Download Simulating Policy Change Using a Dynamic Economy

Simulating Policy Change Using a Dynamic
Overlapping Generations Model of the Australian
Economy
Dr George Kudrna and Professor Alan Woodland
University of New South Wales
1 April 2010
Contents
1 Introduction
4
2 The Overlapping Generations Model
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Model description . . . . . . . . . . . . . . . . . . . . . .
2.2.1 Households . . . . . . . . . . . . . . . . . . . . .
2.2.2 Pensions and superannuation . . . . . . . . . . .
2.2.3 Production . . . . . . . . . . . . . . . . . . . . .
2.2.4 Government . . . . . . . . . . . . . . . . . . . . .
2.2.5 Foreign sector . . . . . . . . . . . . . . . . . . . .
2.2.6 Equilibrium . . . . . . . . . . . . . . . . . . . . .
2.2.7 Steady state and transition path solutions . . . .
2.3 Calibration of the model . . . . . . . . . . . . . . . . . .
2.3.1 Parameterization . . . . . . . . . . . . . . . . . .
2.3.2 Simulation results and comparison with data . . .
2.4 Baseline simulation . . . . . . . . . . . . . . . . . . . . .
2.4.1 Baseline amendments to model parameterization .
2.4.2 Baseline solution . . . . . . . . . . . . . . . . . .
2.5 Policy simulations . . . . . . . . . . . . . . . . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
3 Policy Simulation Results
3.1 Simulation I – A reduction in the statutory corporation tax rate . . . . . .
3.1.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.1.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2 Simulation II – An increase in the mandatory superannuation contribution
rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.2.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3 Simulation III – Changes to taxation of superannuation contributions . . .
3.3.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
6
6
7
7
8
9
9
9
10
10
11
11
13
15
15
16
17
19
20
20
20
21
22
23
23
23
24
25
26
26
26
CONTENTS
3.4
3.5
3.6
3.7
3.8
3.9
3.10
2
3.3.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.3.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation IV – A reduction in the superannuation fund’s earnings tax rate
3.4.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.4.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation V – Preferential tax treatment of private investment income . .
3.5.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.5.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation VI – A reduction in personal income taxation . . . . . . . . . .
3.6.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.6.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.6.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.6.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation VII – A tax on intergenerational transfers . . . . . . . . . . . .
3.7.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.7.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.7.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.7.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation VIII – Gradual increases in the superannuation preservation age
3.8.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.8.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.8.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.8.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Simulation IX – Aggregation of simulations I, III, IV, V and VIII . . . . .
3.9.1 Policy change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9.2 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9.3 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.9.4 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary of policy simulation results . . . . . . . . . . . . . . . . . . . . .
3.10.1 Macroeconomic implications . . . . . . . . . . . . . . . . . . . . . .
3.10.2 Welfare implications . . . . . . . . . . . . . . . . . . . . . . . . . .
4 Discussion
4.1 Demographic change . . . . . . . .
4.2 Interest rate adjustment . . . . . .
4.3 Alternative budget-balancing taxes
4.4 Age pension indexation . . . . . . .
4.5 Government consumption . . . . .
5 Conclusions
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
27
29
29
29
29
30
31
31
31
32
33
34
35
35
35
36
37
37
37
37
38
39
40
40
40
41
42
43
43
43
44
45
45
45
47
49
49
50
51
51
51
54
CONTENTS
6 Appendices
6.1 Technical description of the model .
6.2 Figures and tables for Chapter 2 . .
6.3 Figures and tables for Chapter 3 . .
6.4 Figures and tables for Chapter 4 . .
3
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
57
57
63
64
65
Chapter 1
Introduction
This document constitutes the report on economic modelling undertaken at the University of New South Wales under contract to the Treasury of Australia. The purpose of
the modeling is to provide information on the potential economic consequences of the
implementation of a range of policy changes.
The research strategy used is to simulate the consequences of each policy change by
computing the solution to a dynamic, overlapping generations model for Australia under
the policy change and comparing it to the solution to the model obtained under existing
policy settings. In other words, we compare the policy simulation solution with the
baseline solution to the model. In this way, we can calculate the e¤ect of the new policy
proposal upon the initial steady state solution (initial impact), upon the solution for the
new steady state (long run impact) and along the transition path between these steady
states (transition path impacts).
The model we use has several features that make it appropriate for this tax policy
evaluation task. First, the model has a very detailed household sector speci…cation.
Households are distinguished by generation and by productivity type and so the model
can be used e¤ectively to determine the intra- and inter-generational impacts of the policy
changes upon households. Second, it is a general equilibrium model and so the solutions
re‡ect impacts of the policy changes upon such things as the labour market, capital
market, international trade, wage rates and the government budgetary situation. Third,
the model incorporates the main features of the government’s policy settings regarding
taxes, pension policy and superannuation policy. Adjustment in pension expenditures
and receipts by individuals, superannuation assets and taxation receipts by government
are endogenous.
Fourth, the model is dynamic in structure. This is important, since changes to the tax
system are bound to have e¤ects that take place over time as well as immediate e¤ects.
Our dynamic structure manifests itself in several ways. Households make decisions over
their entire lifetimes in what is called a life cycle framework. Thus, they make decisions on
consumption and labour supply for every year of their life and, in doing so, determine their
asset pro…les. More importantly, for our purposes, they decide not only hours of work,
but also when to retire. Another manifestation is through the growth of the capital stock
and the arbitrage equilibrium between capital and bonds. This links markets through
time.
4
CHAPTER 1. INTRODUCTION
5
A more detailed, but still broad, account of the model is provided in the chapter that
follows. A more complete account is relegated to the appendix. Following our broad
description of the model, we then proceed to show how the model is made operational
by determining the numerical values for parameters. Some are taken from the literature,
while others are obtained by calibration methods whereby they are determined to ensure
that the model matches some observed empirical facts. Included in the discussion of the
calibration procedure is a comparison of some of the simulation solution results with data
on various economic variables for Australia obtained from other sources.
The remainder of this chapter then describes and discusses the baseline simulation of
the model, in which the government’s tax policy setting that apply currently (2009-10)
is incorporated. This simulation of model is used as the platform on which the various
policy changes to be simulated are built. The baseline solution for the model forms the
basis of comparison for the solutions obtained by imposing each proposed policy change
in turn.
The main results are presented in Chapter 3. In this chapter, each policy proposal
is considered in turn and the e¤ects of the policy change upon macroeconomic variables
and the welfare of households are discussed. The policy change implementations are
given, results are tabulated and graphed, and an overview of the impacts are discussed
with more detailed descriptions following. In the …nal section, we bring these policy
simulations together.
Chapter 4 provides a brief discussion of alternative model assumptions that might
have been made and of how the results might be a¤ected. The …nal chapter provides some
concluding remarks.
Chapter 2
The Overlapping Generations Model
2.1
Introduction
This chapter outlines the structure of a general equilibrium, dynamic, overlapping generations model that is used to generate various policy simulations dealt with in this report.
Section 2 verbally describes the model. The model description is followed by a brief account of the calibration of the model in Section 3. This involves a description of the
parameterization of the model followed by a discussion of key macroeconomic and lifecycle results of the numerical solution of the model and a comparison of these with actual
aggregate and life-cycle data. The calibration exercise provides the parameters of the
model based upon the data and policy settings that apply in the 2008-09 …nancial year,
the last year for which all the required information is available.
Section 4 deals with the baseline simulation for the model. This di¤ers from the
calibration simulation in that it takes as its basis the taxation and age pension policy
settings that apply in the base year for the policy simulations, namely the …nancial year
2009-10. Application of the model to the 2009-10 …nancial year requires some amendments to several parameters as a result of the new policy settings and these are described.
This is followed by a description of the baseline simulation solutions for some key macroeconomic variables. The last section brie‡y outlines the policy simulations, with their
macroeconomic and welfare results reported in the next chapter.
The connection between the model, its calibration, the baseline simulation and the
policy simulations may be clari…ed through Chart 2.1. This chart shows several boxes,
the top one referring to the overlapping generations model. This box refers to the structure
and behavioural assumptions that constitute what we call the model, described in the next
section and, in more detail, in the appendix. This theoretical model is de…ned in terms
of endogenous variables, exogenous variables and parameters.
In order to make the model numerically solvable, the exogenous variables and parameters need to be given numerical values. This task is described by the calibration box in
Chart 2.1. This indicates that the calibration is done (numerical values obtained) using
both data and policy settings from …nancial year 2008-09, the last …nancial year for which
all the required data are available.
The third box is labelled "baseline simulation". The baseline simulation is the model
solution obtained using the taxation and pension policy settings that apply in the …nancial
6
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
7
year 2009-10. Thus, the baseline simulation di¤ers from the calibration simulation in
several important respects, First, as a result of the policy changes some parameters had
to be amended. Second, the gradual change to the eligibility age for the age pension
alters the model structure. Third, the tax and pension policy changes also changed tax
and pension rates and the income test. Importantly, this baseline solution starts from a
steady state (based on an eligibility age of 65) and moves through time along a transition
path to a new steady state (based on an eligibility age of 67). Thus the baseline solution
changes over time.
The purpose of this baseline simulation is to form the model solution to which other
model solutions based upon a range of new policy settings will be compared. That is, the
e¤ects of new policy settings contemplated in the following chapter are compared with
the baseline simulation solution based on the 2009-10 policy settings. This is the content
of the …nal box in Chart 2.1.
2.2
Model description
The model is a small-open economy version of Auerbach and Kotliko¤’s (1987) overlapping generations model that features a stationary demographic environment. The total
population grows at a constant rate and lifespan uncertainty (the only uncertainty in
the model) is given by time-invariant survival probabilities. The assumption of stationary demographics implies that the cohort shares (i.e., shares of each generation in the
total population) and thus the old age dependency ratio are constant over time.1 The
model consists of household, pension, production, government and foreign sectors that
are discussed below.
2.2.1
Households
The household sector is very detailed. The household sector is populated with overlapping
generations of heterogeneous households distinguished by age (i.e., generations aged from
21 to 90 years) and their earnings ability (i.e., every generation consists of three income
types – low-, middle- and high-income households). There are 210 households alive in
every time period (i.e., 70 generations of three income types).
All households face lifespan uncertainty. Given the stochastic survival, some fraction
of each generation dies and their assets (consisting of both ordinary private and superannuation assets) are assumed to be equally redistributed to surviving households of the
same income type and aged between 45 and 65 years as accidental bequests.2
Household behavioural follows the life-cycle theory developed by Modigliani and Brumberg (1954) according to which people make rational choices about their consumption and
savings over their …nite lives. Each household begins life with zero assets and makes plans
1
Thus, the model does not account for population ageing in Australia with a increasing old age
dependency ratio.
2
This bequest redistribution assumption is based on the following: child bearing occurs largely between
ages 25 and 35 and the probability of death is particularly high at older ages from 80 to 90 in the model.
Thus, the bequest range is set to be 45 to 65 years, re‡ecting intergenerational transfers from parents to
their children.
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
8
to bequeath zero assets should the maximum age of 90 years be reached. Each household
faces a productivity by age pro…le that rises at early ages and falls at advanced ages. Each
household also has a lifetime utility function that discounts future utility from consumption and leisure according to a time discount factor and the probability of survival. In our
model, labour supply and the date of retirement are endogenously chosen. Accordingly,
within this context, households make annual decision about hours of work, whether to
retire and how much to consume (hence save) out of income in order to maximize their
lifetime utility function.
Table 2.1 summarizes the di¤erences amongst the three types of households. These
households are distinguished by having di¤erent productivity pro…les over age and are
thus referred to as income types – low, middle and high. In addition, our model allows
these three types of households to di¤er in other respects. For example, the non-negativity
assets condition (i.e., borrowing constraints) is imposed only on low-income households.
The other two income classes are free to borrow any time and as much as they wish at the
exogenous interest rate, provided that their terminal assets are non-negative. Low-income
households are the most time impatient (i.e., highest value of the subjective rate of time
preference – see the model parameters in Table 2.3). Only low-income households aged
between 21 and 60 years are assumed to receive constant government bene…ts. Of course,
the three households types also have di¤erent shares of each income type within a cohort
(see the next section on calibration).
2.2.2
Pensions and superannuation
The model incorporates essential aspects of the …rst two pillars of the Australian retirement system – the means tested age pension and the fully funded superannuation
guarantee [SG]. The age pension is paid to households from age 65 (i.e., current eligibility
age pension age for males) provided that they satisfy the means test. The means test
consists of income and assets tests. The test that results in a lower pension applies (i.e.,
binding test). Under the means test rules, the age pension received by an individual is the
statutory maximum rate provided income and assets are below the respective thresholds
and then declines via the taper rates for higher income or assets until reaching zero. The
eligibility age for receiving the age pension is increased gradually from 65 to 67 years of
age, in accordance with the policies introduced in the Australian government’s May 2009
budget.
In addition to ordinary private assets, households accumulate superannuation assets
through the mandatory superannuation guarantee contributions made by the representative producer. Superannuation assets are invested by the superannuation fund and earn
fund interest income at the same exogenous interest rate as the interest on ordinary private
assets. Contributions and fund investment earnings are taxed at concessional (statutory)
‡at tax rates.3 The superannuation bene…ts are assumed to be paid out as a tax-free
lump-sum when households reach age 60.
3
Note that there is no capital gains tax (CGT) discount in the model. Both private and superannuation
assets are assumed to be held in bank accounts or bonds. Thus, all investment earnings from private
assets holdings are included in personal taxable income and taxed at marginal tax rates. Investment
income earned by the superannuation fund is taxed at the statutory ‡at rate of 15 percent.
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
2.2.3
9
Production
The production sector is simple relative to the household sector. It contains one …rm,
which represents a large number of perfectly competitive …rms. This aggregate …rm is
assumed to produce a single all-purpose output good that can be consumed, invested in
production capital or traded internationally. The production technology is represented
by a constant elasticity of substitution (CES) production function in which output is
produced using capital and labour.
Investment decisions follow the Q theory of investment (Tobin, 1969), according to
which …rms invest whenever the market value of their assets exceeds the cost of replacement. Capital formation is subject to convex adjustment costs (Hayashi, 1982), but in
the steady state equilibrium, there are no adjustment costs.
The producer makes mandatory superannuation contributions on behalf of households
and also pays the corporation ‡at tax from its pro…ts. For the purpose of taxation, pro…ts
are de…ned as revenue minus the costs of labour (including mandatory superannuations
guarantee contributions) and minus depreciation of the capital stock. It should be evident
from the this formulation that the corporation tax rate is applied to the earnings of capital,
net of depreciation. Accordingly, it may be interpreted as a capital earnings tax.
2.2.4
Government
The government sector is represented by a balanced budget constraint. On the expenditure side of the public budget, there are government consumption, age pension expenditures and ‡at bene…ts to low-income households. Government consumption generates no
utility to households in the model. Revenues from consumption, personal income, superannuation and corporation taxation are on the income side of the budget. Consumption,
superannuation and corporate taxes are linear while income taxes are progressive (i.e.,
households with higher taxable income pay greater average tax rates) and correspond to
the Australian income tax schedule.
The government is assumed to maintain the exogenously …xed government consumptionoutput ratio, with the consumption tax rate adjusted accordingly to balance the government budget. The results are sensitive to the assumption of growth for government
consumption, where a constant government consumption to output ratio implies that any
policy reform generating an output increase will require increased government taxation
revenue to …nance the extra government consumption and this will require an increase in
the consumption tax rate. Another approach to deal with this issue, is to assume that
government consumption is kept constant. Sensitivity analysis reported in Section 4.5 indicates that these rival government spending assumptions generate signi…cantly di¤erent
results for the measure of welfare.
2.2.5
Foreign sector
The assumption of small open economy means that the domestic interest rate is exogenous
and equal to the world interest rate. International capital ‡ows make sure that the balance
of payment is in equilibrium. Hence, whenever domestic savings fall short of domestic
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
10
capital, foreign capital will be employed, which has negative e¤ects on the current account.
Foreign and domestic assets are perfect substitutes, meaning that import and export are
indeterminate and that only the trade balance (i.e., net export) can be determined. The
trade balance is calculated from the goods market equilibrium condition, implying that if
output falls more than domestic demand, the trade balance deteriorates.
2.2.6
Equilibrium
The endogenous variables of the model are determined such that all agents optimize their
objective functions subject to any constraints and such that markets clear in every period.
Speci…cally, every household (distinguished by generation and income type) chooses
the level of consumption and leisure in every year of life to maximize lifetime utility
subject to the lifetime budget constraint. The representative …rm also maximizes pro…ts
in every period by choosing its demand for labour and capital and, hence, output. The
government chooses the consumption tax rate to ensure that its budget is balances in
every period.
In every period, the labour market clears, thus determining the wage rate. Output
of goods must match the demand by households for consumption, plus investment and
government demands plus the net exports going to foreigners.
Dynamic conditions include the way by which the capital stock increased through new
investment and the arbitrage condition between bonds and capital assets. In every time
period, the value of the capital stock equals to the sum of domestic and foreign assets.
2.2.7
Steady state and transition path solutions
There are two types of solution to the model. The …rst is the steady state solution;
the second is the transition path solution from one steady state to another. A steady
state solution applies if we assume that the policy settings and all exogenous variables
are given and constant, and that there has been su¢cient time for the economy to adjust
completely to these settings. In this case, the endogenous variables (such as the wage rate,
for example) are constant through time. Households of di¤erent generations, but of the
same productivity type, face exactly the same economic environments (though at di¤erent
calendar times) and so behave in exactly the same way. On the production side, there
are no adjustment costs and so the steady state decisions of the …rm remain unchanged
through time also.
