MODELLING INCOME TAX AND THE MEDICARE LEVY IN STINMOD. Simon Lambert. STINMOD Technical Paper No. 4, September 1994

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1 MODELLING INCOME TAX AND THE MEDICARE LEVY IN STINMOD Simon Lambert STINMOD Technical Paper No. 4, September 1994

2 National Centre for Social and Economic Modelling STINMOD Technical Paper Series Faculty of Management, University of Canberra The National Centre for Social and Economic Modelling was established on 1 January 1993, following a contract between the University of Canberra and the then Federal Department of Health, Housing, and Community Services (now Human Services and Health). NATSEM has been established to develop microsimulation models, for use by government departments and the wider community, and to foster the use of microsimulation and microdata techniques and models within Australia. STINMOD is NATSEM's first static microsimulation model and the STINMOD Technical Paper Series documents various aspects of the model's construction. The DYNAMOD Technical Paper Series fulfils a similar role for the NATSEM dynamic simulation model. NATSEM is also publishing a Discussion Paper Series to make research undertaken by the Centre using microsimulation models or microdata available to a wider audience. Lists and copies of available Discussion Papers, and information about NATSEM and its other publications, may be obtained from: The Publications Officer National Centre for Social and Economic Modelling University of Canberra GPO Box 563, Canberra City, ACT 2601, Australia Ph: (06) Fax: (06) Director: Professor Ann Harding A/g Deputy Director: Ms Susan Antcliff Publications Officer: Ms Lynne Simpson

3 MODELLING INCOME TAX AND THE MEDICARE LEVY IN STINMOD by Simon Lambert National Centre for Social and Economic Modelling, Faculty of Management, University of Canberra STINMOD Technical Paper No. 4, September 1994 Core funding for NATSEM is provided by the Federal Department of Human Services and Health ISSN ISBN call UCAN Library for this number

4 Authors' Note Simon Lambert is a Senior Research Fellow in the National Centre for Social and Economic Modelling (NATSEM), Faculty of Management, University of Canberra. Acknowledgments

5 About STINMOD STINMOD is a static microsimulation model which has been developed by the National Centre for Social and Economic Modelling (NATSEM). STINMOD is NATSEM's first publicly available model. It is a generalpurpose, static microsimulation model which has been developed to provide government and non-government organisations - as well as academic and other researchers - with an accessible and practical tool to allow examination of the immediate impact of a range of policy changes on family incomes and government expenditure. STINMOD is a general-purpose microsimulation model, as it models a broad range of Federal Government programs. The programs currently modelled in STINMOD are Social Security pensions, allowances and family payments, Veterans' Affairs pensions, AUSTUDY, the Medicare levy and income tax. Estimates of the cash value of government expenditure on public housing and health have also been added to the STINMOD database. In later releases, other government programs will be added to the model, to improve the coverage of both cash and noncash transfers. As a static microsimulation model, STINMOD provides a 'snapshot' of the economic circumstances of the Australian population, both as it was just before the introduction of a new policy and as it would be immediately after a policy is introduced. By examining the changed economic circumstances of the model's population, it is possible to predict accurately the likely first-round effect of a new policy change on the real population.

6 Abstract This paper is one of a series of technical papers which document and discuss aspects of the development of STINMOD, NATSEM's first static microsimulation model. The focus of this paper is on the simulation of the federal income tax and Medicare levy programs within STINMOD. The elements of these two programs that are included in STINMOD are described and then the methodology used to model them is discussed. Any issues that arose during this modelling are also considered and suggestions are made for future enhancements and refinements. STINMOD's outcomes for income tax and Medicare are compared against relevant administrative data. The paper concludes with an outline of the likely direction of the future development of this component of STINMOD.

