An Introduction to Microsimulation Tax-Benefit Models

Incidence: Who Really Pays Taxes?¹

All the examples above and almost all of what follows are about things that directly affect people, by, for example, taking some of their income in tax, raising their wages, or paying them benefits. But we can use Microsimulation to study, for example, policy changes affecting companies, industries, schools, or Local Authorities. This raises an important point: ultimately the effects of a change to, say, the taxation of corporations or the funding of local councils falls on people, by changing, say, dividends, local taxes, or the quality of local parks, but the effect is at one remove from the policy. Resolving this indirection is know as finding the effective incidence of the change; the first-round effect is the formal incidence. For example, recent debates about the fairness of the United States tax code revolve round the question of whether corporation tax - which has been cut heavily in recent years, ultimately falls on wages or profits².

Considering the ultimate incidence of policy changes is very important, but can be very difficult. Even the direct changes we’re concentrating on here can have an incidence beyond the those immediately affected - an income tax increase might cause higher prices in some industry, and so be ‘passed on’ to consumers who weren’t the direct targets of the tax. For the most part we’ll be considering first-round effects on the people directly affected by our policy changes - so, the formal incidence of the policy - but it’s worth keeping in mind that the effective incidence may be different.