One consequence of this is that the open economy assumption has some special implications for the steady state solution to the model. Since the …rm chooses labour and
capital inputs to maximize pro…ts, it sets the marginal products of labour and capital
equal to the prices of these inputs (wage and rental rate) faced by the …rm. The arbitrage
condition equating the rates of return to capital and bonds ensures that the rental rate on
capital in the steady state (without adjustment costs) is determined by the exogenously
given rate of interest. This, combined with the constant returns to scale assumption for
the production function, then implies that the capital labour ratio is determined.4 Finally,
4
Under constant returns to scale, the marginal product of capital and labour each depend upon the
capital-labour ratio.
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
11
since the marginal product of labour is determined by the capital-labour ratio, this means
that the wage rate faced by the producer is also determined by the world interest rate in
the steady state equilibrium.
An implication of this property of the model (shared with many other small open economy models) is that the steady state equilibrium capital-labour ratio and the wage rate
will only be a¤ected by a policy change that alters either the superannuation contribution
rate (that creates a wedge between the market wage rate faced by households and the
wage rate faced by the …rm) or the tax rate on the earnings of capital (for an analogous
reason). Other policy changes will have no impact on the steady state capital-labour ratio
or the market wage rate.
Transition path solutions involve adjustments over many periods to move the economy
from one steady state solution to another. In this context, endogenous variables (such as
the wage rate, for example) change over time until they converge to the new steady state.
During this transition, households and the …rm face a changing economic environment
and so their decisions also change through time, not just because of increasing age in the
case of households. On the …rm side, adjustment cost considerations play an important
role until convergence to the steady state.
2.3
Calibration of the model
The model is calibrated to the …nancial year of 2008-09 with the tax and pension policy
settings and parameters of that …nancial year. Importantly, it should be recalled that the
pension policy settings applying then have the eligibility age for the age pension set at 65
years. This section reports on some of the details of the calibration procedure, presents
the resulting parameters for the model and then compares the simulation solution of the
model with Australian data for some variables.
2.3.1
Parameterization
The model is scaled such that the values of all the monetary variables are expressed in
units of $100,000. The scaling makes the model computation easier as the di¤erences in
the values of model variables are reduced.
The targets to which some model parameters (mainly production function parameters) are calibrated are reported in Table 2.2. The targeted investment-output ratio is
calculated from the Australian National Accounts (ABS, 2009a). Investment expenditures (gross …xed capital formation) exclude government investment, which is included
in government spending. The government budget is assumed to be balanced (no government debt or surplus). The targeted ratios of corporation and consumption tax revenues
to GDP are calculated using data from Commonwealth of Australia (2009) and ABS
(2009a). We set the corporation and consumption (GST) tax rates to their statutory
rates and compute "tax base" parameters for these taxes to reproduce the targeted revenues to GDP ratios. We also endogenize the government spending to output ratio in the
calibration to target the statutory GST rate of 10 percent. Net foreign assets are largely
negative; almost 20 percent of domestic assets was owned by foreigners (targeted negative
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
12
foreign assets to capital ratio taken from ABS, 2008). The wage rate is normalized to one
and the value of the exogenous interest rate of r  : is based on empirical observations
of the historical real rate of return on bonds and the historical real rate of return on
equities in Australia.
Table 2.3 reports the chosen values of the main parameters of the model. Some
parameters are taken from related literature (utility function parameters), some exactly
match actual values in 2008-09 (pension sector parameters) and some are calibrated to the
calibration targets (production function parameters and tax base parameters). The model
features stationary demographics with a constant population growth rate of 1.45 percent
per year, which is approximately the annual growth rate of the Australian population in
the …ve year period ending in June 2008 (ABS, 2009b). Conditional survival probabilities,
sa ; are taken from ABS (2007) life tables 2005-07 for males.
The values of the utility function parameters are within the estimated ranges obtained
from relevant empirical studies. The parameter values are the same for every income class
except for the subjective rate of time preference, which is the smallest for high-income
households. This assumption is based on the fact that richer households tend to be less
time impatient compared to poorer households that prefer to consume a greater fraction
of their income now rather than later.
In contrast with taste parameters, most production function parameters are calibrated
to replicate the target variables. The technology parameter, , is a scaling parameter,
which is chosen to reproduce the target market wage rate. The elasticity of substitution
in production, , is calibrated to the exogenous interest rate. The depreciation rate of
the capital stock, , is set to target the investment-output ratio. The capital share, ";
is derived from the Australian National Accounts and the adjustment cost parameter of
  is taken from Auerbach and Kotliko¤ (1987).
The age-speci…c earnings ability (or productivity age) pro…les are exogenous and di¤er
across the three types of households. The earnings ability, which is the full wage earned
with all the time endowment allocated to work for each income class, eia , is given as
eia  i eia w; where eia is the normalized e¢ciency variable for each income group i at
age a that is derived from the estimates by Reilly at al. (2005). The productivity pro…les
have the standard shape; they rise at younger ages, peak and then fall at more advanced
ages.5 The term w is the wage earned by a 20 year old average earner (i.e., middle-income
household in the model) with full time endowment spent at work. The value of this
parameter of 1.0374 is expressed in units of $100,000 and obtained as an hourly wage of
$19 multiplied by the full time endowment assumed to be 5460 hours per year, which
5
Their estimated wage function is normalised such that the wage for a 20 year old
middle-income household with no experience in the model is equal to one, that is, eia =
2
exp 2:235 + 0:04 a S i 5
0:00067 a S i 5
= exp(ei20 ); where S denotes years of schooling
and a represents age. Normalisation of the wage function is performed to account for the fact that the
estimates by Reilly at al. were obtained for year 1999. The three income types of households are assumed
to attend di¤erent years of schooling. The low-income household have 10 years of schooling (S 1 = 10),
middle-income 12 years (S 2 = 12) and high-income households 15 years of schooling (S 3 = 15). As
Reilly at al. consider only workers aged 15 to 65, we assume that the wages after age 65 decline at a
constant rate and reaches zero at age 90 for the low- and middle-income households and at age 80 for the
high-income households. This assumption is made in order to avoid positive labour supply at very old
ages.
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
13
corresponds to about 15 non-sleeping hours per day. In the model this time endowment
is normalized to unity. The hourly wage is calculated from ABS (2009c) as average gross
earnings of full-time persons aged group of 15-24 over 40 work hours. The shift parameter
i
is set to 0.3 for low-income households, one for middle-income households and three
for high-income households (based on Fehr et al., 2008). Approximately, this means that
bottom 30 percent of households (low-income households) earn one third of earnings of
middle-income households while the top ten percent (high-income households) earn three
times more relative to what middle-income households earn.
As already mentioned, consumption and corporation tax rates are set to their statutory rates. The model e¤ective tax rates can be obtained by multiplying these statutory
rates with the tax base parameters calibrated to the ratios of company and GST revenues
to GDP. The resulting e¤ective corporation tax rate is about 24 percent and the e¤ective
consumption tax rate is about 6.7 percent, which is approximately GST revenue (Commonwealth of Australia, 2009) over private consumption expenditures ABS (2009a).6
The income tax function approximates the 2008-09 personal income tax schedule.
The approximation tax function is estimated by nonlinear least squares. A grid of equally
spaced incomes in the range [0, 200] and the corresponding income taxes are generated.
There are 401 observations for both variables income and income tax, both expressed in
units of $1,000. The income tax schedule, T y, is rescaled in the model to be expressed
as all other variables in units of $100,000.
We also assume that the government pays bene…ts only to low-income households aged
21 to 60 that are ‡at and equal to 33 percent of their average disposable income (ABS,
2009c).
The age pension policy setting and parameters in this calibration model are as of 20
March 2009 and the concessional superannuation tax rates of 15 percent are applied to
contributions and fund’s investment earnings while lump-sum superannuation bene…ts are
assumed to be paid out tax free.
2.3.2
Simulation results and comparison with data
This section presents the simulation results at macroeconomic and disaggregate household
levels generated by the model and provides comparison with the actual data.
Table 2.4 indicates that the model replicates the Australian economy fairly well. The
components of domestic aggregate demand are close to their actual values expressed in
percent of GDP, except for the trade balance (i.e., external demand), which is implied
by the targeted negative foreign assets. The same holds for the displayed government
indicators. The receipts from personal income taxation are also greater than the actual
revenue in 2008-09. This is because the model does not account for any tax o¤sets, thus
taxing more households on lower personal incomes.
The di¤erence between the model and actual revenues from superannuation taxation
6
Note that the consumption tax base includes only the GST (not all taxes on goods and services).
Incorporating all consumption taxes would generate an e¤ective consumption tax rate well over 10 percent.
The expenditure side of the government budget does not incorporate all government expenditures. Higher
e¤ective consumption tax rate would then generate greater G/Y ratio and lower C/Y without introducing
other government expenditures.
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
14
can be explained by (i) the full maturity of the superannuation system assumed in the
model and (ii) imposing the statutory concessional tax rate on fund’s investment earnings
rather than the e¤ective one. Applying the e¤ective fund’s investment earnings tax rate,
which is about seven percent, would generate lower superannuation tax revenue but at
the same time, it would also lead to a signi…cantly greater superannuation assets accumulation. Currently, given the 40 year period of receiving the nine percent mandatory
contributions, the model generates about half of the total assets held in superannuation
and the other half in ordinary private assets. If the lower e¤ective earnings tax rate is used
instead, the share of superannuation assets would increase signi…cantly while the proportion of ordinary private assets in total assets would decline due to higher superannuation
o¤sets.
Figure 2.1 shows life-cycle pro…les of consumption, total and ordinary private assets,
total income, age pension and labour supply for each income type of households generated
by the model simulation. Households choose consumption, leisure and labour supply at
each age to maximize their lifetime utility subject to budget and time constraints.
As shown in Figure 2.1, consumption pro…les are hump-shaped with the intra-generational
di¤erences arising mainly from exogenous earnings ability pro…les discussed in the previous section on parameterization of the model. Labour supply presented as a fraction
of time spent at work is smallest for low-income households. These households between
ages 21 and 60 receive some government bene…ts that generates the income e¤ect on
their labour supply. This together with their lower productivity is behind fewer hours
worked relative to the other two income groups. Middle-income households retire fully
from workforce at age 65 because of higher e¤ective marginal tax rates coming from the
binding income test of the age pension and progressive income taxes. On the other hand,
high-income households una¤ected by the age pension means testing at early age pension
ages provide some labour supply and retire after age 70. For low-income households the
means test is never binding and therefore, they get the full pension from age 65 onwards
(the eligibility age pension age in 2008-09).
Total income consists of labour earnings, investment income, age pension and government bene…ts only received by low-income households aged 21 to 65 years. Labour
earnings are the major source of total income for all three households during their working
years while the age pension becomes the main source of total income for middle-income
and especially low-income households in retirement. The rapid increase in total income
of middle- and high-income households at age 61 is caused by a higher investment income
generated by superannuation savings paid to private assets accounts at age 60.
The total assets pro…les that include ordinary private and superannuation assets are
also hump-shaped. Superannuation assets are accumulated through mandatory contributions and investment earnings in the superannuation fund until age 60. At the age,
the fund is assumed to pay out the superannuation savings into ordinary private assets
accounts and superannuation assets accumulations cease to exist. As shown, after age 60
there are ordinary private assets that are run down to fund retirement consumption.
Figure 2.2 provides comparison of average life-cycle pro…les from the model simulation
(weighted across the three income types of households) with HILDA life-cycle pro…les. The
shapes of the displayed model and HILDA pro…les are very similar. However, the HILDA
pro…les relate to year 2005 and so this partly explains why the model pro…les of average
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
15
labour earnings and assets in the calibration year of 2008-09 are greater. As mentioned,
the other reason for larger superannuation assets and thus total assets relative to those
obtained from HILDA data sets is the assumed 40 years’ superannuation accumulation
while the superannuation guarantee was introduced in 1992.
2.4
Baseline simulation
In this section we discuss the methodology of implementing the baseline simulation. The
baseline simulation consists of an initial steady state that is based upon the tax and
pension policy settings in 2009-10, which includes an eligibility age for the age pension
of 65 years. Because of a phased increase in the eligibility age for the age pension, the
baseline solution moves from the initial steady state along a transition path to a new
steady state based upon the new …nal eligibility age of 67 years. In addition to this time
dependence of the baseline solution due to the gradual phasing in of the higher eligibility
age, the solution is also a¤ected by the other changes to the income taxation schedule
and to the age pension rate and means test.
The baseline solution to the model (comprising the initial steady state, the …nal steady
state and the transition path between these steady states) is the solution with which each
of the policy simulation solutions is compared. Importantly, as mentioned above, the
baseline solution to the model re‡ects the policy settings that are currently (2009-10) in
force so the research strategy is to compare the e¤ects of new policy changes with those
obtained under the current policy settings.
2.4.1
Baseline amendments to model parameterization
The baseline simulation is based upon the income tax and pension policy rules applicable
in 2009-10. Under these policies, the 2009-10 personal income taxes were reduced and
substantial changes were made to the pension system e¤ective from 20 September 2009.
The major pension changes implemented in the initial steady state are (i) an increase in
the legislated ratio of maximum single rate pension to the Male Total Average Weekly
Earnings (MTAWE) from 25 to 27.7 percent that led to over 10 percent increase in the
base rate of the maximum age pension, (ii) means test changes such as the increase in the
income taper rate from 40 to 50 percent and only half of labour earnings up to $13000
per year income tested and (iii) gradual increases in the age pension age from 65 to 67
years.
To implement the …rst pension policy change, we calculate the ratio of the maximum
age pension (set as a parameter to its value on 20 March 2009) to average gross labour
earnings in the calibration model. We use only gross labour earnings of households aged
between 35 and 50 years. However, their hours worked range from 30 to 38 hours per
week, which is below 40 hours worked on average by full-time earners used in calculations
of gross MTAWE. We then compute a "maximum pension base" factor as the model
generated ratio of maximum pension to average gross earnings divided by the statutory
ratio of 0.25.7 In the initial steady state of the baseline simulation of the model, we
7
The "maximum pension base" factor is greater than unity as average gross labour earnings in the
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
16
endogenize the maximum age pension such that it amounts to the maximum pension base
factor multiplied by the new statutory ratio of 0.277 and by average gross labour earnings
of households aged 35 to 50 years. Then, in the baseline transition to a new steady state,
the maximum single rate is set to greater of the legislated ratio of average gross labour
earnings and the maximum age pension calculated under the initial steady state. This
means that the maximum rate of the age pension can never decline below the legislated
ratio of average gross labour earnings or its value in the initial steady state.8
The income tax cut and especially the increase in the maximum age pension in 200910 would require some adjustments to be made to balance the government budget, an
assumption of our model. Rather than raising the statutory consumption tax rate to
maintain a balanced budget, we endogenize the government consumption to output ratio
to ensure a balanced budget. In the initial steady state, the G/Y ratio decreases to 0.169
(in the calibration based upon 2008-09 policy settings, G/Y was 0.174) because of higher
age pension expenditures and lower income tax revenue.
Gradual increases in the eligibility age for the age pension were announced in the 200910 federal budget but they are to be implemented in the future according to a prescribed
timing. In the baseline simulation, we assume that the age pension age is increased to 66
in 2018 (i.e., the …rst generation eligible for the age pension from this higher age pension
age is aged 57 years at the time of the policy announcement) and to 67 in 2023 (i.e., the
…rst generation eligible for the age pension from this higher age pension age is aged 52
years at the time of the policy announcement), approximately re‡ecting the announced
schedule for the pension age increases.9
2.4.2
Baseline solution
This section presents and discusses the macroeconomic solutions from the baseline simulation of the model. Since the baseline simulation is based upon the policy settings
applicable for the …nancial year 2009-10, it involves a phased increase in the eligibility age
for the age pension from 65 to 67 years. Accordingly, the baseline solution moves from an
initial steady state along a transition path to a new steady state. It is this solution with
which the various policy reform solutions will be compared in the following chapter.
The main features of this transition path for macroeconomic variables of most interest
may be discerned from Table 2.5 and Figure 2.3(a-d). Table 2.5 presents the level values
of the macroeconomic variables in the initial steady state and in the selected years of the
baseline transition path.10 More detailed macroeconomic results are presented by Figure
calibration simulation (for average hours worked) are smaller than MTAWE (for hours worked by full-time
earners only). This means that the purpose of this pension base factor is to account for the di¤erence
between MTAWE and average gross labour earnings generated by the model.
8
This holds not only for the baseline simulation but for all policy simulations listed in the next section.
9
The government’s schedule increases the eligibility age for the age pension (i) to 65.5 in July 2017 for
those currently aged 55.5 to 57, (ii) to 66 in July 2021 for current ages of 54 to 55.5, (iii) to 66.5 in July
2021 for current ages of 52.5 to 54 and (iv) to 67 in July 2023 for those currently aged 52.5 or younger.
10
Recall that all the monetary variables are expressed in units of $100,000 per capita. This implies
that output per capita (GDP per capita) in the initial steady state equals about $68,000, which should
be compared to GDP per civilian population. The presented wage rate is the market wage rate paid to
households and is normalised to unity. The labour supply is expressed as a fraction of time spent working
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
17
2.3, which plots percentage deviations in the selected variables from the initial steady
state.
The policy of the higher age pension eligibility age slightly increases pension costs to
the government only initially but, as Figure 2.3(a) shows, there is almost a …ve percent
decline in the government pension costs in 2018 when the eligibility age is increased
to 66 years, followed by another …ve percent decline in 2023 when the eligibility age is
increased to 67 years. In the long run, the pension costs are almost 10 percent lower
relative to the initial steady state mainly due to a shorter period of pension payments to
low- and middle-income households. The transitional impacts on the pension costs are
closely correlated with the changes in the statutory consumption tax rate that, by our
assumption, is adjusted to balance the government budget. The consumption tax rate
declines also by almost 10 percent in the long run (from 10 percent to about 9 percent).
