Working Papers SOCIAL EVALUATION OF ALTERNATIVE BASIC INCOME SCHEMES IN ITALY. R. Aaberge, U. Colombino, S. Strom

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1 Workng Papers SOCIAL EVALUATION OF ALTERNATIVE BASIC INCOME SCHEMES IN ITALY R. Aaberge, U. Colombno, S. Strom ChlD n. 12/2000

2 Socal Evaluaton of Alternatve Basc Income Schemes n Italy Rolf Aaberge a, Ugo Colombno b, Stenar Strøm c a Research Department, Statstcs Norway, Oslo, Norway, b Department of Economcs, Unversty of Torno, Italy, c Department of Economcs, Unversty of Oslo, Norway Abstract Ths paper dscusses methodologcal prncples for socal evaluaton of tax systems and tax reforms when the concern s prmarly turned to who gans and who loses. The dscusson s followed by an emprcal analyss based on Italan household data. Usng a household mcroeconometrc labor supply model we have smulated behavoral responses and welfare gans and losses for marred couples resultng from replacng the Italan tax system as of 1993 by three alternatve hypothetcal reforms, namely, a flat tax, a negatve ncome tax, and a work fare scheme. Keywords: Labor supply, taxaton, welfare gans and losses, socal welfare JEL classfcaton: D19, D69, J22 1

3 1. Introducton Snce the 1970s there has been a growng concern n Western socetes regardng the loss n effcency due to dsncentves and dstortons on worker behavor caused by progressve taxaton. The perceved dsncentves on labor supply appeared to be the major justfcaton for reducng margnal tax rates n many European natons durng the 80s and the early 90s. At the same tme there has been a growng nterest n reformng the welfare system or the varous nsttutons devoted to supportng ncomes or consumpton of dsadvantaged households. Whle ths last ssue s broader, there s an obvous connecton wth the former, n that both call for a redesgn of the tax-and-beneft system wth the am of mplementng a new confguraton of ncentves that could eventually lead to more effcency and not more nequalty. There s a massve producton of research addressed to these problems. Most of the contrbutons that use behavoral models of labor supply are able to account for complex budget sets but at the cost of usng very smple and restrctve functonal forms for utlty functons or behavoral functons (e.g. lnear labor supply functons n Hausman, 1981). Alternatvely, very flexble and complex preference or behavoral functons are adopted (e.g. Blundell and Meghr 1985) but at the cost of replacng the exact budget sets by smplfed approxmatons or n some cases even by lnear subsets. Computatonal feasblty s the man reason for these choces. Most of these models are based on the margnalst verson of the standard neo-classcal model of lesure-ncome choce, where the dervaton of a behavoral functon (labor supply) nvolves comparsons between margnal varatons of utlty. The extenson of the basc framework wth constant margnal wage to more complex cases wth non-lnear and knked budget sets are theoretcally straghtforward but computatonally burdensome. The focus on these problems has frst and foremost generated econometrc research on estmaton and computaton problems and may explan why most behavoral models have been complemented wth manly llustratve polcy smulaton exercses based on some representatve typology of households or usng aggregate measures of welfare change such as average compensatng or equvalent varaton. Very detaled statc (non-behavoral) mcro-smulaton models have also been developed for many countres, see e.g. Callan and Sutherland (1997) and Bourgugnon et al. (1997). The specfc contrbuton of these models resdes n provdng wth exact mcro-analytc nformaton upon the changes n the budget sets nduced by tax reforms. Ther lmtaton s equally clear, n that by constructon they do not take changes n behavor nto account. An mplcaton s that whle they can perform an analyss of the drect dstrbutonal consequences of a reform, they must be totally slent 2

4 upon effcency ssues and dstrbutonal effects that are caused by changes n the behavor. Another crucal mplcaton s that non-behavoral models are forced to equate cash ncome and welfare snce they cannot account for lesure n measurng welfare changes. We must remember that lesure ncludes any useful and tme-consumng actvty beyond market labor supply. Therefore t also ncludes those ncome-generatng actvtes that are possbly left unmeasured n the data collectng process (underground economy, etc.). The utlty brought about by lesure also ncludes the net utlty produced by these actvtes. Specalzed local surveys and nconsstences between dfferent offcal sources of data suggest that n Italy the extenson of ncome-generatng actvtes that are left unmeasured by natonal surveys s probably large. Accountng for lesure n the evaluaton of reforms s therefore not only a matter of consstency wth mcroeconomc foundatons but also, and possbly equally mportant, a way to account for unoffcal or unmeasured ncome-generatng actvtes. In ths study we use a prevously estmated model to smulate ndvdual welfare effects of alternatve tax-beneft reforms and we adopt a consstent methodology to perform a socal evaluaton of the reforms. The model, whch draws upon Dagsvk (1994), tres to overcome some of the lmtatons that affect most of the behavoral models used so far for polcy smulaton and evaluaton. In partcular t s a smultaneous model of household labor supply of both spouces, t allows an exact representaton of the budget sets ndependent of how complex they are and t accounts for quantty constrants and lmtatons n the choce of hours of work. These enlarged capabltes are acheved by adoptng a contnuous verson of the multnomal logt famly (e.g. Ben-Akva and Watanatada 1981) that dffers from the standard labor supply models by characterzng behavor n terms of a comparson between utlty levels rather than between margnal varatons of utlty. Ths model s close to other recent contrbutons adoptng a dscrete choce approach such as Dckens and Lundberg (1993), van Soest (1994) and Duncan and Gles (1998). Appendx A provdes a short descrpton of the model, whch s presented elsewhere n more detal (Aaberge et al. 1999, 1998). The socal evaluaton methodology s adapted from Kng (1983), where measures of welfare are derved from equvalent ncomes defned n terms of a reference household and of the prces (wages) that ths household faces. The ntroducton of a reference state (household characterstcs and prces) s made n order to compare welfare across households and opportunty sets. However, snce the conclusons of the analyss may depend on the choce of the reference state, a senstvty analyss wll be provded. A recent example of a polcy smulaton exercse usng a consstent socal evaluaton methodology whch s close to the one adopted n ths paper s provded n an nterestng paper by Fortn et al. (1993). Ther study, however, reles on a calbrated (not estmated) and very restrctve model of 3