7 Contents 1. Introduction Microsimulation Australia's Income Tax and Medicare Levy Programs Major Elements of the Income Tax Program Recent Developments Unit for Income Tax Major Elements of the Medicare Levy Program Modelling Methodology Tax Module and STINMOD Assessable Income Deductions Income tax Policy Consistent Pension and Allowance Rebates Rebates for Dependants Low Income Rebate Omissions and Limitations Benchmark Outcomes Future Work...27 Appendix A...29 Appendix B...30 Bibliography...31

8 Modelling Income Tax and the Medicare Levy in STINMOD 1 1. Introduction The purpose of this technical paper is threefold. First, it presents the technical details of how the income tax and Medicare levy programs are modelled in STINMOD. Second, it discusses some of the issues that arose during the translation of the rules and realities of income tax and the Medicare levy into computer code that operates on the STINMOD base population. These issues often suggested areas for future refinement of STINMOD. Third, it provides a general guide to the key elements of the income tax and Medicare levy programs and how they interact with other government programs. The paper is intended to be of interest to both the specialist and general reader. It should also assist those using the user-friendly version of STINMOD to better understand the tax/medicare parameter screens and to interpret simulation outcomes - which, because of interactions between government programs, do not always produce intuitive results. The paper begins with an overview of microsimulation and the policy context in which the income tax and Medicare levy programs operate. Next, the elements of income tax and the Medicare levy modelled in STINMOD are described. This is followed by an analysis of some comparisons between STINMOD outcomes and the latest available administrative benchmarks. The paper concludes with an outline of the likely future development of the income tax and Medicare levy component of STINMOD. 2. Microsimulation Microsimulation is a means of modelling socio-economic systems by simulating the behaviour of individual units within the system. It is a technique which is particularly suitable for systems where the decision-making occurs at the level of the individual unit and where

9 Modelling Income Tax and the Medicare Levy in STINMOD 2 the interactions within the system are so complex that it is not possible to find an exact solution. The major advantage of microsimulation models for social and economic policy analysis is that they produce results which can be analysed at the individual level. Thus, the distributional impact of a policy measure across different types of families or different geographical regions can be assessed. At the same time, estimates of the aggregate outcomes can still be derived easily, by summing the individual results. It is these features which led a recent exhaustive review of microsimulation in the United States to conclude "that no other type of model can match microsimulation in its potential for flexible, fine-grained analysis of proposed policy changes" (Citro and Hanushek, 1991:115). The idea of applying microsimulation techniques to socio-economic modelling was pioneered by Guy Orcutt in the United States in the late 50's and early 60's (Orcutt, 1957; Orcutt et al, 1961). However, until relatively recently, the enormous cost of the computing resources required by such models and the lack of appropriate data had made their development and use for policy formation in Australia of questionable value. Only with the development of increasingly powerful computer hardware and the greater availability of individual record data has microsimulation modelling become a cost-effective and accessible option (Harding, 1993b). The starting point for microsimulation models is a unit record file, which provides comprehensive information on such things as earnings, family characteristics, labour force status, education, and housing status for every individual on the file. Typically, adjustments will need to be made to this base data file to ensure that it reflects as fully as possible the population which is being modelled and includes all of the variables which will be needed. Percival (1994) provides a detailed description of the process of preparing the base population data set for use in STINMOD. Microsimulation models can be static or dynamic. Static models take a cross-section of the population at a specified point in time and apply program rules to the individual units to measure the instantaneous or 'morning after' effects of policy changes. Such

