Income Distribution in Discrete Hours Behavioural Microsimulation Models: An Illustration of the Labour Supply and Distributional Effects of Social Transfers

The distributional implications of an extreme hypothetical reform of the Australian tax-transfer system are examined using the Melbourne Institute Tax and Transfer Simulator. This simulation model predicts labour supply using a probabilistic discrete hours approach. The analysis of the distribution of income is difficult because, even for a small sample with a modest range of labour supply points, the range of possible combinations over the sample is extremely large. This paper demonstrates the use of a pseudo income distribution, where the probability of a particular labour supply value occurring (standardised by the population size) is used to refer to a particular position in the pseudo income distribution. The superior performance of the pseudo approach compared to using the expected income or taking 10 draws from the possible set of distributions is clearly illustrated by the simulation example for sole parents, in which the whole social security system is abolished. The example shows further that even if sole parents could move freely into the labour force, they do not manage to compensate fully for their loss of income when no benefit payments are available.