5 household labor supply based on a Stone-Geary utlty functon whch has not been subjected to emprcal testng. As an alternatve to the approach to socal evaluaton adopted here, Blackorby et al. (1994) propose a method for evaluaton of socal welfare that s ndependent of the choce of reference state. Moreover, they provde condtons under whch socal welfare prescrptons are ndependent from reference prces. In general, the condtons turn out to requre farly restrctve specfcatons of both household preferences and socal welfare functons. Ths s demonstrated by the fact that prce ndependence s obtaned only when preferences are homothetc, whch s dfferent from the specfcaton of preferences n the model used n the present study. However, there s a trade-off between prce and/or reference state ndependence and flexblty or plausblty of preferences. To rely on homothetc preferences n order to obtan prce ndependence seems to be an extreme choce along ths trade-off. Whether and to what extent welfare prescrptons are prce ndependent s an emprcal queston whch can be answered by a senstvty analyss where results based on dfferent reference states are produced. The methodology for welfare evaluaton s explaned n secton 2, whlst a bref outlne of the mcro-econometrc labor supply model whch we use n the analyss of tax reforms s gven n appendx A. The smulaton results are reported n secton 3. Secton 4 provdes a summary and a dscusson. 2. Interhousehold comparson and socal evaluaton of ndvdual welfare gans and losses Appled welfare analyses of tax reforms must deal wth comparson and socal evaluaton of the changes n welfare of dfferent households or ndvduals. As wll be demonstrated below the conclusons attaned from these types of analyses may depend crucally on the nformatonal bass of the employed evaluatve system. The standard approach for determnng the change n welfare resultng from tax reforms s to employ monetary measures lke compensaton varaton and equvalent varaton. These measures are defned n terms of money values of ndrect utltes. For gven consumer prces and a reference tax regme f * the money metrc utlty y k s defned mplctly by ~ * k ~ =, (1) V ( y, f ) V ( m, f ) k 4

6 where ~ V and m are the ndrect utlty functon and exogeneous ncome of household. 1 Thus, y k affords household the same level of utlty under tax regme f * as that attaned under tax regme f k wth exogeneous ncome m. When focusng on reforms of the tax system, conventonally we put k = 0 for the pre-reform tax and k = 1 for the post-reform tax. Then y 0 and y 1 wll represent the monetary measures of pre-reform and post-reform utlty attaned by household. It may then appear natural to employ the change n the money metrc utltes, caused by movng from tax system f 0 to tax system f 1, as a measure of the welfare change. Ths measure, whch s gven by (2) WG = y 1 y 0, clearly depends on the choce of reference tax system. There are two specal choces for the reference tax system f * that reduce WG to the analogous of the conventonal measures compensatng and equvalent varaton. Thus, a specfc choce of reference tax system represents a partcular normalzaton of a household s ordnal utlty functon even though WG s nvarant wth respect to monotonc ncreasng transformatons of the utlty functon V ~. When the post-reform tax system f 1 s taken as reference system,.e. f * = f1, then the compensatng varaton CV, defned by (3) CV = m y 0, emerges as a specal case of WG. By nsertng (3) n (1) when f * = f1 t follows that CV may be defned mplctly by (4) ( m CV,f ) ( m,f ). V ~ V ~ 1 = 0 As an alternatve to CV we may use equvalent varaton (EV) whch emerges from (2) when the ntal tax system s taken as reference system. Snce compensatng varaton, equvalent varaton and the varous other measures defned by (2) represent alternatve measures of the welfare change of movng from tax system f 0 to tax system f 1, the magntudes of these measures normally wll dffer. The sgn of CV, EV and any other WG wll, however, be the same for any choce of reference system snce WG for dfferent reference systems represents alternatve measures of the same utlty dfference. Thus, rrespectve of choce of reference system we are nevertheless capable to determne the proportons of wnners and losers of the reform from (2). 1 For expostory reasons we suppress the dependence of the reference tax regme n the notaton of the money metrc utlty. 5

