Combining micro- and macroeconomic approach to simulate labour tax wedge cut in Italy

The overall tax burden on labour is high in Italy as compared to the EU average. A high marginal labour tax inevitably causes disincentives to work, especially among the lower paid whose labour market participation choices are typically highly responsive to marginal tax rates. In 2014/2015 Italy undertook measures to lower its tax wedge on labour, a key element of which was the introduction of a refundable in-work tax credit of EUR 80 per month for low-income earners. In this paper we study the effects of the abovementioned reform, combining the advantages of the microsimulation model with these of an overlapping generations (OLG) model. This allows us to take advantage of both the detailed, disaggregated information at the micro level and the broader behavioural responses of economic agents at the macro level, providing a broader analysis of the reform than either of the two methodologies in isolation. The microsimulation model used is EUROMOD, a tax-benefit model for EU countries. EUROMOD simulates benefit entitlements and tax liabilities of individual and households according to the tax-benefit rules in place in each Member State. The simulations are based on representative survey data from the European Statistics on Income and Living Conditions – EU-SILC (a full description of the EUROMOD model is available in Sutherland, 2007). To get labour supply response we make use of a structural discrete choice labour supply model (as in Bargain, Orsini, and Peichl, 2014) that has been estimated using the microsimulation model EUROMOD and EU-SILC household data. The macroeconomic model is an overlapping generations dynamic general equilibrium model. The household sector consists of several generations living alongside each other at any point in time, who make labour, consumption and savings choices so as to optimise their lifetime utility. On the supply side, firms maximise profits generated from the production of a single good. Government collects revenues from taxes on consumption, labour and capital which are used to finance spending on public consumption and transfer payments to different generations. A calibration procedure based on micro data has been applied to the OLG model for Italy. We calibrate earnings profiles and consumption profiles by age using EUROMOD. Taking exogenous consumption profiles implies that the discount rates in the model are time-varying. We match the labour elasticities estimated using micro-data to the more aggregated individual agents of our OLG model producing our labour supply curve. The simulation can be split into three components: (i) the static microsimulation effects, (ii) the microsimulation effects with the labour supply response, and (iii) the dynamic macroeonomic consequences. The static microsimulation using the standard EUROMOD version shows the first-round effects by individual worker (in the EU-SILC data), which is aggregated to show the impacts by household categories. First-round effects have been recently analysed in Astarita, Maestri and Schmitz (2016). The second step is to incorporate the labour supply response in the microsimulation model, which provides a partial picture of the impact on employment of the policy. The final stage, using the OLG model, addresses the long-run dynamic macroeconomic consequences, including relaxing the assumption of unchanged GDP (a core contribution of the dynamic scoring approach; for example, see Gravelle, 2014). Of particular interest to this study is the labour demand response to the policy reform. The preliminary results are split into the three methodological components. The static microsimulation shows that the policy improves equity outcomes as it is focused on low paid workers. Nevertheless when aggregated to the household level, a fair portion of the benefits go to higher income households where the second income earner is low paid. The tax revenue loss at this stage can be considered an overestimate as the behavioural responses are believed to act to reduce the loss. The labour supply extension of the microsimulation model suggests that a significant increase in employment can be anticipated due to the cuts in the marginal labour tax rates. This has direct impacts on the public finances by reducing expenditures on unemployment benefits and increasing income tax revenues. By design the labour supply in the OLG model mimics that of the extension to the microsimulation model, with individuals working more in the present to save and have more leisure in the future. This in turn increases savings and capital stock over the long run. The labour demand also rises over time, which further raises employment. This key finding that keeping labour demand fixed underestimates the employment effects, while keeping labour supply fixed overestimates them, demonstrates the importance of combining microsimulation and general equilibrium models to examine policy reforms.