10 Modelling Income Tax and the Medicare Levy in STINMOD 3 models thus usually show the 'first-round' effects of policy changes, before individuals have had time to adjust their behaviour to the changes. Generally, these models will allow the analyst to vary the rules of eligibility or liability, and produce output showing the gains or losses (both to individuals and in aggregate) from the policy change. The distinguishing feature of dynamic models is the ageing of the original unit records on the basis of probabilities of different real life events occurring. This allows the original population to be projected forward in time while maintaining detailed information on the individuals within the simulation. During the past decade, static microsimulation models have become an important tool in the development of tax/transfer policy in most industrialised countries 1 - and have sometimes played a decisive role in determining whether or not a proposed new policy measure in implemented (Harding, 1993a). In the United States, for example, Congress will not consider any social security or tax legislation without closely examining the distributional outcomes predicted by microsimulation models (Citro and Hanushek, 1991). In Australia, at least five comprehensive static microsimulation models are in use within government departments and research organisations (Bradbury, 1990; Gallagher, 1990; King et al, 1990). The power of such models to affect public debate was demonstrated in 1992 and 1993, when the Opposition parties proposed a package of sweeping tax and transfer changes (Liberal and National Parties, 1991). The immediate distributional impact of this policy shock was estimated using a static microsimulation model. STINMOD represents a departure from other microsimulation models developed in Australia in that it has been specifically designed for public use. This has resulted in a far wider range of payments and services being modelled, to give a more comprehensive picture of the impact of Government spending and taxes and be of use to a broader group of users. In addition, 1See Harding (1993a:381) for a comprehensive list of references.

11 Modelling Income Tax and the Medicare Levy in STINMOD 4 considerable attention has been given to the development of a userfriendly interface, which facilitates the use of the model by those who have no experience of microsimulation models or computer programming. 3. Australia's Income Tax and Medicare Levy Programs 3.1 Major Elements of the Income Tax Program Assessable income refers to income from sources that are taxable. Not all income sources are taxable and some are taxable in some situations and not in others. Separate net income is used to establish dependency of a spouse and/or children. It includes all assessable income as well as income from some sources that are not assessable. Deductions are offsets against assessable income which reduce the amount of assessable income that is taxable. Some are provided as recognition of costs involved in obtaining assessable income (eg protective clothing), while others are provided for broader social reasons (eg donations to charities). The higher the marginal rate faced by a taxpayer, the greater will be the reduction in income tax for a given level of tax deduction. Taxable income is total assessable income minus deductions. Gross Income tax is levied on taxable income through the application of an income tax scale. Typically these scales have several steps. Each step is defined by a threshold and a marginal rate. Taxable income above a threshold is taxed at the marginal rate of that step until another tax threshold is reached. For example, the second step

12 Modelling Income Tax and the Medicare Levy in STINMOD 5 in the current income tax scale has a threshold of $5,400 (per annum) and a marginal rate of Each dollar of taxable income above $5,400 is subject to 20 cents of gross income tax until the next threshold ($20,700) is reached. There is usually a tax threshold below which no income tax is paid. In Australia the income tax scale is applied to an individual's taxable income. Income tax rebates are offsets against income tax. Rebates are provided for a variety of reasons. Some are for dependency and recognise that more than one person relies on an individual's income. Others are provided to ensure that the tax liability of pension and allowance recipients is not too high. Some rebates are income-tested (eg dependent spouse rebate), while others are not (eg sole parent rebate). In order to get maximum value from a rebate an individual must have sufficient taxable income to generate an income tax liability which is equal to or greater that the value of the rebate. However, unlike deductions, rebates are not of greater value to those facing higher marginal tax rates. Net income tax is gross income tax minus total rebates. 3.2 Recent Developments The bulk of federal government revenue comes in the form of taxation revenue. For the financial year 1993/94, income tax (including Medicare levy) paid by individuals is estimated to be $50.3 billion (with 87 per cent of this contributed by PAYE taxpayers). The two other major sources of taxation revenue (see Fig 1) are income tax on companies - estimated at $13 billion for 1993/94 - and indirect taxes - estimated at $24.7 billion for 1993/94 (Treasurer, 1994a). Income tax generates half of the total revenue received by the federal government. Any change to the income tax system must always be considered in terms of its impact on government revenue and the government's ability to fund its expenditure programs. Of equal importance is the impact it will have on Australia's distribution of disposable income.