7 As emphaszed by Sen (1974), Kng (1983) and Hammond (1990) one needs to compare gans of some to losses of others when concern s bascally turned to the dstrbutonal mpact of the reform. As a frst step we mght ntroduce nter-household comparablty wthout cardnalty whch allows a descrpton of how the reform affects the rankngs of households n the dstrbuton of household welfare. But, of course ths approach does not solve the problem of comparng the magntudes of gans and losses. Alternatvely, we may use the household-specfc WGs as bass for socal judgments. The WGs or utlty dfferences are then requred to be nter-household comparable. Judgments based on nter-household comparson of utlty dfferences allow for statements such as (5) ( m,f ) ( m,f ) > ( m,f ) ( m,f ), V ~ V ~ V ~ V ~ 1 0 j j 1 j j 0 whch means that household gans more than household j from the tax reform. Alternatvely, the statement (5) may be expressed n terms of money values of utlty dfferences as defned n (2). The nformatonal structure gven by (5) allows comparsons of gans and losses of a reform as captured by the WG-measures. Aggregatng the household-specfc WGs as a bass for socal judgement may, however, be less meanngful snce the normatve sgnfcance of aggregaton across the dstrbuton of WGs s stll not clear. Ths s due to the fact that the prce of lesure and the level of the pre-reform utlty vary between households. The latter pont smply means that we do not know whether a household wth, say, a large WG had a low or hgh pre-reform utlty. To deal wth these problems Kng (1983) suggested to base the comparson of gans and losses on equvalent ncomes defned n terms of the state of a R reference household. Equvalent ncome ( y k ) for household s then defned as that level of (exogenous) ncome that affords the reference household the same level of utlty under the reference tax regme f * as household attans under the tax regme f k,.e. y k R s defned mplctly by (6) ( y,f ) = ( m,f );k 0,1. Thus, the dfference between y 1 R V ~ R * R k k = and y R 0 V ~ emerges as a natural measure of the welfare effect of the reform to household. Snce the money values of the households utltes are defned n terms of a reference household who faces fxed prces, ths measure can be consdered as a specfc choce of WG that allows comparson of welfare changes across households Thus, we denote t comparable welfare gan (CWG), R (7) CWG = y y R

8 Applcaton of (7) requres utltes to be cardnal comparable across households. Ths nformatonal structure allows gans and losses of dfferent households to be compared. However, as s also recognzed by Kng (1983), the CWGs depend n general on the choce of reference household and reference prces. Thus, t s mportant to examne the senstvty of the results wth regard to the choce of reference state. An alternatve to the approach outlned above s to employ WG as a measure of welfare change and relate the household specfc WGs to welfare relevant attrbutes such as age, number of chldren and pre-reform ncome. Ths type of approach s n lne wth the suggestons of Hammond (1990). In ths framework households observed ncomes and/or other welfare relevant attrbutes form the bass for comparsons of gans and losses and thus serve a smlar purpose as the reference household and the equvalent ncome n the CWG-approach. However, although the comparsons of WGs are closely related to other welfare relevant varables the nter-household comparablty s weakened due to the fact that the WGs are computed at dfferent prces of lesure and dfferent household characterstcs. When evaluatng the welfare effects of a tax reform t may be useful to summarze the gans and losses by a socal welfare functon. The smplest welfare functon s the one that adds up the comparable welfare gans (CWGs) over households. The objecton to the lnear addtve welfare functon s that the households are gven equal welfare weghts, ndependent of whether they are poor or rch. Concern for dstrbutve justce requres, however, that poor households are assgned larger welfare weghts than rch households. Ths structure can be captured by the followng famly of welfare functons, (8) W ak 1 1 = a y d Fk (y), a 0, 1 a = log y d Fk (y), a 1 a 1 where F k s the dstrbuton of equvalent ncomes under tax regme f k and a s the nequalty averson parameter whch shows ncreasng nequalty averson wth ncreasng values 2. Let ~ y ak be the equally dstrbuted (equvalent) level of equvalent ncome derved from (8). Thus, ~ y ak s gven by 2 The assumptons leadng to (8), and ts propertes, are llustrated for example by Myles (1997). 7

9 1 [ ] (9) ~ 1 a = y df (y) 1 a k y ak exp ( log ydfk (y)),, a 0, a = 1 a 1 Then, followng Kolm(1969) and Atknson (1970) a famly of nequalty measures may be defned as (10) I ak = 1 ~ y µ ak k, where µ k = ~ y 0 k s the mean level of equvalent ncome under tax regme k. As demonstrated by Kng (1983) we can nterpret the rato defned by (11) γ a ~ y a = ~ 1 = ya0 µ µ ( 1 I a ) ( 1 I ) a0 as the equal proportonate ncrease n pre-reform equvalent ncomes whch would gve a level of socal welfare equal to that attaned under the post-reform tax system. Kng (1983) denotes γ the proportonate socal gan. Snce W ak reduces to the sum of equvalent ncomes when a = 0, γ 0 s smply the rato between the mean equvalent ncomes under the post- and the pre-reform systems. Thus, γ 0 s a measure of the effcency effects of the reform. The normatve foundaton of (8) and (9) can also be gven an nterpretaton that reles on a parallel wth the expected utlty theory of choce under uncertanty. Smlarly, we may use the nonexpected utlty theory (see Yaar, 1987, 1988) to justfy applcaton of the followng welfare functons, (12) W ~ bk b = y b 1 ylog b 1 ( 1 F (y)) ( F (y)) k k df k df k (y), (y), b 0, b = 1 b 1 where b s the nequalty averson parameter. Note that the nequalty averson decreases when b ncreases. It follows by straghtforward calculatons that ~ W bk µ k and that W ~ bk s equal to the mean µ k f and only f F k s the egaltaran dstrbuton. Thus, ~ W bk can be nterpreted as the equally dstrbuted (equvalent) level of equvalent ncome under tax regme k. Aaberge (1995) used (12) as bass for dervng the followng famly of nequalty measures, (13) C bk ~ Wbk = 1, b 1. µ k 8

