Treasury has released a working paper outlining the constraints of its static microsimulation modelling, used for costing tax and transfer policy options within the forward estimates period, when applied to the medium-term.
Static microsimulation models are a commonly used tool for producing distributional analysis. In effect, it takes a snapshot of the population at a particular point in time and simulating short run or ‘morning after’ impacts of changes in tax policy.
It suggests that the financial impact of tax policies can be very different at maturity, due to an increase in forecast errors, behavioural changes in individuals and businesses in response to tax changes, and changes in the target population.
In short, there are constraints in Treasury’s modelling methods for key tax policies.
“For instance, some individuals who may wish to take advantage of a new tax concession may not be able to restructure their affairs in time for a policy announced at budget and legislated in the same year, but they will be able to plan ahead for subsequent years,” the paper said.
“This means that the longer the modelling horizon, the more uncertain behavioural assumptions can become.”
Treasury’s use of static microsimulation models, similarly used by domestic and international agencies, is not designed to accurately produce detailed year-by-year costings beyond the forward estimates.
It notes that while dynamic microsimulation models are better suited for medium-term costings, there are also limits and complexities, including being more costly to maintain and more computationally demanding.
The paper suggests communicating the uncertainty in medium-term costings to inform public debate and decision-making by using less precise rounding than is used in the forward estimates, aggregating results across years and providing estimates as a per cent of gross domestic product.
“Revenue costings beyond the forward estimates are subject to greater uncertainty and, as such, must be accompanied by appropriate caveats to avoid misrepresenting confidence in those estimates,” said the paper.
“Regardless of the method, it should be clearly communicated that the estimates are only a broad indication of the costs involved.”