The elasticity of taxable income: estimates and flat-tax predictions using the Hungarian tax changes in 2005

Flat-tax schemes are being adopted by many Central and Eastern European countries as a way of boosting their economies and tax revenues. Though there are signs that some countries do manage to improve in both respects, it is hard in general to distinguish the behavioural response to tax changes from the effect of increased tax enforcement. This study addresses this gap by estimating the elasticity of taxable income in Hungary, one of the outliers in terms of not having a flat-tax scheme. The authors analyse taxpayer behaviour using a medium-scale tax reform episode in 2005, which changed marginal and average tax rates but kept enforcement constant. They employ a Tax and Financial Control Office (APEH) panel dataset for 2004-5, with roughly 215,000 taxpayers. The results suggest a relatively small but highly significant tax-price elasticity of about 0.06 for the population earning above the minimum wage (about 70 per cent of all taxpayers). This value increases to about 0.3 for the upper 20 per cent of the income distribution, with some income groups exhibiting even higher elasticities (0.45). Using these results, the authors have quantified the impact of a hypothetical flat income-tax scheme. The calculations indicate that although there is room for parallel improvement of budget revenues and after-tax income, the gains are modest (2.0 and 1.4 per cent, respectively). Moreover, such a reform entails important adverse changes in income inequality, with the burden falling mostly on lower-middle income taxpayers.