10 Note that { C bk, b } 2 s the generalzed Gn famly ntroduced by Mehran (1976). It can be easly verfed that C 2k s equal to the Gn coeffcent and that C 1k exhbts more nequalty averson than the Gn coeffcent, whch n return exhbts more nequalty averson than C 3k. Analogously to (8)-(11), (12) forms the bass for the followng alternatve measure of proportonate socal gan, (14) ξ b ~ W ~ W b1 = = b0 µ µ 1 ( 1 Cb1) ( 1 C ) 0 b0. In the lmtng case when b, ξ b reduces to the rato between the means of the post- and pre-reform equvalent ncomes. The essental dfference between the socal welfare measures derved from (8) and (12) s revealed by ther senstvty to transfers. Whle the transfer propertes of I ak and γ a solely depend on the choce of the nequalty parameter a, the transfer senstvty propertes of C bk and ξ b depend on the form of the dstrbuton(s) of equvalent ncome as well as on the choce of the nequalty averson parameter b. Ths means that the weghtng-profle on transfers wll depend on the relatve occurrence of small, medum-szed and large equvalent ncomes. 3. Tax smulatons The labor supply model outlned n appendx A has been estmated on Italan data for marred couples n The estmaton results and the labor supply elastctes have been reported and dscussed by Aaberge et al. (1998). Prevous labor supply models based on Italan data takng taxes and to a certan extent quantty constrants nto account are presented n Colombno (1985) and Colombno and Del Boca (1990); however n these studes only the wfe s labor supply decson s modeled and the opportunty set s smplfed wth a convex approxmaton. The model that we use n the present study takes smultaneously nto account both spouses choces, an exact representaton of ncome taxes, and the quantty constrants on the choce of hours of work. Recently, there have been a few emprcal studes of labor supply that account for constrants on avalable jobs and hours. Blundell, Ham and Meghr (1987) allow for nvoluntary employment and Ilmakunnas and Pudney (1990) and Dckens and Lundberg (1993) mpose restrctons on avalable hours. We refer to Aaberge et al. (1998 and 1999) for a dscusson of dfferences between these approaches and our approach. 9

11 Ths paper uses the estmated model as a tool for examnng the effcency and welfare effects of hypothetcal reforms replacng the Italan tax system as of 1993, usng the methodology outlned n secton 2 and appendx A. The core of the actual (1993) tax rule s a system of ncreasng margnal tax rates, gong from 10 per cent (up to 7,2 mllons of ITL) to 50 per cent (over 300 mllons of ITL), whch are appled to ndvdual total ncome. For more detals we refer to appendx B. The hypothetcal reforms are stylzed representatons of deas that are a matter of debate and proposal n Italy (as well as n other OECD countres, wth dfferng focus on dfferent aspects of the tax regme). On the one hand there s a quest for a flatter profle of the margnal tax rates n order to reduce dsncentves and enhance effcency 3. However, relaxng the degree of progresson n taxes s often questoned snce ths reform may brng about unacceptable dstrbutonal effects. On the other hand, and specfcally n Italy, t s recognzed that the system of basc ncome support provdes transfers that are not cost-effectve and do not respond to any explct desgn of socal or famly polcy, and that therefore the system needs to be ratonalzed on more transparent and unversalstc bass. Under dfferent labels, the deas belongng to ths second strand, converge on proposng some knd basc ncome scheme, ether n the form of a unversal transfer or n the form of transfer that compensate ncomes up to a basc level. The quests for more effcency va a flatter tax profle and for more, or not less, equalty va a more cost-effectve system of ncome support are far from beng mutually exclusve. In fact many proposals (e.g. Atknson, 1994 and, for Italy, Rzz and Ross, 1997) match a flat tax wth a basc ncome scheme. In what follows, we smulate three smple systems that n one way or another can satsfy these crtera. The frst s a proportonal or flat tax (FT). If Y represents total gross ncome, the tax FT R to be pad by the household s FT (14) R = t FTY where t FT s a constant margnal tax rate. Besdes ncorporatng the dea of mnmzng dstortons, t s also a benchmark system, useful for comparson. It wll also be used as the reference tax rule (.e. as f * n (1) and (6)) snce t s computatonally convenent to do so. The second reform s a smple negatve ncome tax (NIT), where a flat tax s complemented wth a transfer (a negatve tax) that guarantees households ncome up to a basc level: 3 Another motvaton for less progressve tax rates s to reduce the ncentves to evason and eluson. 10

