A microeconometric model for analysing efficiency and distributional effects of tax reforms Evidence from Italy and Norway Rolf Aaberge (Research Department, Statistics Norway, Oslo) and Ugo Colombino (Department of Economics, University of Turin) ”La microsimulación como instrumento de evaluación de las políticas: métodos y applicaciones” Fundación BBVA, Madrid, Nov. 2004

Various Modelling Approaches for Analysing Tax Reforms Static microsimulation models Behavioural microsimulation models (Partial equilibrium) General equilibrium models (CGE), where labour supply is represented by a representative agent Combining a behavioural microsimulation model and a CGE

Outline of what follows The microeconometric model Labour supply elasticities (Italy and Norway) A simulation of some tax reform proposals (Italy) Looking for the optimal tax system (Norway) Testing the model: comparing model predictions to the observed effects of a reform (Norway) Integrating the microeconometric model and a General Equilibrium model (Norway)

We develop a model of labour supply which features: simultaneous treatment of spouses’ decisions exact representation of complex tax rules quantity constraints on the choice of hours of work choice among jobs that differ with respect to hours, wage rate and other characteristics

Reference material Aaberge, Colombino and Strøm, J. of Applied Econometrics, 1999 Aaberge, Colombino and Strøm, J. of Population Economics, 2000 Aaberge, Colombino and Roemer, Statistics Norway, Discussion paper 307, 2001 Aaberge, Colombino, Holmøy et al., Statistics Norway, Discussion paper 367, 2004 Aaberge, Colombino and Strøm, J. of Population Economics, some recent unpublished results

Labour supply elasticity The main purpose of behavioural modeling is to account for labour supply responses to policies Is labour supply really responsive, i.e. elastic w.r.t. economic incentives?

Labour supply elasticity If, for example, we look at the overall labour supply elasticity in Norway 1994, we read a modest …and then we would answer: NO, this is not relevant, forget about behavioural modelling! But if we look BEHIND the aggregate figure the picture changes quite a lot…

Labour supply elasticities w.r.t. wage Married couples, Norway 1994

Labour supply elasticities w.r.t. wage Married couples, Italy 1993

A simulation of some reform proposals in Italy Two (old) ideas for reforming the tax- transfer system: Improving EFFICIENCY by flattening the marginal tax rates Improving EQUALITY by introducing a universal transfer or a minimum guaranteed income

Percentage of “welfare-winners” under alternative tax reforms

Percentage variations of Social Welfare and its components (Gini Welfare Function)

Conclusions All the reforms are efficient FT is disequalising, but NIT and WF are equalising There is scope for designing tax systems that produce bigger “cakes” and more equal “slices” too. Of course there might be even better reforms. In what follows we look for optimal reforms …

Optimal taxation An exercise for Norway We use the model to identify optimal tax- transfer rules “Optimal” means maximizing a Social Welfare Function

The model max U(C, h,  ) s.t. C=f(wh, I) (h, w,  )  B where: U( ) = utility function f( ) = tax-transfer rule C = net income h = labour supply w = wage rate I = exogenous income  = other job characteristics B = opportunity set

Simulating tax reforms Given a new tax function t( ) and using the estimated U( ) and B the simulation consists of solving for each household max U(C, h,  ) s.t. C=t(wh, I) (h, w,  )  B to get new values of h and C

Optimal taxation Class of tax-transfer rule We consider 4-parameter tax-transfer rules: Net = T -  1 min(Gross,A) –  2 max(0, Gross – A) T = lump-sum transfer  1 and  2 = marginal tax rates for the two brackets A = cut-off value between the two brakets

Optimal taxation: Social Welfare Function The Social welfare function is defined as the average individual welfare ( ) times (1 – Inequality Index) There are many type according to how we define the Inequality Index:

Optimal taxation: results

Out-of-sample prediction (Norway) In 2001 we are able to observe the effects of a reform of the tax rule actually implemented We use the model estimated on 1994 data to simulate the effects of the reform We then compare the model predictions to the observed effects…

Out-of-sample prediction Observed and predicted mean disposable income for couples, single females and males in 1994 and NOK CouplesSingle malesSingle females Obs.Pred.Obs.Pred.Obs.Pred

Observed and predicted relative distributions of disposable income in 2001 CouplesSingle malesSingle females DecilesObservedSimulatedObservedSimulatedObservedSimulated

Integrating the Micro- and the CGE- model CGE model Microeconometric model Wage Cash transfers Capital income Labour supply

Integrating the Micro- and the CGE- model Simulation at 2050 of a flat tax that supports fiscal equilibrium