The policy e¤ects on aggregate labour supply are positive, as shown in Figure 2.3(b).
Smaller pensions paid to low- and middle-income households over shorter periods generate
a substitution e¤ect on their lifetime labour supply. When the eligibility age increases
are phased in, aggregate labour supply goes up rapidly because of the shift of retirement
ages for the two a¤ected household groups to the new eligibility ages. Higher aggregate
labour supply by households causes a lower wage rate during the transition to the new
steady state solution.
Domestic total assets grow over the entire transition period (Figure 2.3(c)), supported
by higher private assets and superannuation asset accumulations. Both types of assets
increase because of higher labour supply and lower consumption taxes. In the long run,
domestic total assets are up by almost 2.3 percent. The policy e¤ects of the capital stock
are also positive due to a higher price of capital. The increases in the domestic total assets
exceed those in the value of capital, causing domestic saving exports and improvements
in Australia’s foreign liabilities position.
The e¤ects of the higher age pension age policy upon the economy are positive both
in the short run and in the long run (Figure 2.3(d)). Initially, output is greater due to
higher investment, government consumption and a positive trade balance (not plotted).
In the subsequent years, the output increases even further because of increasing aggregate
consumption. The policy impact on this largest component of output improves over the
transition period as the consumption tax rate decreases.
2.5
Policy simulations
The policy changes that are simulated using the overlapping generations model are listed
below, with a detailed description provided in the next chapter.
Simulation I – A reduction in the statutory corporation tax rate
Simulation II – An increase in the mandatory superannuation contribution rate
Simulation III – Changes to taxation of superannuation contributions
per average household (per capita).
CHAPTER 2. THE OVERLAPPING GENERATIONS MODEL
Simulation IV – A reduction in the superannuation fund earnings tax rate
Simulation V – A preferential tax treatment of private investment income
Simulation VI – A uniform personal income tax cut
Simulation VII – A tax on intergenerational transfers
Simulation VIII – Gradual increases in superannuation preservation age
Simulation IX – Aggregation of simulations I, III, IV, V and VIII.
18
Chapter 3
Policy Simulation Results
In this chapter we present the welfare and macroeconomic results of the policy simulations.
We start with a detailed description and a model implementation of each of the policy
simulations. Then we discuss the welfare and macroeconomic policy impacts in the short
run, during the transition path and in the long run. We close this chapter by summarizing
long run and short run macroeconomic impacts of the proposed simulations.
The output presented in the tables and …gures comprise the implications for the main
macroeconomic variables in the model and the welfare implications for the three di¤erent
household types at di¤erent ages. Here we brie‡y describe the general contents of these
tables and graphs.
Macroeconomic implications: The macroeconomic implications of the simulated
policy changes are presented as the percentage changes in the main model variables from
the baseline simulation in Tables 3.1 to 3.9. The following discussion involves the impacts
of each policy change on the labour market, capital accumulations, output market and
government indicators in the short run, over the transition and in the long run. The
tables also reports the level values of the presented variables in the initial and …nal steady
states of the baseline simulation, and the level values in the new steady state for each
policy change. The level values for all the monetary variables are expressed in units of
$100,000 and per model capita (which should be compared with actual data per civilian
population).
Welfare implications: The welfare implications are assessed on the basis of equivalent variations for generations (cohorts) of each income class. The equivalent variation for
a particular generation is de…ned as the percentage increase in this generation’s wealth in
each year of remaining life needed under the baseline simulation to produce the realized
remaining lifetime utility in the policy reform scenario. Given the homogenous property
of the utility function (see Auerbach and Kotliko¤, 1987, p.87), these increases in generations’ wealth are identical to the proportional increases in consumption and leisure, which
would make them in the benchmark scenario as well o¤ as in the reformed scenario.
The welfare plots (Figures 3.1(a-h) and Figure 3.2) records on the horizontal axis the
periods when each generation enters the model relative to the period of the policy change,
which is assumed to be period 0. A generation’s age at the time of the policy shift can be
obtained by subtracting the number on the horizontal axis from the assumed entry age
19
CHAPTER 3. POLICY SIMULATION RESULTS
20
of 21.1
3.1
3.1.1
Simulation I – A reduction in the statutory corporation tax rate
Policy change
In this simulation, the statutory corporation tax rate is reduced from the existing 30
percent by …ve percentage points to a new rate of 25 percent. Given the corporation
base factor calibrated to target the 2008-09 corporation tax revenue to output ratio in
the calibration model, this …ve percentage point reduction in the statutory corporation
tax rate (i.e., 16.67 percent reduction) leads to a reduction in the e¤ective corporation
tax rate of about 0.24 to 20 percent. The macroeconomic results of this policy simulation
are presented in Table 3.1 and the welfare implications are plotted in Figure 3.1(a).
3.1.2
Overview
The main e¤ect of this policy change is to reduce the costs of using capital and, hence, to
increase the pro…tability of using capital as an input for production. This reduction in the
cost of capital relative to labour increases the incentive of producers to use more capital
per unit of labour in production. Therefore, a long run implication is for the capital stock
to increase (as does long run investment to maintain this higher level of capital stock),
with the increase funded through foreign in‡ows of funds. An associated consequence
of lower production costs is that output also increases, with pressure put on the labour
market. This manifests itself in higher wages, but not higher labour supply in the long
run.
Another important direct consequence of the policy change is a reduction in government corporation tax revenues. While the increase in output over time raises some
government tax revenues, the main impact is on the consumption tax rate. This has to
rise signi…cantly to maintain a balanced government budget by increasing consumption
tax revenues to replace the lost corporation tax revenues.
The welfare e¤ects upon households are dominated by the higher consumption tax
rate required to balance the government budget and the higher wage rates arising from
the growth in output. It is readily seen from the welfare graphs that all three household
types su¤er a reduction in welfare upon impact, primarily due to the higher consumption
tax rate, and that these negative welfare e¤ects are strongest for older Australians. While
welfare improves for younger generations as the economy expands and incomes increase,
primarily due to wage increases, none of the household types gain in the long run. The
middle and higher income groups end up with welfare unchanged as a result of the policy
change, while lower income households su¤er the brunt of higher consumption taxes.
Under an alternative assumption that government consumption is kept constant, the
long run welfare of all three household types improves due to the smaller increases in
1
For example, the generation born 40 years (-40) prior to the policy change is 61 years old at the time
of reform.
CHAPTER 3. POLICY SIMULATION RESULTS
21
the consumption tax rate than under the assumption of a constant ratio of government
consumption to output (see Section 4.5).
These are the main implications of the policy change. We now proceed to a more
detailed description of the macroeconomic and welfare changes.
3.1.3
Macroeconomic implications
Labour market:
Aggregate labour supply falls by 0.434 percent on impact as older generations of all
three income types facing signi…cantly higher consumption taxes work less. In the subsequent years, the labour input improves, even rising above that in the baseline simulation.
This is because younger generations work more when their productivity is rising as they
get paid a higher market wage rate (w). The market wage rate goes up over the entire
transition path as the corporation tax cut increases net return to capital, which then leads
to capital deepening (i.e., higher capital labour ratio). In the long run, the market wage
rate increases by 1.756 percent. This has the income e¤ect on average household labour
supply, leading to a minor decrease in long term aggregate labour supply.
Assets and capital:
This policy increases demand for capital (because of higher net return to capital) that
grows over the entire transition. In the long run, the capital stock increases by 4.678
percent. The impacts on domestic total assets are negative for most of the transition
path as negative e¤ects of higher consumption taxes outweigh the positive e¤ects of higher
wages on assets accumulations. However, domestic total assets increase by about 0.974
percent in the long run, with both aggregate ordinary private and superannuation assets
rising above their baseline levels. This implies increases in aggregate domestic savings,
which are far less than the capital stock increase, thus causing capital imports and a
further increase in the foreign net liabilities.
Goods market:
Output decreases on impact, but the economy expands in the subsequent years because
of the growing capital stock. In the long run, output is 1.921 percent higher than under
the baseline simulation. The impacts on aggregate consumption are negative. In the
short run, generations consume signi…cantly less because of a higher consumption tax
rate (o¤setting the decrease in the corporation tax revenue). During the transition path,
aggregate consumption improves relative to the impact e¤ect as younger and future born
generations are paid higher and increasing wages. Because of the signi…cantly positive
policy e¤ect on the price of capital (that indicates that investors expect a higher net
return on capital), investment demand - the second largest component of output - goes
up. The trade account (or net export) that balances domestic demand and output is
initially negative but in future years, it becomes positive as output grows faster than
domestic demand.
Government indicators:
Apart from …rst few years, total government expenditures go up due to rising pension
costs and especially because of higher government consumption that increases, under
our assumptions, in the same proportion as output. The higher pension expenditures
are caused by increases in the maximum rate of the age pension benchmarked to higher
CHAPTER 3. POLICY SIMULATION RESULTS
22
average labour earnings (that are higher due to rising wages). In the long run, the age
pension expenditures are up by 1.672 percent. Tax receipts from personal income taxation
are greater, which arises mainly from higher labour earnings but also from higher age
pension payments and from improvements in investment income in the long run.
The 16.7 percent cut in the corporation tax rate reduces the corporation tax revenue
by almost 19.6 percent on impact. This revenue improves in the subsequent transition
years because of greater …rm’s revenue (given by increasing output). In the long run, the
corporation tax receipts are about 17 percent lower. This long term decline is still above
the 16.7 cut in the corporation tax rate, caused by higher tax deductible expenses of the
producer on labour costs and especially on capital depreciation. That is, in the long run,
the lower corporation tax rate encourages investment in the capital stock, which increases
by around 4.7 percent, and encourages greater production. This, in turn, increases the
demand for labour causing the market wage rate to rise. In the long run, therefore,
…rms have lower taxable pro…ts due to greater tax deductions on capital depreciation
and total wage bill (including higher superannuation guarantee contributions). In short,
general equilibrium e¤ects of a decrease in the corporation tax rate reduce the corporation
income tax base in the long run so the corporation tax receipts decline.
3.1.4
Welfare implications
The welfare implications for old generations of all three income groups, as shown
in Figure 3.1(a) are negative, with welfare falling by 0.68 for the oldest low-income
households, by 0.64 for the oldest middle-income households and by 0.55 for the
oldest high-income households. This is because of a higher consumption tax rate
that increases to o¤set the corporation tax revenue losses.
The welfare of younger cohorts and future born generations of all three income
groups improves due to higher wages paid by the producer. Younger generations
directly gain from a rising market wage rate through greater labour earnings and
consumption. Older, already retired generations also bene…t from a higher wages
through a higher maximum base rate of the age pension that is set to 27.7 percent
of average labour earnings. The resulting larger pension payments also explain
rapid welfare improvements for lower income households, for whom the age pension
represents by far the major component of their total income.
In the long run, welfare is almost unchanged for middle and high income households.
In fact, middle income households gain negligibly in the long run, implying that the
positive e¤ect of higher wages outweighs the negative e¤ect of increased consumption
taxes on lifetime consumption. For lower income households, the increase in the
consumption tax rate dominates, causing about 0.12 percent loss in the long term
welfare.
CHAPTER 3. POLICY SIMULATION RESULTS
3.2
3.2.1
23
Simulation II – An increase in the mandatory
superannuation contribution rate
Policy change
The superannuation guarantee contribution rate is increased from nine percent by thee
percentage points to a new rate of 12 percent. The initial steady state value of the
superannuation guarantee contribution rate represents the statutory contribution rate
that employers in Australia are mandated to paid on behalf of their workers. The rate
applies to gross labour earnings and the employer claims it as a tax deductible expense
(i.e., these mandatory superannuation contributions are included in the total wage bill
and thus they reduce the …rm’s taxable pro…t).
3.2.2
Overview
The increase in the superannuation guarantee contribution rate will directly increase the
superannuation assets available to employees upon reaching the access age, which is set
to 60 years in our model speci…cation. The resulting increase in total assets and interest
income upon reaching the eligibility age for the age pension should, therefore, mean that
the assets and/or income tests are more binding for some potential age pension recipients
and hence that age pension expenditures by the government decline. This outcome is
achieved as can be seen from the result in Table 3.2 that age pension expenditures fall
throughout the transition period and by 0.88 percent in the long run compared to the
baseline solution. In this sense, there has been a substitution between the age pension
and superannuation as retirement supports, albeit a small one.
However, there are several indirect e¤ects that are important. First, the higher contribution rate provides an incentive for households to work more hours, when most productive, to enlarge their superannuation payouts. This occurs amongst middle and higher
income households, but not for low income households for whom superannuation is less
important. A consequence of this behavioural response is that the wage rate falls. This
provides an incentive for the production sector to increase production and this, in turn,
encourages an equi-proportional increase in the long run capital stock.
Second, household will alter their saving behaviour of the life cycle in response to
the increased future superannuation payout arising from the higher contribution rate.
Speci…cally, there is now less incentive to undertake private saving. This e¤ect is quite
signi…cant as can be seen from Table 3.2, which shows that, while superannuation assets
increase (over the baseline outcome) by over 30 percent, private assets fall by almost 23
percent. Thus, there has been a partial substitution of mandatory superannuation for
private saving. Third, middle and high income households feel wealthier and alter their
life cycle consumption pro…les, increasing consumption over many ages. The upshot is an
increase in aggregate consumption.
Although pension expenditures by the government fall as a result of the policy change,
income taxes decrease (due to lower labour earnings as a result of the wage drop) and have
to be compensated through an increase in the consumption tax rate. This tax increase is
largely responsible for low income households, who rely on the age pension rather than
CHAPTER 3. POLICY SIMULATION RESULTS
24
superannuation in retirement, being worse o¤ under this policy change, as illustrated in
Figure 3.1(b). While older generation of all household types su¤er losses in welfare, the
higher superannuation assets arising from the policy change bene…t future generations in
the middle and (especially) high income groups, since they rely more signi…cantly upon
superannuation in retirement.
3.2.3
Macroeconomic implications
Labour market:
The higher superannuation guarantee rate policy raises aggregate labour by 0.755 percent on impact. Generations aged 60 years and younger at the time this policy is adopted
increase their working hours to earn greater labour income and thus to receive higher
superannuation contributions. Therefore, the policy generates labour supply incentives.
After few years of the transition, the labour input starts to decline relative to the impact
e¤ect. This is because of the income e¤ect of larger superannuation assets accumulated by
younger cohorts through the increased superannuation guarantee rate made over a longer
period. In fact, future born generations of middle- and high-income households work
more when they are young and their productivity is rising but less at older working ages
when their productivity declines. In the new steady state, the labour input is 0.55 percent
greater. The wage rate presented in Table 3.2 (and the tables with macroeconomic results
for the other simulations) is the market wage rate received by households.2 This wage
rate falls by 2.957 percent on impact, mainly caused by the increased superannuation
guarantee contribution rate paid by the producer. In the subsequent years, the wage rate
improves relative to the impact e¤ect and converges to a new market wage rate that is
2.679 percent smaller than under the baseline simulation; a percentage decline needed to
keep the long run marginal product of labour unchanged under this policy simulation of
three percentage point increase in the superannuation guarantee contribution rate.3
Assets and capital:
The domestic total asset accumulation is impacted positively as the increases in superannuation assets caused by the higher superannuation guarantee contribution rate more
than compensate for the declines in ordinary private assets (some superannuation o¤sets
experienced especially by liquidity unconstrained younger households). The stock of domestic total assets is 2.373 percent higher in the long run, implying the positive e¤ect of
this policy simulation on household savings. Some of the domestic saving increases are in2
Note that the wage rate paid by the …rm is this market wage rate plus the superannuation guarantee
contribution. This superannuation adjusted wage rate, which is set to equal to the marginal product of
labour (one of the pro…t maximization condition), is unchanged in the long run.
3
In the long run, the marginal product of labour, the wage rate paid by …rms (that includes the
SG contribution rate) and capital labour ratio are determined by the exogenous word interest rate and
the production function parameters in this open economy model. Because of the interest rate and the
parameters are constant, in the long run, the wage rate paid by …rms has to return to its initial rate
and the capital sock has match the percentage changes in aggregate labour supply (aggregated across the
generations of three income classes) for the long run capital labour ratio to be constant. The constant
return to scale property of the production function then implies the same long run percentage change
in output to those in aggregate labour supply (the small open economy argument with the exogenous
interest rate).
CHAPTER 3. POLICY SIMULATION RESULTS
25
vested in higher domestic capital and some are invested abroad, leading to improvements
in the foreign assets position during the transition path. As shown, foreign assets decline
only on impact because of a higher capital price that raises the value of the capital stock
(with both capital and total assets stocks …xed in the …rst year of the transition).
Goods market:
The policy e¤ects upon the economy are positive. Output goes up by 0.440 percent
on impact and in the subsequent years, it keeps on rising, with the long run impacts determined by the percentage changes in aggregate labour supply. Aggregate consumption,
that constitutes the largest component of output, increases over the entire transition path
to a new steady state value of 0.836 percent higher than in the baseline simulation. This
is because of higher consumption of young and future born generations of middle and
high income households, bene…ting from larger lifetime assets. The investment demand
improves due to a higher capital price. The positive changes in public demand, government consumption, are identical to those in output as the government in the model is
assumed to maintain the government consumption-output ratio obtained from the initial
steady state of the baseline simulation. The last component of aggregate demand, the
trade balance improves initially as output goes up while domestic demand decreases (due
to lower aggregate consumption). The long run e¤ect on the trade account is negative as
domestic demand increases more than output.
