http://www.iser.essex.ac.uk/publications/working-papers/iser/2009-02

In general, simulation models are tools which are designed to answer “what if” questions about different policy reform options. In the run-up of the implementation of a specific reform proposal, it is crucial to predict the expected consequences on individuals (gains and losses, income distribution), the government budget and key economic indicators (e.g. employment, prices, consumption) to provide policymakers with well-founded decision guidance. Other than in the natural sciences, it is seldom possible in economics to construct natural experiments for the analysis of a given treatment (policy). Policy simulations can be interpreted as quasi-experiments which allow the economist to ex-ante analyse a reform proposal controlling for behavioural responses of different agents in the economy. Simulation models are frequently used by economists, policy-consultants and policy-makers to predict the impacts of changes in fiscal policies. Several different types of simulation models can be used depending on the research question in mind. Mircrosimulation models (MSM) and Computable General Equilibrium models (CGE) have both been widely used in policy analysis. The combination of these two model types allows the utilisation of the advantages of both types. The aim of this paper is to describe the state-of-the-art in simulation and to illustrate the benefits and problems of linking micro and macro models by analysing flat tax reform proposals for Germany. Applying the linked model to a not revenue neutral flat tax proposal shows that taking the general equilibrium effects into account indeed increases the expected efficiency gains in the long-run. The overall employment effects are larger than the labour supply reactions because of reduced costs of labour and capital resulting in increasing labour and investment demand. Therefore, a personal flat income tax can indeed overcome the fundamental equity-efficiency trade-off. However, combining this flat tax with a cash flow flat tax on business income still increases inequality due to the large gains at the top of the distribution. Therefore, we conclude that due to their limited efficiency effects and their problematic short-term distributional impact, flat tax reforms are unlikely to spill over to the grown-up democracies of Western Europe.

The aim of this paper is to describe the state-of-the-art in simulation and to illustrate benefits and problems of linking micro and macro models by analysing flat tax proposals for Germany. The analysis shows that a personal income flat tax can indeed overcome the fundamental equity efficiency trade-off while simultaneously increasing the tax revenue. However, this result does not hold for a flat tax combining a personal income flat tax with a corporate cash flow flat tax, even when allowing for an ex-post loss in revenue as the top of the distribution still gains the most. Working Paper 2009-02 2009-01-28 Andreas Peichl Institute for the Study of Labor (IZA) http://www.iza.org/