12 (15) R NIT = Y G t NIT f ( Y G ) Y G f Y G where G s the guaranteed ncome level for household and t NIT s a constant margnal tax rate. G s set equal to 75 per cent of the poverty lne adjusted accordng to a standard equvalence scale 4. Last, we consder the so-called WorkFare (WF) system, whch essentally s a modfcaton of NIT where the transfer s receved only f the household works a mnmum requred amount of hours: (16) R WF = 0 f Y Y G t WF G f ( Y G ) Y G and f Y H < and G H mn H > H mn where t WF s a constant margnal tax rate, H represent the total hours worked by the wfe and the husband and H mn s a mnmum requred number of hours worked (set equal to 1000 n the smulaton). NIT and WF are nterpreted as reforms that try to compound the crteron of lessenng dstortons for hgh ncome households and the crteron of redesgnng the basc ncome support system n a more effectve way. Snce the actual basc ncome support polces are thought to be rather wasteful and occasonally even nequtable, there mght be scope for reforms that are able to ncrease both effcency and equalty. All the reforms are constraned to generate the same tax revenue as under the actual 1993 system. Thus, to acheve the constant revenue constrant for each reform the smulaton has to be terated to fnd the values of the margnal tax rates t FT, t NIT and t WF, whch turn out to be 0.184, and 0.273, respectvely. The correspondng average household tax rates (.e. the rato between total tax revenue and total gross ncome) are equal to 0.184, and 0.195, respectvely, and thus are lower than the average 1993 household tax rate observed n the sample, whch equal to The poverty lne for a two-people household s defned as the average per capta dsposable ncome n the sample. The equvalence scale used was computed n Commssone d Indagne sulla Poverta (1985). 11

13 3.1 Effects on Labor Supply and Income Table 1 shows the smulated effects of the alternatve tax rules upon labor supply, gross ncome and dsposable ncome. Apart from the results for WF the results of Table 1 have prevously been reported by Aaberge et al. (1998), but may form a helpful bass for nterpretaton of the welfare results gven n secton 3.2. Table 1. Partcpaton rates, annual hours of work, gross ncome, dsposable ncome and taxes for marred couples under alternatve tax regmes by decles of dsposable household ncome under 1993-taxes Tax regme tax rules FT NIT WF Decle Partcpaton rates, per cent Annual hours of work Households, 1000 ITL 1993 Gven partcpaton In the total populaton M F M F M F Gross ncome Taxes Dsposable ncome All All All All We focus on three mportant ponts emergng from the results. All the reforms lead to an ncrease of average household gross and net ncome. As expected the FT scheme creates less dstorton on labor supply than the NIT and WF schemes. However, compared to observed labor supply under the 1993 tax rules female labor supply has a small reducton as a consequence of NIT, a small ncrease as a consequence of WF, and a slghtly larger 12

14 ncrease as a consequence of FT. However, whatever the reform, labor supply among females n the frst two poorest decles always ncreases. In other words, no sgnfcant dsncentves to partcpaton or any poverty trap effects emerge n the lowest two decles 5. Among the possble explanaton of ths apparently counterntutve result, we stress two. Frst, the pattern of cross-elastctes reported by Aaberge et al. (1998) shows that the cross elastcty of labor supply for the wves n the two poorest decles (wth respect to the husband s wage) s postve (0.82 per cent). On the other hand, for a majorty of men, the margnal wage rate ncreases as a consequence of any of the reforms, partcularly on full-tme jobs. Gven the postve cross-elastcty, ths leads to an ncrease n the wfe s labor supply. Second, there s a possble effect of the nteractons of the reforms wth the quantty constrants on the hours choce. Gven that part-tme jobs are hard to fnd, at least for some women the relevant comparson s the one between non-partcpaton and full-tme jobs. Thus, t may well be the case that a reform mples a lower (compared to the 1993 system) tax burden on a full-tme job. Ths effect wll encourage partcpaton even f the entrance margnal tax rate s hgher (FT) or f unearned ncome ncreases (NIT and WF). Note that ths phenomenon could not have been captured by the conventonal margnal calculaton framework. The computaton of the Gn coeffcent n Table 2 reveals that all reforms have a dsequalzng effect on dsposable ncome, very strong n the case of FT and rather mld n the case of NIT and WF. To gve an nterpretaton of the magntude of the change n the Gn coeffcent we wll employ the hypothetcal nterventon method suggested by Aaberge (1997). Ths method shows, for example, that the ncrease of 17 per cent for the Gn coeffcent due to the FT reform corresponds to mposng an equal-szed lumpsum tax of 17 per cent of the mean dsposable household ncome n 1993 followed by redstrbutng the collected tax revenue (7,336,000 ITL per couple) as proportonal transfers where each couple receves 17 per cent of ts dsposable ncome n Note that ths nterventon conssts of regressve transfers and leaves the mean ncome unchanged. From the fgures based on 1993-taxes, dsplayed n Table 1, we fnd that the hypothetcal nterventon reduces the dsposable ncome of the poorest decle by 33 per cent and ncreases the dsposable ncome of the rchest decle by 9 per cent. An analogous nterpretaton holds for NIT and WF, whch mply an ncrease of the Gn coeffcent (for dsposable ncome) respectvely of 5.3 per cent and 6.4 per cent. However, as wll be demonstrated n Secton 3.2 the mplcatons on the dstrbutonal effects of the reforms wll n part change when we turn the focus from cash ncome to welfare. 5 One would expect a dsncentve to partcpaton from FT snce t ncreases the entrance margnal tax rate, and a poverty trap effect (on top of a dsncentve to partcpaton) from NIT (f not from WF) snce t guarantees an ncome G even to non-partcpants and apples a 100 per cent tax rate up to the pont when labor ncome reaches G. 13