Government indicators:
Total government expenditures immediately go up as the increase in government
spending outweighs the decline in pension expenditures. The decline in pension expenditures results from a more binding means test and a lower maximum pension rate in
the short run.4 The receipts from income taxation decline because of the lower market
wage rate and also increased borrowing by young generations of middle and high income
households against larger future superannuation payouts, which generates lower private
investment income. The superannuation tax receipts are up signi…cantly as a result of
higher superannuation contributions. At the time of the policy change, the consumption tax rate increases by 4.81 percent to o¤set the decline in income tax revenue. In
the long-run, the consumption tax rate is up by 9.6 percent compared to the baseline
simulation.
3.2.4
Welfare implications
As depicted by Figure 3.1(b), old generations that are not directly a¤ected by this
policy change (those out of labour force not receiving employer superannuation
contributions) attain lower welfare due to higher consumption taxes that go up to
compensate for lower income tax receipts (falling mainly due to lower market wages).
All generations supplying some labour are paid the increased 12 percent superannuation guarantee contribution rate, which causes welfare of middle and high income
households to go up. On the other hand, welfare of younger generations of lower
income households younger than 60 years at the time of the policy change declines.
4
While the pension rate cannot fall below the initial baseline steady state value, it declines relative to
the baseline solution along the transition path.
CHAPTER 3. POLICY SIMULATION RESULTS
26
These households are liquidity constrained and cannot smooth their consumption by
spending more prior to the superannuation preservation age and by consuming less
in retirement. Moreover, they receive a lower market wage rate from their labour
supply that is behind smaller labour earnings and pre-retirement consumption.
Future born generations of higher income households gain the most in terms of welfare, about 0.34 percent. Future-born generations of middle income households also
achieve higher welfare while the long run welfare impact on low-income households
is negative by about 0.22 percent.5
3.3
3.3.1
Simulation III – Changes to taxation of superannuation contributions
Policy change
Under the baseline simulation, superannuation contributions are taxed at a concessional
tax rate of 15 percent. In this simulation, the superannuation contributions are included
as a one of the components of total taxable income. The concessional tax rate on superannuation contributions is abolished and a uniform 15 percent contribution rebate is paid
to all income classes for the assumed 40 year period of the superannuation assets accumulation. This refundable contribution rebate is paid by the government. The simulation
results of this policy are reported in Table 3.3 and Figure 3.1(c).
3.3.2
Overview
E¤ectively, the policy makes superannuation contributions tax free for low income households on a 15 percent marginal tax bracket, taxable at the current 15 percent for those on
a 30 percent marginal tax bracket, and at correspondingly higher e¤ective tax rates for
households in higher income tax brackets. In short, contributions are taxed at progressive
e¤ective rates. Accordingly, compared to the existing superannuation policy, the new
policy provides tax advantages for those on low incomes, is neutral for those in the 30
percent tax bracket, and provides tax disadvantages for those on higher incomes.
One impact of this policy change is for aggregate labour supply to fall slightly, on
impact and over the complete transition period, resulting in a 0.55 percent fall in the
long run. Older workers in the low income household group increase hours of work prior
to age 60 years (when superannuation assets become available) to take advantage of the
5
Note that current superannuation policy legislation imposes limits on employer contributions (that
includes mandatory superannuation guarantee contributions implemented in the model and also other
employer contributions such as salary scarifying contributions that are not modelled in our framework).
As many higher income earners voluntarily sacri…ce some of their gross wages into superannuation though
these concessional contributions, they, in fact, may lose in welfare from this policy if they already are paid
maximum contributions (or their mandatory employer contributions are close to the limit) and the limits
would not be increased under the hypothetical policy of a higher superannuation guarantee rate. Higher
superannuation guarantee rate with the unchanged limits on employer contributions would then generate
less negative impacts on the market wage rate, improving welfare of lower income working households.
CHAPTER 3. POLICY SIMULATION RESULTS
27
tax bene…ts. However, those in middle and high income households reduce their hours
of work prior to age 60 years compared to the baseline case, since the new policy makes
superannuation a less pro…table investment.
The removal of the concessional contribution taxes leads to higher aggregate superannuation assets that increase throughout the transition and in the long run. However,
private assets decline (because after tax incomes have declined for high income households) more than the superannuation assets increase so total domestic assets decline as a
result of the policy change.6
Because of the removal of the superannuation contributions tax, superannuation taxation revenue declines. On the other hand, the government now will receive even more
income tax revenue (after the rebates) from the same amount of contributions, which
are now income taxable. Other things being constant, the government should obtain a
net increase in net aggregate tax revenue. However, middle and high income households
adjust their life cycle choices to reduce private assets and this means less interest income.
The outcome is that government revenue falls (everywhere along the transition path),
thus requiring an increase in the consumption tax rate, by 8.5 percent in the long run,
to balance the government budget. This consumption tax rate increase discourages consumption throughout the life cycle for middle and high income households (encourages
for low income households) and in aggregate, throughout the transition period. Output,
consumption and labour supply all fall.
The e¤ect on the government’s age pension expenditures is minimal. Low income
household continue to get the full age pension, high income households only do so at
advanced ages and middle income household are hardly a¤ected in their pension rates.
In terms of welfare, older people at the time of the policy change su¤er a reduction
largely because of the increase in the consumption tax rate. The future generations of low
income households clearly gain in welfare from the policy change as they receive the 15
percent contribution rebate and e¤ectively pay lower net taxes on their superannuation
contributions, have larger superannuation assets upon retirement, and still get the full age
pension. Future high income households lose signi…cantly since they face higher income
taxation. Future middle income households end up a little worse o¤ due mainly to the
higher consumption tax rate.
Overall, the policy change is e¤ectively a redistributive device favouring low at the
expense of high income households.
3.3.3
Macroeconomic implications
Labour market:
Aggregate labour supply declines by almost one percent on impact because of higher
income tax burden on middle- and high-income households.7 Although the labour input
6
The policy also e¤ectively removes salary sacri…ce. Voluntary salary sacri…ce is not included in our
model. If it had been, the baseline model would show signi…cant salary sacri…ce contributions by middle
and upper income households. The policy change would only allow post-tax contributions and so the
likely outcome would be a more signi…cant drop in superannuation assets.
7
Their superannuation contributions calculated from labour earnings are part of their taxable income
in this simulation.
CHAPTER 3. POLICY SIMULATION RESULTS
28
improves during in the subsequent years of the transition, the long term impact is still
negative with aggregate labour supply down by about 0.55 percent. Lower aggregate
labour supply (and negative impacts on the marginal product of labour) causes the market
wage rate to increase.
Assets and capital:
The policy impacts on domestic total assets are negative because of declines in aggregate ordinary private assets (due to lower labour supply and thus labour earnings of
middle- and high-income households that face higher income taxes). Even though aggregate superannuation assets increases substantially as a result of the abolition of the
15 percent concessional tax rate on superannuation contributions, domestic total assets
fall by 1.88 percent in the long run. The capital stock also declines but by less than
the decrease in domestic total assets, causing capital imports and further increasing net
foreign liabilities.
Goods market:
On impact, output decreases by 0.584 percent due to lower aggregate labour supply.
In the subsequent years, output keeps on falling but there is a slight improvement in
long run output relative to the impact e¤ect because of less negative policy e¤ects on the
labour input. Aggregate consumption also falls as young and future born generations of
middle income and high income households negatively a¤ected by higher income taxes
earn less and cut their consumption expenditures. Higher lifetime consumption of future
born low-income households is not enough to o¤set lower consumption of the other two
income classes. The impact on investment expenditures is negative because of a lower
capital price. Net export initially decreases to balance a higher decline in output relative
to that in domestic demand. This reverses in the medium run, with trade balance rising
by 4.393 percent in the long run.
Government indicators:
Total government expenditures presented in Table 3.3 also includes government contribution rebate (i.e., uniform 15 percent refundable rebate to households aged 21 to 60
when mandatory contributions to superannuation are made). This rebate is the reason
of why total government expenditures are signi…cantly higher. The pension costs initially
declines because of a lower maximum pension but in the long run, they are slightly up
by 0.07 percent. Because of taxing superannuation contributions at marginal income tax
rates (that for most middle income and especially higher income households are greater
than the 15 percent concessional tax rate on contributions in the baseline simulation),
the income tax receipts are signi…cantly higher. This biggest component of the total tax
revenue increases by over 10 percent on impact. The removal of the concessional contribution tax leads to lower superannuation tax receipts that are down by 44.32 percent in
the …rst period of the transition. The superannuation tax receipts improve as households
accumulate larger superannuation, with the long run superannuation tax revenue about
35 percent below that in the baseline simulation. The consumption tax rate increases by
1.1 percent in the short run and by 8.5 percent in the long run, caused mainly by the
contribution rebate and lower superannuation tax receipts.
CHAPTER 3. POLICY SIMULATION RESULTS
3.3.4
29
Welfare implications
Generations born 40 years prior to this policy changes (aged 61 years and over at the
time of the policy change) are not directly a¤ected but they lose welfare as they have
to pay a higher tax rate on their consumption. These generations also gets smaller
pensions due to a decline in the maximum rate of the age pension benchmarked to
27.7 percent of average labour earnings.
The welfare of younger generations of low-income households improves, with the lowincome individual aged 21 years at the time of this reform gaining about 0.3 percent
in remaining resources. This household bene…ts from lower taxes on superannuation
contributions (the marginal income tax rates for low income households are below
30 percent) and from receiving the 15 percent contribution rebate over the entire
superannuation accumulation period of 40 years. The similar story holds for the
middle-income households, with the welfare gains of 0.05 percent for the middleincome individual aged 21 years. On the other hand, the welfare of high-income
generations aged 60 and younger at the time of this shift decreases as the net tax on
superannuation contributions (accounting for the 15 percent contribution rebate)
is greater than the concessional tax rate of 15 percent assumed under the baseline
simulation.
The increases in the consumption tax rate and a falling market wage rate lead to
slightly lower welfare of future born low-income households relative to the welfare
gains for the 21 year old in low income household. The long run welfare of lowincome households is, however, still positive, about 0.2 percent higher than in the
baseline simulation. Future born generations of middle- and high-income households
experience welfare losses.
3.4
3.4.1
Simulation IV – A reduction in the superannuation fund’s earnings tax rate
Policy change
The statutory tax rate on superannuation fund’s investment earnings is cut from the
existing 15 percent rate to a new rate of 10 percent.
3.4.2
Overview
The clear direct implication of the reduction in the statutory tax rate on superannuation
fund’s investment earnings is to make superannuation a more pro…table investment for
households. As a result, other things unchanged, superannuation payouts will be higher
than previously due to a greater after-tax rate of accumulation within the fund.
This is clearly the case in the simulation results. Table 3.4 show that, as the new policy
works its way through current and future generations, superannuation funds increase in
size relative to their baseline levels and end up a little over 4 percent higher in the long run.
CHAPTER 3. POLICY SIMULATION RESULTS
30
The other major e¤ect of this policy is the reduction in tax revenue (lower superannuation
earnings taxes) for the government necessitating an increase in the consumption tax rate
to balance the budget. This e¤ect occurs upon impact and gradually increases in size
leading to a long run increase of 9.6 percent in the consumption tax rate.
Other macroeconomic e¤ects are minimal in size, including a rather small reduction
in age pension expenditures.
Life cycle e¤ects on households are also minimal. The only substantive e¤ect is that
superannuation assets increase over remaining years until age 60. This positive e¤ect is
higher the higher are superannuation contributions and these are related to labour earnings. Taking into account the negative welfare e¤ect of the higher consumption tax rate,
the policy change bene…ts future high income households (superannuation asset increases
outweigh consumption cost increases) but reduces the welfare of future low income households (the consumption tax increase dominates since superannuation assets are small)
with future middle income households neutrally e¤ected in welfare. All older households
at the time of the policy change attain lower welfare since they have no superannuation
funds but su¤er from the consumption tax rise; they subsidize younger cohorts.
3.4.3
Macroeconomic implications
Labour market:
There are positive e¤ects on labour supply in the short run. Older generations that at
the time of the policy change are near the superannuation payout age work longer hours
and earn greater labour income. This leads to higher superannuation contributions and
larger superannuation assets. In the medium and long run, the income e¤ect of rising
superannuation assets dominates, generating slightly lower aggregate labour supply.
Assets and capital accumulations:
The policy impacts on the capital stock are negative during the entire transition path
but in the long run, capital is only negligibly smaller by 0.03 percent. On the other
hand, domestic total assets are up because of higher superannuation assets that more
than compensate for lower ordinary private assets.8 Foreign assets improve by about 1.8
percent in the long run due to net out‡ows of higher domestic savings abroad.
Goods market:
The economy is positively a¤ected in the short run because of higher labour supply.
In the long run, output decreases slightly as both inputs to production are lower. The
impact on aggregate consumption is opposite to that on output, falling in the …rst 15 years
then it goes up slightly. The increases in aggregate consumption are caused by higher
consumption spending by future born generations of middle- and high-income households
as for them higher superannuation fund earnings that are taxed at the reduced tax rate and
received over a longer period generate larger superannuation assets with positive e¤ects
on their lifetime consumption. Lower aggregate consumption initially causes domestic
demand to fall while output is higher, implying that the trade balance improves. This
reverses after 2030 and trade balance deteriorates by 1.8 percent in the long run.
Government indicators:
8
Similarly to the policy of higher mandatory SG rate, liquidity unconstrained households borrow more
against larger superannuation payout, leading to some superannuation o¤sets and lower private assets.
CHAPTER 3. POLICY SIMULATION RESULTS
31
The …ve percentage point cut in the superannuation fund’s earnings tax rate leads to
a decline of 18.54 percent in the superannuation tax revenue on impact. This revenue
improves over time due to greater superannuation assets accumulations by all three income
classes. Higher superannuation assets (leading to larger total assets) are also behind lower
pension costs to government because of a more binding means test for especially middleincome households. The consumption tax rate needs to increase to o¤set the tax revenue
loss from superannuation taxation, thus making the government budget balanced. In
the long run, the consumption tax rate is up by 9.537 percent relative to the baseline
simulation.
3.4.4
Welfare implications
Similarly to simulation II, the …ve percentage point reduction in the superannuation
fund earnings tax rate generates welfare losses for those generations that already
collected their superannuation payouts and are una¤ected by the policy change. All
these generations have to pay a higher consumption tax rate that needs to increase
to o¤set mainly the decline in superannuation tax revenue.
Younger generations of all three income classes accumulating superannuation assets experience welfare improvements as their receive superannuation fund earnings
taxed at the reduced rate. The high-income individual born 18 years prior to the
policy change (aged 39 years at the time of the change) experiences largest welfare
gains, gaining over 0.1 percent in welfare. The similar welfare shapes for the other
two income types suggest that this policy has positive e¤ects especially on those
that already accumulated some superannuation assets.
The long run welfare implications of this superannuation policy simulation are positive for high- and middle-income households but negative for liquidity constrained
low-income households that cannot borrow against larger superannuation payouts
to fund higher pre-retirement consumption.
3.5
3.5.1
Simulation V – Preferential tax treatment of private investment income
Policy change
Under the baseline simulation, all investment income is included in taxable personal income. Here, only 60 percent of private investment income is included in taxable income
and taxed at marginal tax rates. The remaining 40 percent is exempt from personal income taxation (i.e., tax free proportion of investment earnings). This policy would re‡ect
a preferential tax treatment of income generated by savings held, for example, on bank
accounts.
CHAPTER 3. POLICY SIMULATION RESULTS
3.5.2
32
Overview
This policy change has interesting and complex implications. The policy reduces the
taxation of interest income and, other things being unchanged, should encourage the
accumulation of private assets.
This prediction is con…rmed by the simulation results in Table 3.5. Private assets
increase over the transition path, ending up almost 44 percent higher than the baseline
level in the long run (year 2150). A consequence of this is that reliance on the age
pension is reduced in the long run due to the income and/or asset tests being more
binding for many (middle income) households, government age pension expenditures being
lower by almost 5 percent. Other signi…cant macroeconomic implications include a long
run reduction in output, labour supply, capital stock and consumption - the economy
contracts - and a modest 2 percent increase in the consumption tax rate.
These broad macroeconomic e¤ects hide some more complex life cycle behavioural
responses by households. The following account of the more salient of these e¤ects is
based upon life cycle solutions arising from the simulation but not recorded in this report
fro space conservation reasons. Because the proposed policy increases the incentive to
accumulate private assets, households of most ages and all income types …nd it advantageous to revise their life cycle choices to take advantage of this. In particular, they are
encouraged to work longer hours (increasing their earning) and to reduce consumption at
early ages, thus increasing the amount of saving and levels of private assets. This turns
out to be the behavioural response for older and younger cohorts at the time of the policy change, thus causing an initial increase in labour supply and hence output. Further
into each household’s life cycle, the behavioural response is the reverse and they begin to
reap the rewards of frugality by increasing consumption and reducing hours of work, thus
saving less than at earlier ages and accumulating private assets more slowly. Aggregate
labour supply eventually (by 2030) falls as a result of the policy change and later along
the transition path aggregate consumption rises.
Overall, the private assets of all household types increase as a result of the policy
change. While this does not a¤ect the pension amounts received by low income households
(they continue to get the full pension), it does have e¤ects on pension payments to the
middle income type. The means tests are more binding for the households and so they
get lower pension payments once in receipt of the age pension. Moreover, high income
households have delayed receipts of the age pension.
