rates. This is because high tax rates lead people to shift their income out of taxable form (Goolsbee, Hall and Katz,
1999: 2)
The analysis of the tax system and its effects on the economy is crucial also because the tax system does not only
alter the relative prices of real variables; but it also provides incentives to misreport income, restructure financial
claims, time transactions, and change the legal form of organization. For this reason, one may encounter low tax
elasticities due to either low elasticities of substitution or the fact that tax policy changes opportunity sets in
complex ways. Disentangling these explanations requires an emphasis on the transaction based nature of the tax
system and the administration and enforcement of tax laws. Because most taxes apply to transactions, their impact
on real variables can be adequately understood only by simultaneously considering their impact on the transaction
behavior whose terms are directly affected by the tax system (Slemrod, 1992: 250, 255).
The second reason why knowing tax elasticity is important relies on the fact that one of the policy tools for
developing countries as well as developed counties for achieving real and sustainable economic growth with price
stability and balance of payments viability is fiscal deficit reduction. In this framework, projections need to be
made of the additional revenues within the existing tax system as GDP grows. These projections indicate the need
to activate additional means of revenue generation (Ehdaie, 1990:1). In this sense, estimating income tax elasticity
becomes essential. The theory of optimal taxation requires that the path of tax rates be chosen to minimize the
deadweight burden of taxation, given an initial level of government debt and an expected future path for
government expenditures. The over-identifying restrictions suggest that the uniform tax model may be too
simplistic with regards to its treatment of business cycle conditions (Hess, 1993:712).
For further macroeconomic issues such as obtaining a substantial rate of growth for the economy will require
periodic income tax reductions unless some reforms are enacted in tax legislation that automatically introduce the
necessary adjustments. The measurement of the elasticity and the flexibility of individual income tax have more
than academic value, having relevance for decisions in the field of tax policy in particular and stabilization policy
in general.
Finally, as a third concern, income tax is considered as the most commonly discussed automatic stabilizer, which
reduces the multiplier effects of demand shocks through the marginal taxation of income fluctuations. A
progressive income tax with high marginal tax rates could substantially reduce fluctuations in after-tax income and
therefore private spending without the need for any explicit policy changes. In terms of tax elasticity, a proportional
income tax has an elasticity of 1.0 while progressive tax systems whose tax-income ratios increase with income
have an elasticity greater than 1.0. This elasticity then serves as an indicator of the tax system’s overall
progressivity. For a given level of taxes, the higher the elasticity the smaller will be the change in after-tax income
that results from a given change in before-tax income (Auerbach and Feenberg, 2000: 40).
The most common measure of the responsiveness of tax revenues to changes in income for analytical applications
is the “tax elasticity” or “built-in flexibility” (Prest, 1962). Tax elasticity is generally related with the personal
income tax. Various approaches to its calculation are found in literature (Tanzi, 1969, 1976; Singer, 1970; Greytak
and McHugh, 1978; Hutton and Lambert, 1980; Ehdaie, 1990). Tax elasticity is the ratio of the percentage change
in (income) tax revenue to the percentage change in national income with a given tax structure (Rosen, 2005). It
can also be thought as the indicator of the sensitivity of the tax system to the changes in national income.
A direct measure of the potential stabilization effect of the tax system is the ratio of the change in taxes with
respect to a change in before-tax income (built-in flexibility). This can be calculated in two ways: