Dynamic scoring of tax reforms in the European Union

In this paper, we present a dynamic scoring analysis of tax reforms for European countries. In this analysis we account for the feedback effects resulting from the adjustment in the labour market and for the economy-wide reaction to tax policy changes. We combine the microsimulation model EUROMOD, extended to incorporate an estimated labour supply model, with the new Keynesian DSGE model QUEST, used by the European Commission for analysing fiscal and structural reform in EU member states. These two models are connected in two ways: by introducing tax policy shocks in QUEST, derived from computing changes in implicit tax rates using EUROMOD; and by calibrating the elasticity of labour supply and the non-participation rates, by skill categories, in QUEST from values calculated using EUROMOD and the estimated labour supply function. Moreover, we discuss aggregation issues and the consistency between the micro and macro modelling of labour supply and interpret the model interaction in terms of tax incidence analysis. We illustrate the methodological approach with the results obtained when scoring specific reforms in three EU Member States, namely, Italy, Belgium and Poland. We compare two different scenarios – one in which the behavioural response to tax changes over the medium term is ignored and another scenario where this behavioural dimension is embedded into the microsimulation model. Our results suggest that accounting for the behavioural reaction and macroeconomic feedback to tax policy changes enriches the tax reforms' analysis, by increasing the accuracy of the direct fiscal and distributional impact assessment provided by the microsimulation model for the three reforms considered. Our results are also in line with the evidence on dynamic scoring exercises, showing that most tax reforms entail relatively small feedback effects (see Gravelle, 2015, for a recent review focusing on the US dynamic scoring experience). In our particular setting, the relatively small behaviour effects are directly linked to the nature of the tax reforms implemented, where a decrease of the employees tax burden generates opposite wage and employment effects in the labour market.