In terms of welfare, the very old at the time of the policy change lose because their asset
incomes are too low to bene…t and they face the higher consumption tax rate. Younger
households, apart from the low income households that have little asset accumulation,
have su¢cient interest income from assets to bene…t from the tax concession and they all
experience increases in welfare. This is especially true for 60 year old households with
large assets, having just received their superannuation payouts. Future generations of all
income types experience welfare gains from this policy change due to having time to take
advantage of it from the beginnings of their working lives. Naturally, the more productive
a household, the greater the welfare gain.
CHAPTER 3. POLICY SIMULATION RESULTS
3.5.3
33
Macroeconomic implications
This policy change has very signi…cant impacts on the key macroeconomic variables and
as shown in Table 3.5, the short run impacts on many variables di¤er quite greatly from
those in the long run.
Labour market:
On impact, labour supply increases by 2.318 percent as older households work longer
hours to earn higher labour income and boost their ordinary assets that generate taxpreferred investment income under this policy simulation. In subsequent years, the labour
input declines and in the long run, it is down by 2.263 percent. The decreases are caused
by the income e¤ect of higher total assets accumulations on working hours experienced
by younger and future born generations of all three income types; these generations work
slightly more only at early working ages when their productivity is rising; but for the
most of their working life they cut signi…cantly their labour supply. The market wage
rate decreases initially but in the long run, it increases to return back to its initial steady
state rate.
Assets and capital:
As a result of this policy simulation, domestic total assets are higher and in the long
run, these assets are up by 23.449 percent. This long run increase is constituted mainly by
the 43.8 percent rise in aggregate ordinary private assets. Private assets accumulations
of all three income groups (higher income households especially) increase due to tax
incentives given by this policy to investment income. The capital stock expands initially
because of a higher capital price. In the long run, the capital stock, however, falls in
the same proportion as labour supply to keep the capital labour ratio constant in the
long run (see the small open economy argument). Apart from the …rst year of the policy
simulation, the foreign assets position improves as the increases in domestic total saving
are entirely exported abroad. Net foreign liabilities decline by 97.7 percent in the long
run.
Goods market:
The short-run increases in aggregate labour supply and the capital stock lead to higher
output that increases by 1.347 percent on impact. However, the falling labour input causes
output to decline. The largest component of output, aggregate consumption falls on impacts by over 2.9 percent as older generations of all income classes are negatively a¤ected
by a higher consumption tax rate while bene…ting only shortly from the investment income tax discount. In the long run, however, aggregate consumption is up by almost
1.8 percent due to higher consumption spending of all three households (higher income
households especially). Larger output and lower aggregate consumption (o¤setting increases in investment expenditures and public consumption and thus generating a decline
in domestic demand) lead to a signi…cant increase in the trade balance (net export) in
the short run. In the long run, the trade balance deteriorates due to lower output.
Government indicators:
The preferential tax treatment of investment income results in a 2.9 percent reduction in the personal income tax receipts in the …rst year of the transition. This biggest
component of total tax revenue declines more in the long run (by 4.4 percent) because of
not only the 40 percent investment income tax discount but also due to decreases in the
CHAPTER 3. POLICY SIMULATION RESULTS
34
other two components of personal taxable income, labour earnings and the age pension.
The age pension decreases for most of the transition path, with a long run decline of 4.64
percent caused by lager assets and investment income at older ages assessed under the
age pension means testing. Lower pension costs together with decreases in government
consumption lead to a 2.4 percent decrease in the long run total government expenditures.
This is in contrast to the increase of 1.149 percent in the total government expenditures
on impact. The consumption tax rate needs to increase to o¤set the losses from personal
income taxation. However, the increases in the consumption tax rate become smaller as
the size of the government budget declines. In the long run, the consumption tax rate is
still higher by about 2.1 percent.
3.5.4
Welfare implications
As indicated in Figure 3.1(e), very old generations of all three income groups attain lower welfare as they negatively a¤ected by a higher consumption tax rate
that is adjusted to o¤set lower income tax receipts and pay for higher government
consumption.
For younger generations of middle income households and especially high income
households, welfare increases signi…cantly due receiving the 40 percent tax discount
on investment income for a longer period. The generation of high-income households born 40 years prior to the change which is aged 61 years at the time of the
reform gain the most. One year prior to the policy change, this generation is paid
the superannuation payout into the private assets account that generates largest
investment income in the …rst years of the policy change. The welfare gain of this
generation is about 1.65 percent. Most generations of middle-income households
also achieve higher welfare while low-income generations born prior to the policy
changes experience small welfare losses. These lower income cohorts earn only small
investment income but, as with the other two income groups, they face signi…cantly
higher consumption taxes and lower wages initially.
The long run welfare e¤ects are higher for all three income types than those for the
generations aged 21 years at the time of the policy due to a declining consumption
tax rate with positive impacts on consumption, higher leisure (the income e¤ect
of signi…cantly larger domestic total assets on labour supply) and improvements in
the wage rate. In the long run, high-income households gain almost 0.9 percent,
middle-income households over 0.4 percent and low-income households about 0.2
percent in initial resources.
CHAPTER 3. POLICY SIMULATION RESULTS
3.6
3.6.1
35
Simulation VI – A reduction in personal income
taxation
Policy change
In this simulation, we assume a uniform 10 percent reduction in the total personal income
tax schedule (i.e., a personal income tax cut). We do this by multiplying the model total
income tax function by 0.9.
3.6.2
Overview
The major e¤ects of this personal income tax cut are likely to be felt in households’ life
cycle decisions and by the government, which su¤ers a loss of income tax revenue.
The income tax reduction immediately reduces income tax revenues, requiring an
increase in consumption taxes to maintain the balanced budget and this, in turn, requires
an increase in the consumption tax rate. The immediate impact is for this rate to increase
by a massive 36.7 percent from 0.10 to 0.137, as indicated in the column for year 2010
in Table 3.6. These e¤ects continue at a subduing rate throughout the transition path to
the new steady state equilibrium. Thus, households have two main shocks - an increase
in the consumption tax rate and lower income taxes.
The other main macroeconomic e¤ects of the policy change are a small long run
increase of 0.314 percent in the real economy (labour supply, capital stock and output) and
a 16 percent rise in private assets, leading to a small reduction in age pension expenditures.
The higher labour supplies reduce the wage rate except in the very long run.
Household life cycle responses vary. Although low income households continue to rely
heavily on getting the full age pension in retirement, they respond to the income tax
reduction consuming less over most of their working lives, more especially at younger
ages, to accumulate more private assets for retirement. They therefore save most of the
tax reductions. The same is true of old middle income households at the time of the policy
change. However, younger middle income and all generations of high income households
decide to modestly increase hours of work and to increase consumption over their entire
future lifespans. Thus, they work harder, consume more, and accumulate greater private
assets throughout their lives. The combination of the consumption e¤ects is for aggregate
consumption to fall for some years after the policy change but then to increase.
The welfare e¤ect on households aged at least 60 years is negative since the substantial
increase in the consumption tax rate is a burden that overweighs the slight income tax
reductions they get from relatively low incomes. This consumption tax burden continues
to weigh heavily on younger and future low income households, and younger middle income
households, that also have small taxable incomes. However, younger and future high
income, and future middle income households have su¢cient time and su¢ciently high
incomes to be able to bene…t from the income tax reduction Accordingly their welfare rises
as a result of the policy change, especially (and not surprisingly) high income households.
CHAPTER 3. POLICY SIMULATION RESULTS
3.6.3
36
Macroeconomic implications
Labour market:
This policy has positive impacts on aggregate labour supply in the short run, during
the transition path as well as in the long run, as shown in Table 3.6. On impact, aggregate
labour supply is up by almost 2 percent as older working generations of all three households
provide more labour supply. In the subsequent years, labour supply declines relative to
the impact e¤ect as the income e¤ect of larger accumulated assets becomes stronger. In
the long run, labour input is still 0.314 percent higher than the value under the baseline
simulation. The market wage rate falls by 0.737 percent on impact due to a lower marginal
product of labour (not displayed).
Assets and capital:
The policy e¤ects on domestic total assets are positive mainly due to larger private
assets that are 16.14 percent higher than in the baseline simulation. All three households
accumulate larger private assets as they earn higher labour income and pay lower income
taxes. Superannuation assets also grow, but far less than ordinary private assets as the
superannuation assets accumulation does not bene…t directly from lower income taxes.
The capital stock increases in the short run and medium run because of the positive e¤ect
on capital price that causes investment demand to expand, thus leading to larger capital
accumulations. The long run e¤ects are still positive, given by the changes in aggregate
labour supply. Except for …rst few years after the policy is adopted, the foreign assets
position improves as most of the increases in domestic total savings invested abroad.
Goods market:
The income tax cut increases output by 1.14 percent on impact due to higher aggregate
labour supply. Relative to the impact e¤ect, the economy (measured by output) contracts
but it is still 0.314 percent higher than under the baseline simulation. Aggregate consumption decreases initially as older already retired generations of all three income classes
consume less because of higher consumption taxes. After few years, aggregate consumption grows above that in the baseline simulation. In the long run, aggregate consumption
is 1.68 percent higher due to greater lifetime spending of all three income classes. The
second largest component of domestic demand, private investment expands as the price
of capital is higher. The e¤ect on the trade balance are positive initially but after 2030
when rising domestic demand (due to higher aggregate consumption) grows faster than
output, the impact on the trade balance start to be negative.
Government indicators:
The income tax cut leads to a 9.3 percent reduction in the personal income tax revenue.
The revenue improves in future years because of higher assets accumulations generating
greater investment income - a component of taxable personal income. In the long run, this
revenue is down by 8.36 percent. Even though the policy increases receipts from corporation and superannuation taxation, the consumption tax rate increases by over 36 percent
on impact. The reasons for this increase are the already mentioned decline in income tax
revenue, higher government consumption increasing in the same proportion as output and
greater pension costs (due to a higher maximum rate of the age pension benchmarked to
27.7 percent of average labour earnings). In the long run, the consumption tax rate is up
by 29 percent.
CHAPTER 3. POLICY SIMULATION RESULTS
3.6.4
37
Welfare implications
The uniform income tax cut has negative e¤ects on old generations of middle- and
high-income households that already retired from workforce and no longer earn
labour income. These households have to pay a higher tax rate on their consumption. The welfare decrease for very old generations of low-income households is signi…cantly smaller compared to the other two income types. These households derives
most of their total income from the age pension whose maximum rate benchmarked
to average gross labour earnings increases as a result of positive policy impacts on
average labour income.
Welfare of younger cohorts and future born generations of middle and high income
households improves. As shown by Figure 3.1(f), there is a signi…cant welfare improvement experienced by older high-income households participating in the workforce that bene…t from lower income taxes. On the other hand, welfare of older
low-income households nearing retirement declines because of the negative e¤ects of
higher consumption taxes and of discounting the increased maximum age pension
on their consumption.
The long run welfare implications of this policy are positive for high income and
middle income households, gaining about 0.9 percent and 0.2 percent of initial resources, respectively. Low-income households attain a welfare loss of about 0.22 percent, indicating that for them the adjustment in the consumption tax rate needed to
balance the government budget dominates the income tax cut implemented under
this simulation.
3.7
3.7.1
Simulation VII – A tax on intergenerational transfers
Policy change
The baseline simulation assumes that intergenerational transfers (represented by accidental bequests left by those who die at every age) are tax free. Here, we impose a tax of 10
percent on these accidental bequests.9
3.7.2
Overview
This policy has the direct e¤ect of reducing the net bequest receipts of households in this
age group. The main expected impacts will be on government tax revenue and upon the
remaining life cycle choices of this pre-retirement set of generations.
The macroeconomic outcomes presented in Table 3.7 show that the main e¤ect is,
indeed, on tax revenues. The government now receives the inter-generational taxes (not
9
Recall that accidental bequests are equal to total assets (consisting both superannuation and ordinary
private assets) of those who die. These assets are aggregated and equally redistributed within each income
type only to those households aged between 45 and 65 years.
CHAPTER 3. POLICY SIMULATION RESULTS
38
shown) and these are su¢ciently large to require a reduction in the consumption tax rate
of about 7 percent immediately rising to a nearly 9 percent reduction in the long run. The
aggregate e¤ect of household behavioural responses is for labour supply and consumption
(hence output and capital stock) to rise slightly (0.229 percent).
The small reduction in the consumption tax rate brings about a small increase in the
consumption of low income households. It is this e¤ect that yields a small increase in the
domestic demand for goods, and hence the level of production activity in the economy.
However, it is emphasized that these e¤ects are small.
The welfare of older Australians improves because of the reduction in the consumption
tax rate, as shown in Figure 3.1(g). Households aged 45 at the time of the policy change
in the middle and upper income groups su¤er the greatest loss of welfare; the lower
income households aged 45 years manage to be better o¤, though they bene…t least of
this income group. Future generations of low income households bene…t more than future
middle income households, while future high income households su¤er a small loss in
welfare. Clearly, the gain is greater for households for whom the consumption tax rate
matters most.
3.7.3
Macroeconomic implications
Labour market:
Aggregate labour supply increases by 0.3 percent on impact due to higher labour
supply of all three income types.10 In the long run, the labour input decreases slightly
relative to the impact e¤ect but it is still about 0.23 percent higher than in the baseline
simulation. The minor decrease relative to the impact e¤ect is caused by larger private
assets accumulations. The impact on the market wage rate is negative due to higher
aggregate labour supply.
Assets and capital:
The capital stock increases during the transition path because of higher investment
expenditures encouraged by the positive e¤ect of this simulation on the price of capital.
The aggregate stock of domestic total assets falls initially due to declining private assets
(because of lower intergenerational transfers). However, after 2020, domestic total assets
rise above the baseline domestic assets as both superannuation assets (through higher
contributions) and private assets (higher labour earnings and lower consumption taxes)
increase. In the long run, domestic total assets are up by 0.68 percent, which is more than
the long run increase in the capital stock, leading to capital exports and improvements in
the foreign assets position.
Goods market:
This policy has positive e¤ects on output that increases by 0.18 percent on impact, by
0.304 percent in 2030 and by 0.299 percent in the long run. Aggregate consumption also
go up as older generations face a lower consumption tax rate and future born generations
accumulate larger assets even though bequests received are lower. The trade balance
decreases on impact but because of higher output growing faster than domestic demand,
10
This tax reduces intergenerational transfers to those households that are assumed to receive them.
To o¤set the decline in their lifetime income, these households work longer hours to earn higher labour
income, resulting in greater aggregate labour supply.
CHAPTER 3. POLICY SIMULATION RESULTS
39
the trade balance improves in future years. In the long run, higher aggregate consumption
causes domestic demand growth to outstrip the output increase, implying a lower trade
balance.
Government indicators:
Total government expenditures are higher due to greater government consumption
and pension expenditures. The age pension expenditures increase because of a higher
maximum age pension supported by increases in average labour earnings. The consumption tax rate declines by 7.1 percent on impact due to the additional tax receipts from
intergeneration bequests. There are further decreases in this tax rate in the subsequent
years as the tax receipts from personal and superannuation taxation go up. In the long
run, the consumption tax rate declines by 8.957 percent to a rate of 8.21 percent.11
3.7.4
Welfare implications
Taxing intergenerational transfers (i.e., accidental bequests in the model) clearly
raises welfare of old generations of all three income types, with oldest low-income
household experiencing the largest welfare gains of about 0.25 percent. Consumption
of these generations aged over 65 years at the time of the policy change is positively
a¤ected by lower consumption taxes.
As shown in Figure 3.1(g), welfare of all three income types receiving accidental bequests rapidly decreases as these generations have to pay the 10 percent tax on these
transfers. The largest welfare loss is experienced by the high-income household that
just reach the age of 45 years when the policy is implemented - the …rst generation
to pay the tax from high bequest transfers. The welfare of other two income types
also is lowest for generations aged 45 years at the time of this policy change. The
reason why the 45 year old individuals are the worst a¤ected is that they are the
…rst to pay taxes on their bequests received over subsequent 20 years. In addition,
there is a further decline in the consumption tax rate during the transition period
so younger individuals are correspondingly more positively a¤ected.
Generations of all three income types younger than 45 years and future born generations experience welfare improvements due to further declines in consumption
taxes (as corporation and especially income tax receipts increase) and also due to
larger accumulations of private assets that imply greater intergenerational transfers
relative to the impact e¤ect. In the long run, the low and middle income households
gain in welfare while high-income households paying higher taxes on their bequest
transfers lose slightly.
11
Recall that the other factor that lowers the consumption tax rate is the higher age pension age, which
is increased gradually in the baseline simulation.
CHAPTER 3. POLICY SIMULATION RESULTS
3.8
3.8.1
40
Simulation VIII – Gradual increases in the superannuation preservation age
Policy change
In this policy simulation, the gradual superannuation age increases are phased in from
2024 with a one year increase in every two years. This means that the generation born
26 years prior to (aged 47 years at) the policy announcement and the generation born 14
years prior to (aged 35 at) the policy announcement are the …rst to face superannuation
eligibility ages of 61 years and 67 years, respectively. It is also important to note that this
policy change makes the new superannuation and the existing age pension eligibility ages
the same. This makes it impossible for households to run down superannuation payouts
prior to being eligible for the age pension to maximize the age pension level. On the other
hand, it cannot prevent the running down of private assets for this same purpose.
3.8.2
Overview
Table 3.8 shows that there are only insigni…cant anticipatory macroeconomic e¤ects of
this policy change and it is only after the change comes into e¤ect that much happens.
These e¤ects then accumulate towards the new steady state solution. The main change
is that superannuation assets increase dramatically by over 40 percent in the long run,
primarily because they are preserved and accumulate for another 7 years. At the same
time, private assets drop dramatically by about 35 percent in the long run so that there
is a deliberate and predictable life cycle behavioural smoothing response to reduce the
build-up of assets by households. Nevertheless, households are subject to more strict
means tests and so age pension expenditures by the government fall by 1.6 percent.