13 Modelling Income Tax and the Medicare Levy in STINMOD 6 The income tax system has been an area of policy debate and change during the 1980s and 1990s, in both Australia and overseas. For much of the 1980s there was concern about the disincentive effect of high (in the international context) marginal tax rates coupled with the impact of bracket creep (where, in times of inflation, incomes rise but tax steps are not adjusted for inflation and the result is an increase in the numbers of taxpayers facing the higher marginal rates in the income tax scale). High Figure 1 - Composition of Estimated Federal Revenue in Sales Tax Other T axes 2% 24% Individual Income T ax 49% Other Income T ax 5% Company Income T ax 13% Non-T ax Revenue 7% Source: Budget Paper No 1 marginal rates were seen by some as encouraging tax avoidance (Hepburn, 1992). There has also been considerable debate on whether Australia should decrease its revenue from direct taxation and increase its revenue from indirect taxation. On both occasions where major policy documents proposed the introduction of a broad based consumption

14 Modelling Income Tax and the Medicare Levy in STINMOD 7 tax (Liberal and National Parties, 1991, Draft White Paper, 1985), offsetting reductions in income tax were proposed. In both cases such a tax proved too difficult to sell. Income tax cuts have also been used as an industrial relations tool. Reductions in income tax as a trade-off for wage restraint were a feature of the Accords negotiated between the current federal government and the ACTU. In a climate of recession and high unemployment there have been calls for increases in marginal rates to fund job creation, and to increase public sector savings (Committee on Employment Opportunities, 1993). In this context promised tax cuts have again recently been deferred (Treasurer, 1994b) Another trend in the income tax system during the 1980s and early 1990s has been the replacement of rebates for dependants with direct cash payments. These changes have reflected changing views about financial roles within families and a desire to make payments to families more visible. Given the political and personal (hip pocket nerve) interest in the income tax system it seems likely that calls for change will continue throughout the remainder of the 1990s. The income tax system also interacts with the cash transfer system. Income tests for cash transfers typically overlap with the income tax system. There has been particular concern in recent years about the implications of this overlap - see Gallagher and Ryan (1992), Whitlock (1994), for a discussion of poverty traps caused by high effective marginal tax rates. There are other types of interactions as well. Special income-tested rebates are available for recipients of allowances (including AUSTUDY) and pensions. Calculation of these rebates and the associated income test parameters depends on elements of both the cash transfer and the income tax systems. 3.2 Unit for Income Tax The primary unit in the Australian income tax system is the individual. The income tax scale relates to the taxable income of the

15 Modelling Income Tax and the Medicare Levy in STINMOD 8 individual. At the same time, the family circumstances of the individual also affect the amount of income tax paid. There are a number of tax rebates that reflect an individual's family circumstances -including the dependent spouse rebate, the sole parent rebate and the pension rebate. These rebates aim to reduce the tax liability of an individual because of other members of their families who are considered to be dependent (dependent spouse rebate, sole parent rebate) or to ensure an individual's tax liability reflects a transfer payment structure based on marital status (pension rebate). Dependency is established through the application of a tapered income test (dependent spouse rebate) or a sudden death income test (sole parent rebate) on the dependant's income. As mentioned in the previous section, there has been a move away from rebates for dependants to direct cash payments for them. In September 1994 the dependent spouse rebate for those with dependants was replaced by a direct cash payment called the home child care allowance. This payment is made to the 'dependent' spouse, unlike the dependent spouse rebate which reduced the income tax liability of the 'non dependent' spouse. The operation of the income tax system with an individual as the focus is, however, not the only option. Other possibilities for the income tax unit include the couple, the family, the household and combinations of these. Income splitting (where couples combine and then split total income equally) was part of Coalition policy for the 1984 election (Liberal Party of Australia, National Party of Australia, 1984) and has recently been revived as a solution to reduce the tax paid by single income families (Gittons, 1994). In practice, some couples are already able to achieve this by artificially splitting selfemployment income or by dividing unearned income in a way which minimises the tax paid on it. One advantage that microsimulation offers in this area is that usually the microdata contains the family relationships of individuals. As a result, STINMOD can be used to examine other possibilities for the income tax unit. Currently the Australian Taxation Office (ATO) is unable to accurately link family data in its taxpayer database - unlike