15 Table 2. Gn coeffcents for the dstrbutons of gross and dsposable household ncome under alternatve tax regmes Tax system Gross ncome Dsposable ncome 1993 tax rules FT NIT WF Effects on Welfare Snce the replacement of the 1993 tax-system by FT, NIT or WF mples that many couples choose a hgher dsposable ncome at the cost of lower lesure, at ths pont the welfare effect of the reforms s not clear. To address ths ssue we start by computng the equvalent ncomes (defned by (1)) and the WGs (defned by (2)) assocated to the three reforms. We use proportonal taxaton as reference tax system (.e. as f * ). The reason for ths choce s that the evaluaton of the equvalent ncome defned by equaton (6) s computatonally much more convenent f the reference system s a system where tax rates are not endogenous. Table 3. The dstrbuton of WG by losers and wnners, and by decles of household ncome under 1993-taxes when the 1993 tax regme s replaced by varous alternatve tax regmes All Losers Wnners Tax regme Decle Mean WG, 1000 ITL FT NIT WF Per cent of populaton Mean WG, 1000 ITL Per cent of populaton Mean WG, 1000 ITL All All

16 All Table 3 provdes estmates of the dstrbuton of WG by decles under the three alternatve reforms, together wth the dstrbuton of wnners and losers. Household s defned to be a wnner or a loser accordng to whether WG s postve or negatve. The results demonstrate that all the reforms have more than 50 per cent of wnners. Ths means that f the reforms had to be decded upon by a majorty referendum, any of them would receve a majorty of favorable votes. In fact WF would receve the hghest majorty. WF also scores a majorty of supporters n all the decles except for the second. By contrast, FT would only receve strong support from households located n the upper two decles of observed dsposable ncome. The overall average WG s postve, agan for any of the reforms. Average WG or WG computed for some representatve household s a tradtonal measure of the welfare effect of a tax reform (more commonly computed n the CV or EV verson). However, as suggested n secton 2, aggregate or average WG s not approprate as a measure of socal welfare snce the normatve sgnfcance of aggregaton over ndvdual WGs are not clear. The rato of the sum of WGs to the (constant) tax revenue can be nterpreted as the per cent reducton of the dead-weght loss of the tax system. For example the average WG of the FT would mply that the ntroducton of a flat tax system brngs about a reducton of 18 per cent n the dead-weght loss. Note that WG n the FT case can be nterpreted as a measure of compensatng varaton smply because the flat tax system both acts as a tax reform and a reference tax system. Table 3 also demonstrates that the average effects shadow for sgnfcant varaton n welfare. Both the mean WG and the proporton of wnners and losers vary dramatcally from decle to decle. From the polcy pont of vew, ths observaton can call for more detaled analyses of the effects accordng to a varety of characterstcs of the household. Polcy makers could make up ther mnd and decde upon reforms by lookng more closely at the characterstcs of wnners and losers, of those who gan or lose most etc. Ths s essentally the poston taken by Hammond (1990). An example of ths type of analyss s presented n Table 4, where we focus upon those who lose most and those who gan most. For each group we report, besdes the average WG, labor supply and ncome n 1993 under the current tax regme. 15

17 Table 4. Partcpaton rates, annual hours of work, gross ncome, dsposable ncome under 1993 rules and mean WG of the 10 per cent households who lose and gan most from a proportonal tax reform FT NIT WF Partcpaton rates per cent Annual hours of work (In the populaton) M F M F Households, 1000 ITL Gross ncome Dsposable ncome WG (1000 ITL) 10 per cent who lose most per cent who gan most per cent who lose most per cent who gan most per cent who lose most per cent who gan most Consderng for example FT, we see that the group of upper has on average a dsposable ncome, whch s almost 2.5 tmes hgher than the average dsposable ncome of the group of the lower losers. Note that the correspondng rato of the mean dsposable ncome of rchest decle and the poorest decle s more than twce as hgh. Ths result ndcates that some of the rch households are not ncluded n the group of the 10 per cent who gan most, and that some of the poor households are not ncluded n the group of the 10 per cent who lose most. Ths knd of analyss s useful f polcy makers are concerned about what happens to specfc types of household. However, t s obvously not suffcent f we need to compare the effects on dfferent households or groups,.e. f we want to make a non-trval socal evaluaton. For ths purpose, as explaned n secton 2, we compute comparable equvalent ncomes (defned by (6)) and comparable welfare gans (CWG, defned n (7)). Table 5 gves the dstrbuton of CWG by losers and wnners. If we compare the results here wth those set out n Table 3 we observe that the proportons of wnners and losers n the total populaton are equal. Ths follows from the fact that the dentfcaton of these proportons solely requres ordnal utlty nformaton. No nterpersonal comparablty of utltes s requred, and hence the 16