For the government, there are larger superannuation taxes but also lower income
taxes (due to greater borrowing by middle and higher income households in anticipation
of greater superannuation payouts) so, overall, a modest increase of 4 percent in the
consumption tax rate is required to balance the long run budget.12
The welfare consequences of the gradual increase in the superannuation preservation
age are interesting, as indicated in Figure 3.1(h). The very old are una¤ected, while those
younger (down to about 45 years of age at the time of the announcement) have slightly
reduced welfare irrespective of income grouping. For younger and future households the
welfare graphs diverge dramatically for the di¤erent household types. The two divergent
spikes for low and high income households are explained as follows. High income households aged 35 are the …rst to access their superannuation payouts at age 67 and so have
very large, tax-preferred superannuation assets, and they have had the opportunity to
undertake life cycle smoothing. By contrast, low income households of that age also have
12
The model assumes that the interest costs of servicing borrowing are tax deductible (i.e., negative
investment earnings are tax deductible). For low income individuals who are not permitted to borrow,
this assumption is of no consequence. Middle income individuals borrow small amounts when young.
High income individuals borrow more and this borrowing increases under policy changes that increase
superannuation payouts. Thus, this assumption is relevant for high income individuals.
CHAPTER 3. POLICY SIMULATION RESULTS
41
larger superannuation payouts but, due to liquidity constraints, have not been able the
undertake smoothing to the same extent and so su¤er a welfare loss.
In the long run, future generations of high income households gain, since they are
able to accumulate large superannuation assets while being able to undertake lifetime
smoothing. Future low income households also gain, primarily because they also have
much higher superannuation and total assets (their ability to smooth over the life cycle
is limited) and their receipt of unintended bequests are therefore higher.
3.8.3
Macroeconomic implications
Labour market:
In the short run, prior to the actual implementation of the gradual preservation age
increases, the labour supply impacts are only slightly positive. From 2024 when the increases in the superannuation preservation age phased in, the positive e¤ects on aggregate
labour supply are more signi…cant. The policy represents labour supply incentives to middle income and high income households that work longer hours at older ages in order to
boost their superannuation through higher mandatory contributions. In the long run,
aggregate labour supply is up by 0.440 percent. The changes in the market wage rate are
minimal.
Assets and capital:
As mentioned, the preservation age increases commence in 2024 and that is when
aggregate superannuation assets start to grow. In 2020, superannuation assets are only
negligibly higher, while by 2030 these assets are up by 11.28 percent. Larger superannuation assets generate the increases in domestic total assets. In the long run, domestic assets
increase by 2.1 percent. This is despite of superannuation o¤sets by middle income and
especially high income households that cause an almost 35 percent decline in aggregate
ordinary private assets in the long run. The policy leads to small capital out‡ows (as
domestic assets increase more than the increase in the capital stock) and thus reducing
Australia’s net foreign liabilities in the long run.
Goods market:
The policy impacts on output are positive both in the short run and in the long run,
supported by higher aggregate labour supply and the capital stock. Aggregate consumption declines in the short run because of smaller spending by old generations (that already
received their superannuation) that pay a higher consumption tax rate and due to lower
consumption of younger generations of low-income households unable to borrow against
their larger superannuation payouts. The long run e¤ect on aggregate consumption is,
however, positive, with consumption rising by 0.7 percent, caused by higher consumption
of high-income households and low-income households (bene…ting from greater intergenerational transfers). Investment demand expands over the transition due to positive policy
impacts on the capital price. The trade balance is positive in the short run and medium
run but in the long run, the trade balance deteriorates as domestic demand growth (supported by higher aggregate consumption) exceeds the long run increase in output.
Government indicators:
The consumption tax rate increases relative to the baseline consumption tax rate
mainly due to lower receipts from personal income taxes. This is even though superan-
CHAPTER 3. POLICY SIMULATION RESULTS
42
nuation tax receipts go up by over 26 percent in the long run. The revenue from personal
income taxation decreases as liquidity unconstrained households borrow more, which implies lower private assets and investment income. The impacts on the government age
pension expenditures are minimal prior to 2024 when the policy is implemented.13 From
2024 onwards, the age pension expenditures decline and in the long run, these government
costs decrease by 1.6 percent. This is because all three income classes at older ages have
larger total assets and higher private retirement incomes that are assessed under the age
pension means tests. Examining life-cycle pension pro…les in the long run (not provided
in the report) shows that even low-income households have their age pension payments
slightly reduced at early age pension ages due to the binding income test.
3.8.4
Welfare implications
Old generations of all three income types that already received their superannuation
payouts at age 60 (the assumed superannuation payout age in the baseline simulation) experience minor welfare losses through general equilibrium e¤ects on the
consumption tax rate that slightly increases prior to the actual implementation of
this policy changes.
As depicted in Figure 3.1(h), the impacts of these gradual preservation age increases on credit constrained generations of low-income households di¤er greatly
from those of the other two income types that are assumed to borrow freely provided that their terminal assets are non-negative. The welfare of low-income generations facing a higher preservation age declines rapidly as they are unable to smooth
their consumption (i.e. reduce their retirement consumption boosted by signi…cantly larger superannuation payout received at higher ages and increase their preretirement consumption). The low-income generation aged 39 years at the time of
the policy announcement attains the lowest welfare while the same age generation
of high-income households achieves the highest welfare. Liquidity-unconstrained
high-income households experience welfare gains arising from the preferential tax
treatment of superannuation. These households borrow against larger superannuation payouts (and thus accumulate substantial private debt prior to the payout) to
fund greater pre-retirement consumption.
The long run welfare implications are positive for high income households but
slightly negative for middle income households. Middle income households consume more from age 60 onwards but this policy change also increases (reduces)
their labour supply (leisure) at older ages, generating a small long run decline in
their lifetime welfare. The welfare of lower income households is higher in the long
run. The signi…cant improvements in welfare experienced by young and future born
generations of these households is caused by larger assets accumulations at older
ages (due to greater superannuation payouts) that leads to higher bequest transfers
with positive e¤ects on both their consumption and leisure.
13
The percentage changes in pension costs prior to 2024 are caused by changes in the maximum pension
rate that initially increases. Therefore, the pension costs go up slightly.
CHAPTER 3. POLICY SIMULATION RESULTS
3.9
3.9.1
43
Simulation IX – Aggregation of simulations I, III,
IV, V and VIII
Policy change
This simulation involves: (i) a reduction in the statutory corporation tax rate, (iii) changes
to the taxation of superannuation contributions, (iv) a reduction in the superannuation
fund earnings tax rate, (v) preferential tax treatment of private investment income and
(viii) gradual increases in the superannuation preservation age. Accordingly, it combines
into one simultaneous policy change …ve of the individual policy changes already separately
simulated and discussed above.
3.9.2
Overview
Because of the complex nature of this combined policy change, it is di¢cult to provide
a simple explanation of the simulation results and of the impacts on the economy. Nevertheless, it seems clear from an examination of the tables and graphs that simulation
V (i.e., the 40 percent tax discount on investment income) dominates the other policy
simulations. This is most clearly seen by comparing the welfare e¤ects in Figure 3.1(e)
with those in Figure 3.2 (the combined policy). The graphs exhibit similar shapes.
As shown in Table 3.9, the main e¤ects of the combined policy change upon the
economy are for the labour supply to drop by around 2.7 percent, for the capital stock to
rise by 1.8 percent, because primarily of a higher net return to capital arising from the
corporation tax cut, resulting in a small output drop. This change (increase) in the capitallabour ratio is re‡ected in a e¤ective higher wage rate. Another major macroeconomic
change is that, not surprisingly, superannuation assets increase by a massive 76 percent
due mainly to the higher superannuation preservation age. However, this is accompanied
by a reduction of almost 20 percent in private assets as middle and high income households
(who are not liquidity constrained) adjust their portfolios. Nevertheless, domestic assets
increase.
As a result of the higher superannuation funds, dependence of households on the age
pension falls somewhat so that age pension expenditures drop by over 7 percent in the
long run. Government revenues fall due to lower superannuation and corporation taxes,
requiring a large increase of over 40 percent in the consumption tax rate.
Older generations of all income groups su¤er a loss in welfare, as illustrated in Figure
3.2. This is primarily due to the immediate loss in government tax revenue, which requires
an immediate large increase in the consumption tax rate. Younger living generations fare
better than the old, but only the high income households experience a gain in welfare. High
income households aged 61 years attain largest welfare from this combined policy because
they have the largest amounts of interest income that is now taxed at a concessionary
rate.
Future generations, for whom the policy changes have always been in place, all end
up gaining in welfare from the combined policy change. High income households gain
the most, while low and middle income households gain roughly equal lesser amounts of
utility.
CHAPTER 3. POLICY SIMULATION RESULTS
3.9.3
44
Macroeconomic implications
Labour market:
As a result of this simulation, aggregate labour supply increases by 0.953 percent
in the …rst year of the transition, caused mainly by the positive labour supply e¤ect
of the preferential tax treatment of investment income. The short run increases are
smaller than those obtained from simulation V alone as some of the other simulations
such as the corporation tax cut and changes to superannuation contribution taxation
have negative short run e¤ects on aggregate labour supply. In the long run, the labour
input declines by 2.719 percent; again largely due to the income e¤ect of higher domestic
total assets resulting from simulation V. Apart from the …rst few years, the market wage
rate increases and in the long run, the rate is about 1.756 percent higher than under the
baseline simulation. This is caused entirely by the reduction in the corporation tax rate
that increases demand for capital and leads to capital deepening with upward pressures
on wages.
Assets and capital:
The capital stock goes up because of a higher net return to capital, which also increases
the price of capital. In the long run, the capital stock rises by 1.833 percent despite the
long run decrease in aggregate labour supply. The stock of domestic total assets also
increases, supported by larger superannuation assets arising from simulation III (changes
to superannuation contribution taxation with the abolition of the 15 percent concessional
tax rate on contributions), simulation IV (…ve percentage point cut in the superannuation
fund’s earning rate) and simulation VIII (higher preservation age policy). In the long run,
domestic total assets are up by 25.5 percent. Net foreign assets decrease initially because
of higher value of the capital stock. In the subsequent years, there are a signi…cant
increases in net foreign assets.
Goods market:
This combined policy simulation generates positive impacts on the economy in the
short run and medium run but negative e¤ects in the long run as the decrease in aggregate labour supply outweighs the long run increase in the capital stock. Aggregate
consumption declines in the short run and medium run because of negative e¤ects of
a signi…cantly higher consumption tax rate on consumption of older generations. In the
long run, consumption is up by 1.67 percent as mainly middle and high income households
bene…t from the 40 percent tax discount on their investment income. The positive e¤ect of
this combined simulation on the price of capital leads to higher investment expenditures.
The trade balance increases greatly in the short run as output increases while domestic
demand falls. This reverses in the long run, causing the trade balance to deteriorate.
Government indicators:
Total government expenditures are higher mainly because of the 15 percent contribution rebate under simulation III. In the subsequent years, total government expenditures
decline relative to the impact e¤ect due to falling government consumption and pension
costs (simulation V). The government costs on the age pension are signi…cantly lower by
7.2 percent in the long run as all three households accumulate larger assets at older ages
that generate greater investment earnings assessed under the age pension means test. The
income tax revenue increases sharply by 7.12 percent on impact, which is caused by sim-
CHAPTER 3. POLICY SIMULATION RESULTS
45
ulation III (superannuation contributions included as part of personal taxable income).
Despite the increase in the personal income tax receipts, the consumption tax rate needs
to be lifted by 55.56 percent to o¤set declines in corporation tax revenue (Simulation
I) and in superannuation tax receipts (Simulations III and IV) and also to pay for the
already mentioned higher total government expenditures (Simulation III with the contribution rebate). In the subsequent years, the consumption tax rate declines relative to the
impact e¤ect because of rising superannuation tax receipts and declining total government
expenditures. In the long run, the consumption tax rate is up by 41.17 percent (i.e. the
consumption tax rate of 12.7 percent in the new steady state).
3.9.4
Welfare implications
The welfare implications for old generations of all three income types are largely
negative, with the oldest low-income households experiencing the biggest welfare
loss of about 1.3 percent. This is because old generations face a signi…cantly higher
consumption tax rate that increases under all policy changes implemented in this
combined policy simulation.
The welfare improvements for middle and high income younger households arise
mainly from policy simulation V and simulation I. The welfare of younger lowincome households increases mainly due to simulation III. The kinks in the welfare
pro…les of all three income classes are due to the implementation of gradual increases
in the superannuation preservation age. The generation of high income households
aged 61 at the time of the change attains largest welfare, gaining almost one percent
in welfare mainly from the 40 percent tax discount on investment earnings.
In the long run, all three income classes achieve higher welfare, with high-income
households gaining 0.75 percent and middle- and low-income households over 0.45
percent in initial resources. This indicates that simulation V (preferential tax treatment of investment income) dominates the other simulations implemented under
this aggregate policy simulation.
3.10
Summary of policy simulation results
In this section we summarize the simulation results and brie‡y discuss them.
3.10.1
Macroeconomic implications
The summaries for the macroeconomic variables are provided in Tables 3.10 and 3.11,
which permit an easy comparison of results from the nine policy simulations. Table
3.10 summarizes the short run results for every policy simulation, the short run here
being de…ned as the period 2 (year 2011) of the transition path. Analogously, Table
3.11 summarizes the long run results for every policy simulation, the long run here being
de…ned as year 2050 by which time the solution has e¤ectively converged to the new
steady state solution.
CHAPTER 3. POLICY SIMULATION RESULTS
46
The short run implications for aggregate labour supply are signi…cantly positive in the
case of simulation V (incentives from a preferential tax treatment of investment income),
simulation VI (labour supply incentives from the uniform 10 percent personal income
tax cut) and also in the case of simulation II (incentives from the higher superannuation
guarantee contribution rate). The short run wage rate is negatively correlated with the
changes in aggregate labour supply. The decline of 2.94 percent in the market wage rate
paid to households resulting from simulation II is caused largely by the three percentage point increase in the superannuation guarantee contribution rate that raises costs of
employing labour to producers. In the long run, aggregate labour supply declines signi…cantly under simulation V due to the income e¤ect of larger domestic assets (and under
simulation IX that includes the 40 percent investment tax discount in simulation V). The
long run market wage rate is unchanged under most of the policy simulations (see chapter
2 for explanation). Simulations I and IX generate positive e¤ects on the long run wage
rate because of a higher net return to capital. In contrast, under simulation II the market
wage rate falls in the long run to keep the marginal product of capital constant when the
superannuation guarantee contribution rate increases.
The short run e¤ects on the capital stock arise from the policy impacts on the price of
capital; a higher price of capital means that investors expect a higher net return to capital,
which increases investment demand and leads to a greater capital accumulation. The
long run impact on capital in this small open economy model is given by the percentage
changes in labour supply aggregated across households to keep the capital labour ratio
constant in the long run. This property does not hold in simulations I and IX, which
demonstrate a positive long run e¤ect on the net return to capital causing an increased
demand for capital. Total domestic assets are accumulated through ordinary private
assets and superannuation assets. There are signi…cantly larger superannuation assets
in the long run under the simulations directly impacting the superannuation rules such
as simulations II, VIII (higher superannuation preservation age) and IX. Even though
some of the larger superannuation assets are o¤set through declines in aggregate ordinary
private assets, these policy simulations have positive impacts on domestic total assets. The
di¤erence between domestic assets and the value of the capital stock determines foreign
assets, which improve signi…cantly by 76.35 percent under the combined simulation IX
due to high out‡ows of substantially larger domestic savings.
The implications for aggregate labour supply and the capital stock determine the
policy impacts upon the economy, measured by changes in output. In the short run, the
economy expands in most simulations (especially simulations V and VI). In the long run,
the corporation tax cut has the most positive e¤ect on the economy due to the relatively
large increase in the capital input. Over the transition path, aggregate consumption
improve greatly for the majority of the simulated policy changes in the long run. For
example, under simulation V aggregate consumption declines by 2.76 percent in the short
run while the long run aggregate consumption increases by 1.77 percent.
Most of the policy simulations directly in‡uence the government budget, which is assumed to be balanced through adjustments in the statutory consumption tax rate. Simulation I immediately reduces the corporation tax receipts requiring a higher consumption
tax rate. Simulations V and VI generate a lower revenue from income taxation causing
the consumption tax rate to rise. The changes in the consumption tax rate also take into
CHAPTER 3. POLICY SIMULATION RESULTS
47
consideration impacts on total government expenditures, a¤ected mainly by government
consumption, pension costs and, in case of simulation III, by the contribution rebate.
The long run policy impacts on pension costs are positively correlated with the changes
in domestic total assets; higher domestic total assets generate higher investment income,
leading to stricter means testing of the age pension. For instance, under simulation IX,
pension costs decline by 7.17 percent in the long run because of higher retirement income
and assets of all three households.
3.10.2
Welfare implications
Previously, we presented the welfare e¤ects upon the three types of households for each
policy reform in a separate …gure to allow a direct comparison by income group at each
age. Now, we present the same information in separate …gures for each of the three income
groups. Each panel of Figure 3.3 graphs the welfare pro…les arising from the nine policy
reforms for a particular income group (low, middle and high), thus allowing for an easy
comparison of the welfare e¤ects of the di¤erent policy reforms for a particular income
group.
