Welfare-improving income tax reforms: a microsimulation analysis

Extensive research has shown that few robust results regarding the optimal tax structure are available. Moreover, the stylized models used in optimal tax analyses are not appropriate for practical policy advice. This paper proposes a method of examining income tax reforms designed to move towards an optimal structure. It uses a behavioural microsimulation model in which the full extent of population heterogeneity is represented along with all the details of highly complex tax and transfer systems. The approach is illustrated using the Australian microsimulation model MITTS. The results show that welfare changes for the Australian income tax structure are not symmetric with respect to increases and decreases in tax rates. In addition, the extent of inequality aversion was found to play a much larger role in the determination of the direction of tax rate changes than the form of the welfare metric or the specification of adult equivalence scales.