16 Modelling Income Tax and the Medicare Levy in STINMOD 9 the STINMOD microdata, where family relationships are clearly identified. These linkages are particularly important for rebate entitlement and the Medicare levy. The current trend in the tax/transfer system in Australia is for the individual's family status to be given less importance, in recognition of the increased participation by women in the paid workforce. While STINMOD calculates outcomes for individuals, its focus is on outcomes for families (the aggregate of family members' outcomes). This puts a different perspective on the impact of changes which are based on the individual. A good example is the low income rebate - a rebate income-tested on the individual's own taxable income. This rebate was introduced in 1993 to reduce the tax liaibility of those on low incomes. A family analysis shows that there are a significant number of high income families that benefit from this rebate: this is because one or more individuals in the family has a low income. 3.4 Major Elements of the Medicare Levy Program Another important aspect of income tax revenue is the Medicare levy program. While revenue from this source is relatively small ( estimated $2.9 billion in 1993/94) (Treasurer, 1994), there is ongoing interest in this source of funding for health expenditure. As health costs increase and Australia's population ages, there may be pressure for an increase in the Medicare levy, or the introduction of a second step in the Medicare scale. The Basic Medicare levy is a fixed proportion of an individual's taxable income. An individual is only liable for Medicare levy if taxable income is above the Medicare levy threshold applicable to that individual. These thresholds vary according to family type - single/married/sole parent and the number of dependants. Above the threshold, a shade-in range of income applies. For a single person in the shade-in range, a higher rate of Medicare levy is applied to the income above the threshold amount. At the end of the shade-in range, basic Medicare levy is applied to each dollar of taxable income.

17 Modelling Income Tax and the Medicare Levy in STINMOD 10 For married couples and sole parents in the shade-in range of income a family reduction amount is calculated (for each partner in a married couple), based on family income. Basic Medicare levy is then calculated on individual income and then the family reduction amount is used to offset this. Any unused family reduction amount can be transferred to a spouse and added on to their family reduction amount. 4. Modelling Methodology 4.1 Tax Module and STINMOD The tax and Medicare levy module is applied to the STINMOD microdata after entitlement to DSS, DVA and DEET payments have been calculated. This module applies the elements of the tax and Medicare levy systems outlined above. The outcomes from the other government programs are required in order to correctly calculate income tax and Medicare liability. Figure 2 presents an overview of the steps involved in modelling income tax. 4.2 Assessable Income The first step in calculating net income tax liability is the identification and summation of assessable income items. There are two sources of income items in STINMOD. The first is the original microdata, referred to as the base files (the distributional file and the hypothetical file) 2. The second is the STINMOD entitlement modules, which impute outcomes for a variety of cash transfer programs. 2The distributional file is derived from a survey undertaken by the Australian Bureau of Statistics and contains detailed information for 18,800 income units. For more detail see Percival (1994). The hypothetical file is a synthetic file of typical family types created 'in-house' for hypothetical analysis.

18 Modelling Income Tax and the Medicare Levy in STINMOD 11 The base files contain the level of income from the following sources - wages and salaries, self employment, dividends, rent, interest, maintenance, superannuation, workers compensation, accident or sickness insurance, road accident compensation, overseas pensions and regular financial support from relatives. Income from business and rent is net of the expenses incurred in obtaining that income: for example, in the case of rental income, the gap between rental income and interest paid on the mortgage would be such an expense. With the exception of maintenance income, all the above income sources are assessable. The STINMOD entitlement modules generate income amounts for the following sources - age pension, disability support pension, wife pension, carer pension, sole parent pension, widows B pension, job search allowance, new start allowance, special benefit, sickness allowance, pharmaceutical allowance, rent assistance, service pension, war disability pension, war widows pension, basic family payment, additional family payment(including rent assistance and guardian allowance where applicable), and AUSTUDY. Many of these are not assessable for tax purposes - disability support pension (if the recipient is below age pension age - 60 for a female and 65 for a male), wife pension (if the recipient and the partner are both below age pension age), carer pension (as for wife pension), war disability pension, war widows pension, basic family payment, additional family payment (including rent assistance and guardian allowance if applicable) and pension education supplement (a form of AUSTUDY) The microdata used by STINMOD contains two sources of dividend income- from an individual's own limited liability company and from some other limited liability company. Dividend income received by the self-employed from their own company is assumed to be fully assessable. Dividend income from the other source is adjusted to take account of dividend imputation before it is added to assessable income. Dividend income can be either franked (fully or partly) or unfranked. Franked dividend income has an imputation credit associated with it.

19 Modelling Income Tax and the Medicare Levy in STINMOD 12 This is a credit for tax paid by a company on its income. Tax statistics (Australian Taxation Office, 1994:42) indicate that about 92% of the total gross dividend income of taxpayers is franked. This percentage is applied to dividend income to determine the amount of franked dividend income an individual receives. An imputation credit for that franked dividend income is then calculated by applying the following formula: imputation credit = franked dividend income * company tax rate / (1 - company rate of tax)

20 Modelling Income Tax and the Medicare Levy in STINMOD 13 Figure 2 - Overview of Income Tax Calculation Sum Assessable Income Impute Deductions Calculate Gross Income Tax Calculate Income Tax Calculate Policy Consistent Rebates Calculate Rebate Entitlement Calculate Net Income Tax

21 Modelling Income Tax and the Medicare Levy in STINMOD 14 This imputation credit is added to an individual's taxable income and an equivalent amount is available as a franking rebate. 4.3 Deductions After all assessable income items are summed, deductions are imputed. If deductions are not imputed then total tax revenue will be overstated. The method used to accomplish this is to use Australian Taxation Office statistics which compare taxable income to net income across 26 taxable income ranges (Australian Taxation Office, 1994:43). Net income is calculated as the sum of the assessable income items outlined above. The definition of net income used in the Tax Statistics is slightly different because it subtracts investment income deductions from the sum of assessable income items. However this adjustment makes only a very small difference to net income (0.002% of total net income). An average level of deductions is calculated for each income range and this is applied to the net income of individuals to calculate their taxable income. The maximum level of average deductions for an income range is 7.88% and the minimum is 0.31%. The overall average is 4.04%. This approach of relating the level of deductions, to level of taxable income, can produce confusing results when individuals' taxable incomes change in a microsimulation run. For example, an income splitting simulation can produce losers who only lose because they move to ranges of taxable income that have lower levels of tax deductions. In practice this would be a highly unlikely outcome. One way to overcome this would be to give everyone the overall average level of tax deductions. Another way would be to to give an individual the same level of deductions in the simulation as in the base scenario. The general problem with using averages is that it hides the variation that does occur in levels of tax deductions. A more sophisticated

22 Modelling Income Tax and the Medicare Levy in STINMOD 15 model of deductions would use variables such as occupation and study status as predictors. Hellwig (1991) has canvassed options for such an approach. It might also include a behavioural component (eg an increase in marginal rates may well lead to an increase in the level of tax deductions and vice versa). Such a methodology would aim to provide a better distribution of taxable income (and hence disposable income) for the base population than an approach based on averaging deductions. This approach will be explored by NATSEM in the near future. The co-operation of the Australian Taxation Office would be required to develop such a methodology as special tables or unit record data would be required. 4.4 Income tax The calculation of an individual's gross income tax liability (before any rebates are considered) is a straightforward matter, as it simply depends on taxable income and the tax scale that is being applied. Taxable income is located within a tax step. The marginal rate for that tax step is applied to the difference between taxable income and the threshold of that tax step. This amount is then added to the tax liability accrued from previous (if any) tax steps. The liability for a tax step is the difference between the next tax step threshold and the tax step in question, multiplied by the marginal rate for that tax step. In STINMOD this process is slightly more complicated because there is a facility to define between one and ten steps in the income tax scale (instead of the current five). The Income Tax Scales Parameter Window for STINMOD/94A is contained in Appendix A. This Window allows users to easily define their own income tax scale for a simulation run. 4.5 Policy Consistent Pension and Allowance Rebates These rebates were introduced during the 1980's to ensure that maximum rate pensioners and allowees with no private income do not pay tax. Both pension and allowance rebates are income-tested on taxable income.

23 Modelling Income Tax and the Medicare Levy in STINMOD 16 Pension rebates are calculated with reference to: maximum pension rates over the financial year pension income test free areas the income tax scale(s) applying in the financial year, and the number of pension paydays in the financial year Maximum pension rates are indexed twice a year with movements in the Consumer Price Index (CPI). As a result, three different values of maximum pension will apply in any one financial year. Occasionally ad hoc adjustments are made to maximum pension rates. The pension income test free area is indexed annually to the CPI, but this occurs at the beginning of the financial year. The steps in the income tax scale will determine the amount of income tax ( and hence the level of the pension rebate) that pension plus free area will attract. In recent years it has not been uncommon to have two income tax scales operating in a financial year. Finally, there are usually 26 pension paydays in a financial year but every 11 years there are 27. All these factors are taken into account by the ATO when the final values for pension rebates are announced (usually early in the second half of the financial year to which they apply). The approach taken in STINMOD is to generate pension rebates 'on the fly' which are consistent with their policy objectives. The pension maximum rates, the pension income test free areas (for married couples the free area is half the combined free area) and the structure of the income tax scale that apply for the simulation are used to calculate policy consistent pension rebates in the following way: rebate threshold = max pension + free area, maximum rebate = Tax 3 (rebate threshold). Allowance rebates are calculated with reference to: 3The amount of income tax payable for the level of taxable income equal to the pension rebate threshold.

24 Modelling Income Tax and the Medicare Levy in STINMOD 17 maximum allowance rates over the financial year the income tax scale(s) applying in the financial year, and the availability of other rebates As with pension rebate, the first two factors can vary during the financial year. The level of maximum allowance also has many different values which vary according to age, family status and the presence of dependants. Separate rebates are calculated for each. The presence of other rebates is also relevant. The value of the allowance rebate for sole parent allowees is currently zero, because the sole parent rebate ensures that a sole parent receiving maximum allowance with no private income does not pay tax. Prior to the introduction of home child care allowance and partner allowance, the dependent spouse rebate was also taken into account when calculating the allowance rebate for a married allowee who received all the allowance. The value of allowance rebates also reflect the fact that in any year an allowee can receive 27 pays in a financial year. Unlike pensioners, there is no set allowee payday. Allowance rebates are set with reference to DSS allowance rates but they also apply to Austudy allowees. This is because there is a link between levels of DSS allowances and DEET allowances. Currently in STINMOD the policy consistent rebate approach only applies to DSS allowances. If the link between these allowances is not maintained in a simulation, then the allowance rebates may not prevent a full year Austudy allowee with no private income from paying tax. The next version of STINMOD will correct this anomaly by calculating separate rebates for each of the AUSTUDY maximum rates. As with pension rebates, the approach taken in STINMOD is to generate allowance rebates 'on the fly' which are consistent with their policy objectives. The allowance maximum rates, the structure of the income tax scale, and values of relevant rebates that apply for the simulation are all used to calculate policy consistent allowance rebates in the following way:

25 Modelling Income Tax and the Medicare Levy in STINMOD 18 rebate threshold = max allowance (27 pays) maximum rebate = Tax (rebate threshold) Once policy consistent pension and allowance rebates and income test thresholds have been calculated the next step is to establish who is eligible for these rebates. Once eligibility is established, the correct maximum entitlement (prior to the application of the income test) is assigned, as is the corresponding income test threshold. In the case of pensioners, this is quite straightforward. If the pensioner is receiving a taxable pension, then they qualify for a pension rebate. The maximum entitlement depends on their marital status. Establishment of eligibility and maximum entitlement for allowees is less straightforward. Marital status, age and the presence of dependent children must all be considered, as these are the factors that determine the level of allowance paid to an individual. In order to establish the dependency of a child, separate net income must be calculated. Separate net income includes all assessable items and some which are not assessable. These include non-taxable DSS and DVA pensions and rent assistance (if not paid as part of family payments). Family payments are not included as part of separate net income. Workrelated deductions can be subtracted in the calculation of separate net income, but other deductions (eg gifts to charities) cannot. In STINMOD, the imputed level of deductions (which includes non work-related deductions) is subtracted and as a result, this understates separate net income. A child under 16 or a student aged 16 to 24 is classified as a dependant if their separate net income is less than $1786. This is the income level at which entitlement to the (abolished) student rebate was nil. Separate net income is also used to establish if a spouse is considered to be dependent and hence entitle their partner to the dependent spouse rebate.