The age pro…les of welfare implications for the three income classes plotted in panels
(a) and (b) of Figure 3.3 indicates that most of the policy simulations generate welfare
results of a relatively low magnitude, ranging from -0.6 percent to 0.5 percent, for lowand middle-income households. Notable exceptions are policy simulations IX (combined
policy) and I (company tax cut), under which older generations of these two income types
of households experience larger welfare loses because of the general equilibrium impacts
on consumption taxes balancing the government budget. Apart from simulation VII
(taxation of intergenerational transfers), all other simulated policy changes have negative
impacts on welfare of older generations that have to pay higher consumption taxes. We do
not compensate older generations on age pension for higher consumption taxes through
indexation of the maximum age pension rate. Such compensation would lead to welfare
improvements for these older households while higher income households and working age
population would have to face even greater consumption taxes.
The pro…les for high-income households in Figure 3.3(c) show much greater welfare
e¤ects than for low- and middle-income groups, particularly at older ages. For example,
there is a welfare loss of over 1 percent for very old generations under simulation IX, and a
welfare gain of over 1.6 percent for the generation born 40 years prior the implementation
of policy simulation V (40 percent tax discount on investment income). Thus, the spread
of welfare gains or losses seems greater for older high-income households than others.
All three …gures show that the preferential treatment of investment income would
increase welfare especially for households with large assets holdings (generating high investment income). Simulation VI (a uniform 10 percent personal income tax cut) delivers
welfare gains of over 0.9 percent to future generations of high-income households.
The shapes of welfare implications are similar for middle- and high-income households,
which are both assumed to be free to borrow at the exogenous interest rate. The di¤erent
welfare impacts on these two households and liquidity-constrained low-income household
are especially apparent in the case of simulation VIII (higher superannuation preservation
age). Middle- and high-income households bene…t from the increases in the superannua-
CHAPTER 3. POLICY SIMULATION RESULTS
48
tion preservation age due to a tax preferred treatment of superannuation while low-income
households (unable to borrow) attain lower welfare because of a longer vesting period of
superannuation savings.
To conclude, the policy changes related to superannuation (simulations II, IV and VIII)
tend to have smaller welfare impacts relative to the other simulated …scal policy changes.
This is because higher superannuation assets are partly o¤set by lower ordinary private
savings, thus leading to only small increases in lifetime total savings. For example, the
…ve percentage point reduction in the statutory superannuation fund’s earnings tax rate
(simulation IV) has very small welfare impacts (and also macroeconomic implications),
ranging from -0.2 percent to 0.2 percent for all three income classes.
Chapter 4
Discussion
The welfare and macroeconomic results presented in the previous chapter are based on
the structure and the assumptions of the overlapping generations model. Clearly, the
results depend upon the model speci…cation and di¤erent results would be obtained from
a model with a di¤erent speci…cation. In this section, we discuss how these policy results
might di¤er when some of the key model assumptions are changed. In particular, we
concentrate on the following properties of the model: stationary demographics, the small
open economy feature with an exogenous and constant interest rate, the use of the consumption tax rate to ensure a balanced government budget and assumptions made about
the indexation (and benchmarking) of the maximum pension rate.
4.1
Demographic change
The model assumes a stationary demographic environment with time-invariant age distribution of the population and a constant rate of population increase. However, Australia’s
population has been ageing, a process that will continue over the next few decades, so
that the age distribution is not stationary. This demographic change, demonstrated by
increases in the median age of population and rising the old-age dependency ratio, will
have signi…cant macroeconomic and …scal consequences.
Because of the slowdown in the labour supply growth, the capital-labour ratio is
expected to increase (i.e., capital deepening) and this will put upward pressures on wages.
Undoubtedly, age related expenses funded by the government on, for example, the age
pension will increase and this will require some adjustments to be carried out for the …scal
policy to be sustainable.
If the consumption tax rate is assumed to be raised to pay for higher pension costs
due to population ageing (as our model assumes), then the baseline solution under a
population ageing scenario would involve a signi…cantly increasing consumption tax rate
(greater than in our baseline simulation based upon stationary demographics). Many
of our policy reform simulations led to increases in the consumption tax rate. Under
an ageing population scenario that would continue to be the case, of course. However,
the percentage increases in the consumption tax rate for such policy reform simulations
would be less than in the stationary demographic environment. This is because the long
run increase in the consumption tax rate resulting from the reduction in the corporation
49
CHAPTER 4. DISCUSSION
50
tax rate, for example, would be applied to a larger consumption tax rate base in the
baseline simulation. As a result, the policy impacts upon household welfare might be
more positive.
The potential implications for the policy results of the relaxation of the stable demographics assumption were investigated for most of the policy reforms considered in this
report by undertaking some further calculations.
Speci…cally, to assess the implications of the policy changes in an ageing environment
we reduced the population growth rate from 1.45 percent to 0.5 percent and examined
the long run (steady state) implications only. The decrease in the population growth rate
(which equals the fertility rate in a steady state) generates an increase in the old age
dependency ratio from about 0.22 to 0.31. The results for the major macroeconomic and
…scal variables are very similar to those in the stationary demographic environment, as
presented in this report. However, the percentage increases (over the baseline solution)
in the consumption tax rate required under most of the policy changes are smaller, since
the baseline consumption tax rate has to be already increased signi…cantly to fund larger
pension costs due to ageing. It is noteworthy that the percentage point increases in the
consumption tax rate are of a very similar magnitude in both demographic environments.
For example, the long run increase in the consumption tax rate under simulation I is 0.025
in the stationary demographic environment and 0.023 in the non-stationary demographic
environment. This smaller percentage point increase in the consumption tax rate has
positive impacts on consumption (household and aggregate) and welfare relative to the
impacts under stationary demographics.
4.2
Interest rate adjustment
The model is a small open economy model in which the domestic interest rate is assumed
to be exogenous and equal to the world interest rate. This interest rate is assumed
to be constant and so independent of the policy changes. An alternative model with
an endogenous interest rate might arise, for example, because of a partial separation of
domestic and foreign bond markets or because of a risk premium attached to Australian
bonds.
The e¤ects of some separation might be illustrated by considering the extreme case of a
closed economy. Under the closed economy scenario, where the interest rate is determined
endogenously by the marginal product of capital, the policy simulations that generated a
higher demand for capital (e.g., the corporation tax cut) would lead to a higher interest
rate and consequently to asset accumulations. In contrast, the policy simulations that
generated higher household savings (e.g., preferential tax treatment of investment income)
would lower interest rates and reduce the savings increases.
The model also neglects the impacts of policy simulations on the risk premium. The
policy simulations that resulted in large reductions in Australia’s net foreign liabilities
are likely to reduce the risk premium, generating lower interest rates. Lower interest
rates would result in smaller asset accumulations by households. However, because lower
interest rates also represent lower user costs of capital there would be higher demand for
capital, leading to higher capital stock and output.
CHAPTER 4. DISCUSSION
4.3
51
Alternative budget-balancing taxes
It is assumed in this research that the government maintains a balanced budget on an
annual basis and that the policy instrument that is used to ensure this balance when
policy reforms change the government’s receipts and expenditures is the consumption tax
rate. This policy instrument was chosen because of its simplicity and because of the ease
of interpretation; it is a convenient scalar measure of the …scal cost of a policy reform.
Alternative choices of the budget-balancing policy instrument would have di¤erent
consequences and have di¤erent distortionary e¤ects. One alternative would be to require
a change in the income taxation schedule, but there are many ways in which this might
be done. One might be to change one of the income tax thresholds, another to change
one of the marginal tax rates. Clearly, there are many possibilities. Whichever is chosen,
the simulation results will depend upon that choice.
4.4
Age pension indexation
The model also assumes that the maximum rate of the age pension is benchmarked to
maintain the legislated ratio of pension to average gross labour earnings and that it cannot
fall below the maximum age pension obtained from the initial steady state of the baseline
simulation of the model. Thus, while the maximum age pension in our model cannot fall
below that value, it is not indexed to rise as a result of changes in the price of consumption
facing households (as legislated). Since that price of consumption includes the e¤ect of
changes in the consumption tax rate and since many policy simulations required the
consumption tax rate to be raised to ensure a balanced government budget, the pension
received by individuals in our model is less than would be the case if indexation had
been incorporated in it. As a consequence, for policy reforms requiring an increase in the
consumption tax rate the welfare of households receiving the age pension calculated on
the basis of no indexation, as presented in this report, is lower than would be the case
under indexation of the age pension.
In short, the interpretation of the welfare e¤ects for pension recipients need to take this
into account. Also, a further consequence is that compensating age pensioners for higher
consumption taxes through greater pension payouts would require further adjustments in
the government budget, thus imposing a larger tax burden on working age generations
and more a-uent households not qualifying for the pension.
4.5
Government consumption
Our modelling of government consumption is based on Auerbach and Kotliko¤ (1987)
and Fehr et al. (2008). In particular, the model assumes that government consumption
generates no utility to households. In the initial steady state of the baseline simulation,
we calculate a ratio of government consumption to output that generates the statutory
consumption tax rate. This ratio is kept constant during the transition in all simulated
policy changes, implying that the impacts on government consumption are proportional
CHAPTER 4. DISCUSSION
52
to the changes in output. This assumption was chosen on the grounds of being empirically plausible as government consumption typically increases along with the size of the
economy.
However, this assumption may complicate the interpretation of welfare results coming
from the model for two reasons. First, some of the gains from a policy reform are not
re‡ected in welfare gains of households. In particular, increases in government consumption are not directly re‡ected in household welfare gains even though they are clearly of
bene…t to the economy. Second, the assumption of a constant government consumption
to output ratio implies that any policy reform generating an output increase will require
increased government taxation revenue to …nance the extra government consumption and
this, under our assumptions, will require an increase in the consumption tax rate. This,
in turn, will have a negative impact on household welfare. Accordingly, for these two
reasons our model simulations will show lower welfare gains than might be the case under
alternative assumptions in cases where the output, and hence government consumption,
increase.
To deal with this issue, one of the following two alternative approaches could be
employed. First, it could be assumed that households in the model can directly derive
utility from government consumption, as well as from private consumption and leisure.
Second, it could be assumed that government consumption does not to generate any direct
utility to households but that it is kept constant in the baseline and policy simulations.
Under this assumption, there is no need for any further adjustment to the consumption
tax rate.
The …rst approach is applied, for example, by Creedy and Guest (2008), who assume
that government consumption is exogenous and separable from private consumption and
leisure in generating lifetime utility. This means that government consumption does not
a¤ect optimal choices of private consumption and leisure. With respect to our modelling,
the introduction of this assumption would have no impact on household and macroeconomic variables in the policy simulations. Only the welfare implications would change,
depending on the additional utility households would derive from government consumption. This would depend upon the assumed utility function. In brief, under this assumption, the policy simulations that lead to higher (lower) government consumption would
improve (worsen) household welfare relative to the welfare results provided in this report.
The second approach is used, for example, by Mendoza and Tesar (1998). Using a
dynamic model of a global economy, they investigated several tax reforms and found
welfare improvements arising from a policy of capital income tax removal funded by an
increase in the consumption tax rate. Similarly to the …rst approach, the assumption
of constant government consumption would generate more positive (negative) welfare
results in the simulated policies that produce higher (smaller) government consumption,
due to smaller (larger) increases in the consumption tax rate. Moreover, because of these
di¤erential e¤ects on the consumption tax rate the adoption of this assumption would
change all the policy results. The major changes would be in the levels of welfare and in
the both household and aggregate consumption.
To illustrate the e¤ects of utilizing this assumption, we simulated the implications of
the …ve percentage point reduction in the corporation tax rate (i.e., Simulation I) keeping
government consumption constant. In contrast with the welfare results provided further
CHAPTER 4. DISCUSSION
53
above under the assumption of a constant ratio of government consumption to output,
the long run welfare of all three household types improves; by 0.073 percent for low
income, 0.187 percent for middle income and 0.169 percent for high income households.
The consumption tax rate increases by 17.29 percent in the long run (compared to 27.17
percent reported further above) and long run aggregate consumption is up by 0.467 percent
(compared with a decline by 0.07 percent).
Thus, the assumption of constant government consumption yields welfare gains for
policy simulation. The di¤erences in other variables are small. The macroeconomic
variables are not a¤ected much except for the consumption tax rate, consumption and
government expenditure. The transition paths are similar to those under the original
assumption, but the end points of some variables are at di¤erent levels of course. Figure
4.1 replicates Figure 3.1(a) of the previous chapter for ease of comparison with Figure
4.2, which shows the welfare e¤ects under this alternative assumption for all relevant
generations. The two …gures are very similar to each other; the main di¤erence is that
Figure 4.2 involves long run welfare gains rather than losses.
To provide further information on the implications of assuming constant government
consumption rather than constant ratio of government consumption to output, the long
run results for the main macroeconomic variables and the long run welfare e¤ects upon
the three household types for the nine policy simulations are presented in Tables 4.1 and
4.2. Table 4.1 repeats the results in Table 3.11 of the previous chapter for the macroeconomic variables, but includes the welfare results in the bottom three rows. Table 4.2
provides the long run results for all simulations under the assumption of constant government consumption for comparison with the results in Table 4.1, which are discussed in
Chapter 3. The e¤ect of the alternative assumption for long run results for the remaining simulations exhibit similar features to those discussed above for simulation I; welfare
e¤ects are typically greater, while macroeconomic variables are not a¤ected much except
for the consumption tax rate, consumption and government expenditure.
Chapter 5
Conclusions
The modeling of a range of possible policy changes to Australia’s tax system has been
undertaken and discussed in this report. The model permits the simulation of these policy
changes so that the impacts on various macroeconomic variables as well as the welfare
and life cycle e¤ects on households can be obtained.
The outcomes from such simulations are dependent on the nature and structure of the
model and its ability to reproduce the more important data features of the Australian
economy. While the model has a very detailed household sector and the essential aspects of the taxation and retirement policy settings are incorporated, the model has a
relatively simple production structure. Thus, our results have focused on the households
and macroeconomic side, without concern for distributional e¤ects within the production
sector. There is also just one consumer good in the model.
The model also has behavioural assumptions built into it. The crucial behavioural
assumption is the households make decisions to maximize their utilities over their complete
lifetimes, the only uncertainty being longevity risk. Also, the model assumes perfectly
competitive markets in every period.
The construction of the model involves the determination of numerical values of the
parameters. Much e¤ort has been put into this task and our report has provided some
evidence on how well the model solution replicates the Australian economy in the calibration year. Nevertheless, the results depend on these choices, as with any computable
general equilibrium model.
Thus, the results presented in this report must be interpreted in the context of the
model used to undertake the simulations. They provide one particular approach to determining the impacts of the policy reform proposals on households and macroeconomic
variables. That said, we believe that the modeling and results contained in this research
report will be valuable in providing economically consistent outcomes for the Australian
economy that will be particularly useful in evaluating the tax reform proposals.
54
Bibliography
[1] Auerbach, A. J. and Kotliko¤, L. (1987), Dynamic Fiscal Policy, Cambridge University Press, Cambridge.
[2] Australian Bureau of Statistics [ABS] (2007), Life Tables, Australia 2005-2007, ABS
Cat. No. 3302.0.55.001, Australian Government Publishing Service, Canberra.
[3] ABS (2008), Australian System of National Accounts 2007-08, ABS Cat. No. 5204.0,
Australian Government Publishing Service, Canberra.
[4] ABS (2009a), Australian National Accounts: National Income, Expenditures and
Product, ABS Cat. No. 5206.0, Australian Government Publishing Service, Canberra.
[5] ABS (2009b), Australian Demographic Statistics, ABS Cat. No. 3101.0, Australian
Government Publishing Service, Canberra.
[6] ABS (2009c), Employee Earnings, Bene…ts and Trade Union Membership, ABS Cat.
No. 6310.0, Australian Government Publishing Service, Canberra.
[7] Commonwealth of Australia (2009), Budget Strategy and Outlook 2009-10, Budget
Paper No. 1, Commonwealth of Australia, Canberra.
[8] Creedy, J. and Guest, R. (2008), “Changes in the taxation of private pensions: Macroeconomic and welfare e¤ects”, Journal of Policy Modelling 30, 693-712.
[9] Fehr, H., Jokish, S. and Kotliko¤, L. (2008), “Fertility, Mortality and the Developed
World’s Demographic Transition”, Journal of Policy Modelling 30 (3), 455-473.
[10] Hansen, G.D. and Imrohoroglu, S. (2008), “Consumption over the Life Cycle: The
Role of Annuities”, Review of economic Dynamics 11 (3), pp. 566-583.
[11] Hayashi, F. (1982), “Tobin’s Marginal q and Average q: A Neoclassical Interpretation”, Econometrica 50, 213-224.
[12] Mendoza, G.E. and Tesar, L. L. (1998) “The international rami…cations of tax reforms: Supply-side economics in a global economy”, American Economic Review,
March 1998.
[13] Modigliani, F. and Brumberg, R. (1954), “Utility Analysis and the Consumption
Function: An Interpretation of Cross-section Data”, in K.K. Kurihara (eds.), PostKeynesian Economics, Rutgers University Press, New Brunswick, N.J. (1954).
55
BIBLIOGRAPHY
56
[14] Productivity Commission (2005), Economic Implications of an Ageing Australia,
Commonwealth of Australia, Canberra.
[15] Reilly, R., Milne, W. and S. Zhao, 2005, “Quality-adjusted labour inputs”, Australian
Bureau of Statistics Research Paper No. 1351.0.55.010, Canberra.
[16] Tobin, J. (1969), “A General Equilibrium Approach to Monetary Theory”q, Journal
of Money, Credit and Banking 1, 15-29.
Chapter 6
Appendices
6.1
Technical description of the model
Demographics
The model assumes stationary demographics whereby the time-invariant survival probabilities, sa , and population growth rate, n; imply cohort shares, a  sa   n a 1 ,
that sum to one and are constant over time. The fraction of each income group in every
generation is denoted by !i .
