Woolley also reminds us that single earner families are better off than two earner families with the same income. Why? The two-earner family has a pile of child care and second-earner expenses that the single-earning family doesn't have, not to mention the value of all the stuff that's done at home by the stay-at-home parent that isn't taxed. The partner who stays at home isn't paid, but neither is that parent taxed for the value of household production. A two-earner family hiring someone to do all the things that would otherwise be done by the stay-at-home parent in the single-earner family would have to pay taxes on the services provided (at least in NZ) and the domestic worker would also have to pay income taxes.
People sometimes think “the work done by parents who stay home looking after their children is valuable, therefore those people deserve a tax break.” They’re already getting an enormous tax break. They’re getting thousands of dollars worth of in-kind income – the value of the work that is being in the home – and not being taxed on it.
I could be brought around to favouring family-based taxation. But only if we value all the services performed by the stay at home parent and charge the single-earner family GST and income tax on the imputed value of excess household production (gardener, cook, maid, daycare, personal assistant...). I'm not sure Peter Dunne would follow me there.

And we shouldn't forget that we already have a form of income splitting in New Zealand: the Working for Families tax credit programme is based on family income. A two-earner couple with two young kids, each parent earning $30,000, gets a $118 weekly family tax credit; a family with one parent earning $60,000 and the other staying at home with two young kids gets the same family tax credit. Check for yourself.

I'd much prefer that tax cuts work to reduce effective marginal tax rates for all cohorts than increase them for some (second earners) while decreasing them for others (single earner families). One stylized fact is that second earners' labour supply is far more elastic than that of first earners'; it's then unlikely that increasing most second earners' marginal tax rates while decreasing them for some first earners is consistent with efficiency.

I don't think income splitting has much traction in NZ - Labour and National both haven't seemed keen. Labour recognizes that most of the benefit would go to families with a high-earning dad and a stay-at-home mom while much of their constituency of two-earning low-to-middle income families would see no benefit. But National could see a form of income splitting as a potentially cheaper replacement for Working for Families. We should fix Working for Families, but not via income-splitting.

Full disclosure: Susan and I both work. We have the same marginal tax rate. However, I'd say the same thing were Susan engaged in household production rather than other work (despite Frances's cheeky tweet)

Update: Mike Moffat makes a similar argument.

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