18 estmates of the proportons of wnners and losers are ndependent of the method employed for measurng the magntudes of gans and losses. Table 5. The dstrbuton of CWG by losers and wnners, and by decles of household equvalent ncome 1) under 1993-taxes when the 1993 tax regme s replaced by varous alternatve tax regmes Tax system FT NIT WF Decles All Losers Wnners Per Per Mean CWG, 1000 ITL cent Mean CWG, 1000 ITL cent Mean CWG, 1000 ITL of pop. of pop. I II III I II III I II III All All , , , , , , , , , , All , , ) I = equvalent ncome s defned n terms of the poorest household under 1993-taxes II = equvalent ncome s defned n terms of the medan-ncome household under 1993-taxes III = equvalent ncome s defned n terms of the rchest household under 1993-taxes Insert Fgure 1 here 17

19 Fgure1 provdes more detaled nformaton on the dstrbuton of gans and losses wthn decle groups of equvalent ncome when the 1993 tax system s replaced by FT. In Fgure 1 households n each decle of the dstrbuton of equvalent ncome are re-ranked by the change n welfare m0easured by CWG, and dvded nto subdecle groups accordng to the magntudes of the CWGs. For each decle of equvalent ncome the vertcal lnes of Fgure 1 connect the means of the frst and tenth decle n the dstrbuton of CWG. Thus, the length of the vertcal lnes shows the dsperson of CWGs wthn each decle group. As complementary nformaton we also dsplay the mean and medan CWG wthn each decle group. We observe that the dsperson of CWGs ncreases wth ncreasng equvalent ncome. Computatons based on dfferent reference households, notably the poorest and the rchest household, show that the structure of the dstrbuton of CWG does not depend on the choce of reference household. The essental feature of ths structure s that the households on average gan from replacng the 1993 tax system by proportonal taxaton, but that the effcency gan s attaned at the cost of ncreased nequalty. Smlar fgures as Fgure 1 could have been produced for NIT and WF. For these tax reforms, however, we restrct to report the nformaton dsplayed n Tables

20 Table 6. Partcpaton rates, annual hours of work, gross ncome, dsposable ncome under 1993 rules and mean CWG of the 10 per cent households who gan most and the 10 per cent households who lose most when the 1993 tax regme s replaced by varous alternatve tax regmes Tax Reference Losers and Partcpaton rates. Per cent Annual hours of work (In the populaton) Households, 1000 ITL System household wnners Gross Dsp. M F M F ncome ncome CWG Poorest 10 per cent who lose most Household 10 per cent who gan most FT Medanncome who lose most per cent Household 10 per cent who gan most Rchest 10 per cent who lose most Household 10 per cent who gan most Poorest 10 per cent who lose most household 10 per cent who gan most NIT Medanncome who lose most per cent household 10 per cent who gan most Rchest 10 per cent who lose most Household 10 per cent who gan most Poorest 10 per cent who lose most household 10 per cent who gan most WF Medanncome who lose most per cent household 10 per cent who gan most Rchest 10 per cent who lose most Household 10 per cent who gan most Although the detaled nformaton provded by Tables 5 and 6 and Fgure 1 s mportant for evaluatng the welfare effects of a tax system or a tax reform, t may be useful to summarze ths nformaton by means of a socal welfare functon. To ths end we use W ak defned by (8) for a =1, 15. and 2 and W ~ bk 19

21 defned by (12) for b =1, 2 and 3. The correspondng measures of socal welfare have been calculated for both the pre- and post-reform dstrbutons of equvalent ncome. The values of proportonate socal gan based on γ a defned by (11) and ξ b defned by (14), measured as percentage changes ~ γ = γ a 100( 1 ) and = ( ) a ~ ξ 100 ξ 1, are gven by Table 7. Note that ~ γ 0 gnores dstrbutonal b b effects and solely captures the effcency gans of the reform. Table 8 reports the percentage varaton n the nequalty measures defned by (10) and by (13). The results for ~ γ 0 n Table 7 confrm the suggeston, whch could be drven from the above analyses that all the reforms are effcent. The gan n average comparable equvalent ncome s always postve. Ths was also the case wth non-comparable equvalent ncome (Table 3) and wth cash ncome (Table 1). However, Tables 7 and 8 show that the applcaton of the socal welfare functons (8) or (12) to the comparable equvalent ncomes produces results that are rather dfferent from before wth respect to nequalty. We have seen that the Gn coeffcent (Table 2) of the dstrbuton of dsposable ncome classfed FT, NIT and WF as dsequalzng compared to the actual 1993 tax regme. Also the descrptve analyss of Tables 3-7 qualtatvely seem to suggest that the reforms mght be more or less dsequalzng even when focus s on welfare rather than cash ncome. However, when nequalty s measured by the socal-welfare based ndexes (10) or (13), whle FT s confrmed as dsequalzng, NIT and WF n fact turn out to be equalzng (compared to the current 1993 system, not compared to FT). Table 7. Proportonate socal gan of varous tax reforms. Per cent Tax system Reference household ~ γ0 ~ γ1 ~ γ ~ 1 5 γ2 ~ ~ ~ ξ1 ξ2 ξ3. FT NIT WF Poorest household Medan ncome household Rchest household Poorest household Medan ncome household Rchest household Poorest household Medan ncome household Rchest household