Households
Households optimally choose consumption, ca;t ; leisure la;t; and the timing of retirement to
maximize their lifetime utility subject to the inter-temporal budget and time constraints.
In undertaking this opimization, households face longevity risk, described by a survivalage probability pro…le, and age-varying productivity in the labour force, described by a
productivity-age pro…le (i.e., earnings ability).
The maximization problem that a household of the type i who begins her economic
life at time t solves can be expressed as
90

EUti   = 
s.t.
Aia;t
cia;t ;lia;t
where uia;t+a


Sa  
i 21 a
uia;t+a
(1 1
21
)
;
a=21
i
i
i
   rAia 1;t 1  wt eia h la;t
  APa;t
 SAi60;t  SPa;t
i
i
1
 Ba;t
T ya;t
   ct  cia;t  GBa;t
;
i
h la;t ;
i
cia;t; la;t
; Ai90;t  ; A1a;t ;
21

cia;t+a
(1 1
21
)

i
la;t+a
(1 1
21
) 1=(1 1
)
(1)
is the instantaneous
constant elasticity of substitution utility and
 represents the borrowing constraint
for low-income households. In the expected lifetime utility, EUti ; there are the following
four taste parameters: the inter-temporal elasticity of substitution, the intra-temporal
elasticity of substitution,
the leisure distribution parameter,
and the rate of time
preference, i . The term Sa  aj=21 sj 1 is the unconditional survival probability.
A1a;t
57
CHAPTER 6. APPENDICES
58
The budget constraint indicates that households earn investment income, rAia 1;t 1 ,
i
at the world interest rate, r; and labour earnings, wt eia h la;t
, where wt eia represents
i
the hourly wage and h la;t is the labour supply. The term wt is the aggregate wage
1
rate and eia is the age-speci…c earnings ability variable. The term GBa;t
represents the
‡at rate government bene…t paid to low income households aged 21 to 60 years. Eligible
i
households may also receive some age pension, APa;t
, that is means tested. At age 60,
i
households collect their superannuation lump-sum payouts, SAi60;t . The term SPa;t
stands
for the superannuation pension, representing mandatory producer’s contributions that are
received only by households aged 61 years and over provided that they are still working.
i
Household consumption is taxed at a linear rate of ct while the income tax, T ya;t
;
i
imposed on taxable income, ya;t; that comprises labour earnings, investment income and
i
; implies that households
the age pension, is progressive. The time constraint, h la;t
i
fully retire from workforce when all time endowment is allocated to leisure, i.e., la;t
 h:
i
Accidental bequests, Ba;t, are assumed to be aggregated within each income class and
equally redistributed to households of the same income type and aged only between 52
and 58. Speci…cally, accidental bequests (i.e., total assets of those households that die)
are aggregated within each income class as Bti  90
sa  Aia;t  SAia;t a :
a=21 
Pensions
The model incorporates the main aspects of the age pension and superannuation guarantee. The age pension is paid to eligible households aged 65 years and over provided that
they satisfy the income and assets means tests. However, only the binding test applies,
i.e., the test that results in lower age pension payments.
i
The age pension, APa;t
, can be expressed as
i
APa;t

 AP iia;t ; AP aia;t ; for a 
;

for a < 
(2)
i
where AP iia    p; p
ya;t
IT ;  represents the income test and AP aia 
  p; p
Aia;t AT ;  is the algebraic description of the assets test. Under
the income test, the legislated maximum age pension, p, is paid to the eligible households
i
, does not exceed the income threshold, IT . Otherwise,
only if their assessable income, ya;t
p is reduced at the income taper rate, , for every additional dollar of assessable income
i
earned, ya;t
IT . Similarly, the eligible households are paid the maximum age pension,
p, under the asset test only if the stock of their private assets, Aia;t, does not exceed the
asset threshold, AT . Otherwise, p is reduced at the asset taper rate, , for every dollar
of private assets over the asset threshold, Aia AT .
The above speci…cation of the age pension payment is based upon a …xed and currently
existing eligibility age. However, we adapt the model to allow for a gradually phased in
increase in the eligibility age to handle the recent change in government policy. This
means that the baseline solution to the model involves a transition from an initial steady
state corresponding with the initial eligibility age, along a path to a new steady state
corresponding with the …nal higher eligibility age.
The superannuation guarantee mandates employers to make contributions for their
employees. In the model we assume that the producer pays the mandatory superannuation
CHAPTER 6. APPENDICES
59
guarantee contributions on behalf of households aged between 21 and 60 years at the afteri
sc
tax contribution rate, 
. These
 cr, from their gross labour earnings, wt eia h la;t
contributions are accumulated in the superannuation fund that earns fund investment
r
income at the given after-tax interest rate, 
 r. Superannuation assets is assumed
to be vested in the fund until households reach age 60 (in the baseline simulation). At that
age, households receive their superannuation savings in the form of a lump-sum regardless
of whether they work and the superannuation assets accumulation ceases to exist. The
stock of superannuation assets, SAia;t; accumulates according to the following formula:
SAia;t 
  

r
 r SAia
1;t 1
sc
 
i
la;t
; for a 
:
for a > 
 cr wt eia h
(3)
To assure that the e¤ective gross wage rate, wt   cr, paid by the producer is the
same across all working households, we assume that working households after receiving
superannuation payouts are paid the mandatory superannuation guarantee contributions
directly into their ordinary private assets account. These mandatory contributions take
i
i
the form of the superannuation pension, SPa:t
 cr wt eia h la;t
; only for a  and
la  h:
Production
The production sector is represented by one …rm, which produces a single output, Yt , using
the capital stock, Kt , and the labour input, Lt . The production technology is described
by a standard constant elasticity of substitution production function,
F Kt ; Lt 
(1 1
"Kt
)
 
(1 1
"Lt
)
[1=(1 1
)]
;
(5)
where is a productivity constant, " represents the capital share and is the elasticity
of substitution in production.
Capital formation is subject to convex adjustment costs (Hayashi, 1982), implying
that the net output is the di¤erence between the gross output and adjustment costs, i.e.,
Yt  F Kt ; Lt 
:
It
Kt
2
n  
Kt ;
(4)
where It represents investment, is the adjustment cost coe¢cient, n is the population
growth rate and denotes the capital depreciation rate.1
The aggregate …rm maximizes the present value of all future (net of corporation tax)
pro…t payments discounted at the exogenous world interest rate subject to the adjustment
costs and the capital accumulation equation, It  Kt+1 
 Kt . The …rst order
conditions from …rm’s pro…t maximization are:
wt 
1
FLt
  cr
(6a)
Note that the adjustment costs occur only during the transition path from one steady state to the
other as the investment rate equals to the sum of depreciation and population growth rates in the steady
state equilibrium.
CHAPTER 6. APPENDICES
60
f
qt+1    

f
f
 FKt  :
It
Kt
2
f
It
Kt

n  2
(6b)
n  
 
qt
f f


(6c)
qt
Condition (6a) gives the expression for the equilibrium wage rate, wt . According
condition (6b), the …rm will invest until the marginal bene…ts, qt+1 , from an additional
unit of capital in the next period amount to the net marginal cost of acquisition and
installation. The term qt is also known as Tobin’s q (Tobin, 1969). The product of the
statutory corporation tax rate, f ; and the corporation tax base factor, f ; gives the
e¤ective corporation tax rate. Finally, condition (6c) represents the arbitrage condition
that requires identical returns to …nancial and physical capital. The latter consists of
the marginal product of capital, FKt , reduction in marginal adjustment costs and capital
gains,
qt ; less depreciation.2
r
Government
The government collects household income, consumption, superannuation and corporation
tax revenue, T Rt  T RYt  T RtC  T RtS  T RtF , and pays for its consumption, Gt , the
3
90
i
age pension costs, AP t 
i=1 ! i
a=65 APa;t a and the government bene…ts to low
income households, GB t . The statutory consumption tax rate, ct , is assumed to adjust
endogenously to ensure that the government budget is balanced in every period t.
Thus, the government budget constraint may be written as
T RYt  T RSt  T RFt 
c
t
c
Ct  Gt  AP t  GB t ;
(7)
where c is the consumption tax base parameter (see the section on the model calibration). The corporation tax revenue is collected from …rm’s taxable pro…t, T RFt 
f f
Yt
  crwt Lt , where   crwt Lt is the labour costs and t Kt repret Kt
sents depreciation of the capital.
Gt is unproductive and generates no utility to households in our model, but any
reduction in the public outlays such as lower age pension expenditures and any increase
in tax revenues are passed onto households in terms of a lower consumption tax rate.
Foreign sector
In this small open economy model, the interest rate, r, is exogenous and equal to the
world interest rate. The international budget constraint is
F At+1
F At  T Bt  rF At ;
(8)
where the left-hand side of (8) represents capital ‡ows and the right-hand side gives
the current account that consists of the trade balance, T Bt , and the interest receipts
(payments) on foreign assets (liabilities), rF At .
2
(1
Note that in the steady state, condition (6b) becomes q = 1; and condition (6c) reduces to r =
f f
) (FK
):
CHAPTER 6. APPENDICES
61
Market equilibrium
Competitive equilibrium requires that the markets for labour, capital and output clear
in every period. Given the household structure, these equilibrium conditions may be
expressed as
Lt 
qtKt 
Yt 
3
i=1
3
i=1
3
i=1
!i
!i
!i
90
i
i
la;t
 a
a=21 ea;t h
90
i
i
a  F At
a=21 Aa;t  SAa;t
90
i
a=21 ca;t a  It  Gt  T Bt :
(9)
The …rst condition states that the quantity of labour demanded by the …rm equals
the total amount of e¤ective labour supply provided by all types of households of all
ages, the e¤ective labour supply taking into account di¤erent productivities. The second
condition equates the value of the capital stock to the value of bonds issued. The …nal
condition indicates that the total quantity of output produced by the …rm is allocated to
consumption by households, investment in new capital stock, government consumption
and net exports to foreigners.
Solving the model
The model is solved for the steady state equilibrium and the transition path using the
GAMS software, applying the Gauss-Seidel method. The basic idea is to make initial
guesses for some of the endogenous variables and to iterate towards a solution. The
iteration involves solving the production side of the model, using the results as inputs
to the household sector and obtaining solutions for all households and then returning to
resolve the production side, and so forth, iterating towards a solution.
In particular, to solve for the steady state equilibrium, we make initial guesses for
accidental bequests, B, and the consumption tax rate, c . The market clearing wage rate,
w, and capital-labour ratio, K=L, are implied by the exogenous world interest rate, r,
and the constant elasticity of substitution production function (production side solution).
Given the initial guesses for B and combined with w and r, the household optimization
problems can be solved, yielding optimal values for household variables (household side
solution). These solutions allow us to update B and c and, thereby, to repeat the above
calculations (iterations). The iterations between the production and household sectors
stop when the solution for the guessed variables equals their solution from the previous
iteration. Then, we calculate the labour input. The capital stock is equal to the product
of the implied capital-labour ratio and the labour input. The di¤erence between the value
of the capital stock and domestic assets represents foreign assets.
Computation of the transition path from one steady state solution to another is slightly
more complicated. First, capital adjustment costs can occur during the transition path,
implying that the capital price (Tobin’s q), the wage rate and the capital-labour ratio
can di¤er from their benchmark steady state values. Second, on the household side,
the generations of three income groups alive at the time the policy change is adopted
must be treated di¤erently than in the steady state solution procedure. At the time of
the policy change, existing generations have already made decisions on consumption and
labour supply up to that point on the basis of the initial policy settings and so their
CHAPTER 6. APPENDICES
62
asset holdings are so determined. These existing generations now solve their optimization
problems again, but over shorter lifetimes (from the years of the policy change onwards
only) given their ordinary private and superannuation assets accumulated prior to the
policy change. The initial assets for these generations are obtained from the benchmark
steady state simulation.
The model economy is given 150 years to reach a new steady state solution, but it
takes only about 60 years for the economy to converge to a new steady state solution.
CHAPTER 6. APPENDICES
6.2
Figures and tables for Chapter 2
63
In $100000
Fraction of time spent working
In $100000
In $100000
In $100000
In $100000
In $100000
Fraction of time spent working
In $100000
In $100000
Changes relative to 2009 (in %)
Changes relative to 2009 (in %)
Changes relative to 2009 (in %)
Changes relative to 2009 (in %)
Table 2.1: Differences across three income groups of households
Income class
Difference
Low-income
Middle-income
High-income
Liquidity constraints
Yes
No
No
Time impatience
High
Medium
Low
Government benefits
Yes
No
No
Exogenous earnings ability
Low
Medium
High
30 percent
60 percent
10 percent
Intra-generational shares
Table 2.2: Calibration targets used in the model
Description
Investment-output ratio [a]
Foreign assets-capital ratio [b]
Market wage rate (normalized)
Interest rate
Corporation tax revenue - output ratio (KTR/GDP) [c]
GST revenue - output ratio (CTR/GDP) [c]
Statutory corporation tax rate
Statutory consumption tax rate
Values
0.2585
-0.1975
1.0000
0.0500
0.0482
0.0359
0.3000
0.1000
Note: [a] Calculated from ABS (2009a); [b] calculated from ABS (2008) as ABS (2009a) does not provide
information on the capital stock; [c] calculated using ABS (2009a) and Commonwealth of Australia (2009).
Table 2.3: Values of the model parameters
Description
Demographics
Population growth rate
Fraction of households of income group
Conditional survival probabilities
Utility function
Inter-temporal elasticity of substitution
Intra-temporal elasticity of substitution
Subjective rate of time preference
Leisure parameter
Production function
Production constant
Elasticity of substitution in production
Capital share
Depreciation rate
Adjustment cost parameter
Policy parameters
Consumption tax base parameter [a]
Corporation tax base parameter [b]
Maximum age pension per year (in $100,000)
Income and assets thresholds (in $100,000)
Income and assets reduction (taper) rates
Age pension eligibility age
Mandatory superannuation contribution rate
Tax rates on super contributions and earnings
Assumed superannuation eligibility age
Values
Source
0.0145
0.3, 0.6, 0.3
ASB (2007)
Data
Literature
Data
0.325
0.9
0.016, 0.012, 0.006
1.6
Literature
Literature
Literature
Literature
0.930
1.094
0.38
0.069
10
Calibrated
Calibrated
Data
Calibrated
Literature
0.656
0.794
0.148148
0.03976 and 3.07
0.4 and 0.039
65
Calibrated
Calibrated
Data
Data
Data
Data
Data
Data
Assumption
0.09
0.15
60
Note: [a] This together with the statutory rate of 10 percent implies the effective consumption tax rate of
6.56 percent; [b] This together with the statutory rate of 30 percent implies the effective corporation tax rate
of 23.9 percent.
Table 2.4: Macroeconomic data comparison
Variable
Expenditures on GDP (Per cent of GDP)
- Private consumption
- Investment [b]
- Government consumption
- Trade balance
Government indicators (Per cent of GDP)
- Age pension expenditures [c]
- Personal income tax
- Corporation tax
- Consumption tax (GST)
- Superannuation taxes
Capital-output ratio [d]
Foreign assets-capital ratio [d]
Investment-capital ratio [d]
GDP per capita [e]
Model
Australia
2008-09 [a]
54.65
25.85
17.35
2.16
55.16
25.85
18.50
0.48
3.17
12.44
4.82
3.59
1.56
3.08
-0.20
0.08
0.68
3.01
10.75
4.82
3.59
0.76
3.02
-0.20
0.08
0.69
Notes: [a] Values calculated from ABS (2009a, 2008), ANA and Commonwealth of Australia (2009),
Budget Papers; [b] excludes government gross fixed capital formation that is included in government
consumption; [c] taken from data files of Productivity Commission (2005) - these are estimates only and
are close to total income support for seniors (which also includes other types of pensions and payments; [d]
capital stock is not provided for June 2009 so the ratios that include the capital stock relates to June 2008;
[e] calculated as GDP over civilian population.
CHAPTER 6. APPENDICES
6.3
Figures and tables for Chapter 3
64
(in %)
(in %)
(in %)
(in %)
(in %)
(in %)
(in %)
(in %)
Figure 3.2: Distributional (welfare) implications of policy simulation IX (Aggregation of
simulations I, III, IV, V and VIII
1
0.5
0
-0.5
-1
low-income
middle-income
high-income
-1.5
-60
-40
-20
0
20
40
60
80
100
Generations - date born
Notes: The x-axis shows the periods when a generation enters the model relative to the period of the policy
change, which is assumed to be period 0. A generation’s age at the time of the policy change can be obtained by
substracting the number on the horizontal axis from the assumed entry age of 21. For example, the generation
born 40 years (-40) prior to the policy change is 61 years old at the time of the reform.
Figure 3.3: Summary of welfare implications of the policy simulations
(a) for low-income households
(b) for middle-income households
(c) for high-income households
Notes: The x-axis shows the periods when a generation enters the model relative to the period of the policy
change, which is assumed to be period 0. A generation’s age at the time of the policy change can be obtained by
substracting the number on the horizontal axis from the assumed entry age of 21. For example, the generation
born 40 years (-40) prior to the policy change is 61 years old at the time of the reform.
CHAPTER 6. APPENDICES
6.4
Figures and tables for Chapter 4
65
Figure 4.1: Welfare implications of simulation I – constant government consumption to
output ratio
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5
low-income
middle-income
high-income
-0.6
-0.7
-60
-40
-20
0
20
40
60
80
100
Generations - date born
Figure 4.2: Welfare implications of simulation I – constant government consumption
0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
low-income
middle-income
high-income
-0.7
-0.8
-60
-40
-20
0
20
40
Generations - date born
60
80
100