22 Table 8. Relatve change n nequalty n the dstrbuton of equvalent ncome when the 1993 tax system s replaced by varous alternatve tax regmes Tax system FT NIT WF I a1 I a0 Cb1 Cb Reference I a0 Cb0 Household a = 1 a = 1. 5 a = 2 b = 1 b = 2 b = 3 Poorest household Medan ncome household Rchest household Poorest household Medan ncome household Rchest household Poorest household Medan ncome household Rchest household Summary and dscusson Ths study dscusses methodologcal prncples for socal evaluaton of ncome taxaton and tax reforms wth partcular reference to dstrbuton ssues. The dscusson s followed by an emprcal analyss based on Italan household data. Usng a household mcroeconometrc labor supply model we have smulated behavoral responses and welfare gans and losses for marred couples resultng from replacng the Italan tax system as of 1993 by three alternatve tax-and-beneft regmes: a flat tax, a negatve ncome tax and a work-fare system. The model allows for observed as well as unobserved characterstcs n preferences and opportuntes, for spouses smultaneous decsons, for non-convex budget sets due to the complexty of the tax system and for quantty constrants on the choce of hours of work. Altogether ths gves a complex model wth non-homothetc preferences. We draw on Kng (1983) by dervng welfare measures from equvalent ncomes n terms of a reference household and of the prces that ths household faces. Snce the results of the emprcal analyss may depend on the choce of reference household a senstvty study has been provded. In ths study the senstvty analyss shows that the man conclusons are not affected by the choce of reference state. All the reforms produce a larger labor supply, a hgher average dsposable ncome and a majorty of wnners. When the reforms are judged on the bass of a socal welfare functon, the strkng result emerges that all of them are 21

23 effcent, and that whle FT s dsequalzng NIT and WF are also equalzng. Therefore ths analyss suggests that there s ndeed scope for desgnng a system that s superor to the current one accordng to both effcency and equalty. Acknowledgement: We would lke to thank Tom Wennemo for skllful programmng assstance, Anne Skoglund for typng and edtng the paper, and K.A. Breke and E. Holmøy for useful comments. Specal thanks to Dno Rzz (Unversty of Veneza), who provded us wth a program (TBM) wrtten by hm for the smulaton of the drect and nverse 1993 tax-beneft rules. Ths verson of the paper was wrtten when Aaberge and Strøm were vstng ICER n Torno. The Regone Pemonte s gratefully acknowledged for provdng fnancal support and excellent workng condtons. Ugo Colombno gratefully acknowledges fnancal support from CNR (research grant CT10) and from MURST (research grants 1997 and 1998). 22

24 Fgure 1.The dstrbuton of CWG of FT reform, defned n terms of the medan ncome household under 1993-taxes, by decles of equvalent ncome mean of frst and tenth decle medan mean

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28 Appendx A The mcroeconometrc model and the smulaton exercse The mcroeconometrc model used n ths paper reles on an explct representaton of household preferences through the drect utlty functon. For expostory reasons, we restrct the llustraton of the model to a sngle-person household, although the estmated model represents the smultaneous behavor of couples, see Aaberge et al. (1995, 1999) for more detals. Let B (h,w) denote the set of jobs wth hours h > 0, and wage rate w > 0, that are feasble to agent. B ( 0, 0) s the set of non-market opportuntes. Let U ( C h j) consumpton C, hours h and opportunty j, where ( ),, denote the utlty for agent of j B h, w, h 0, w 0. The argument j of the utlty functon accounts for the fact that the agent s preferences may vary across job types. The economc budget constrant s gven by (A.1) C = f ( wh, m), where m s non-labor ncome, and f s a functon that transforms gross ncome nto after-tax ncome. The prce ndex of the composte good (called consumpton) s equal to one. When we nsert the budget constrant nto the utlty functon we get ( f ( wh,m ),h, j). Furthermore, we wll assume that U (A.2) U ( f (wh,m),h,j) = v ( f (wh,m),h ) ε (h, w) where v(x,h) s quas-concave n (x,h), ncreasng n x and decreasng n h. The random term ε j (h,w) s assumed to capture the effect of unobservable attrbutes assocated wth opportunty j. Note that ths term s vewed as random from the econometrcan s pont of vew, whle t s assumed known to the { } agent. Specfcally, ( h, w ) j ε accounts for the fact that for a gven agent, tastes may vary across opportuntes, and for a gven opportunty, tastes may vary across agents. The agent s assumed to maxmze the utlty n (A.2) under the budget constrant (A.1) and gven the opportunty set avalable for the agent. Thus, for a gven tax and beneft regme the ndrect utlty functon V ~ s defned by ~ [ ]. (A.3) V ( m, f ) = max max U ( f ( wh, m), h, j) h, w j B ( h, w) j 27