26 Modelling Income Tax and the Medicare Levy in STINMOD 19 Once eligibility and maximum entitlement are established the income tests for pension and allowance rebates are applied to calculate actual entitlement. Allowance rebates provide the simplest case: actual entitlement = max 4 (0, E), where E = maximum entitlement - (taxable income - rebate income test threshold) * income test taper. Pension rebates are more complicated for married couples where unused pension rebate can be transferred to the other spouse. This facility to transfer reflects the fact that income of couples is combined for income test purposes, while income tax liability is assessed on the individual's taxable income. Therefore, if there was no transferability of rebate, then a situation could arise where a couple's combined income could be less than the income test free area, but one partner could still have a tax liability if s/he had most or all of the private income. Transferability is only relevant if one partner is no longer entitled to the full pension rebate (because of her/his taxable income) before any transfer takes place, and the other partner has taxable income below the income test threshold for the pension rebate. Transferability is achieved in the following way. The amount of transferable rebate is calculated by subtracting tax liability from maximum pension rebate. The next step is to calculate the new pension rebate income test threshold. This is done by calculating the level of taxable income that generates a tax liability (under whatever income tax regime applies for the simulation) equal to the new value of the pension rebate (old maximum rebate plus transferable rebate). Once the new maximum rebate and threshold have been calculated, actual entitlement can be calculated in the same way as for the allowance rebate. The method used to calculate pension rebates and their transferability between married couples produces a counter intuitive 4The maximum value of the following two arguments.

27 Modelling Income Tax and the Medicare Levy in STINMOD 20 result when the income tax threshold is increased. Some couples are actually worse off under such a scenario (STINMOD produces an estimate of 51,000 families when the income tax threshold is increased from $5,400 to $7,000 per annum). 4.6 Rebates for Dependants The two rebates for dependants modelled in STINMOD are the sole parent rebate and the dependent spouse rebate. The sole parent rebate is available to unmarried people who have dependent children (as defined above) and is not income-tested. The dependent spouse rebate (DSR) is available to married couples where one spouse is considered to be dependent and they do not have qualifying dependants for the recently introduced home child care allowance (HCCA), which has replaced the DSR for couples with dependants. HCCA has a different definition of dependants to the one used with the DSR for those with dependants - dependant has the same meaning as for DSS family payments. As a result, some of those who qualified for the DSR with dependants will not qualify for HCCA but will receive the DSR at a lower rate than the DSR they used to receive. The DSR is claimed by the non-dependent spouse but is income tested on the separate net income of the dependent spouse. The threshold for that income test is $282 per annum and the taper is Therefore, with the current maximum value of $1211 per annum, entitlement to any DSR ceases when the 'dependent' spouse's separate net income reaches $ Low Income Rebate The low income rebate was introduced in the 1993/94 Budget as an offset for the increases in indirect tax, and the reductions in marginal rates that benefited middle and upper income earners, that were also part of that Budget. Its maximum value was subsequently increased as a result of the negotiations that the federal government had with

28 Modelling Income Tax and the Medicare Levy in STINMOD 21 the minor parties in the Senate to ensure the passage of the 1993/94 Budget. The low income rebate has a maximum value of $150 per annum and is income tested on an individual's taxable income. The threshold for that income test is $20,700 (the threshold for the third tax step) and the taper is The level of taxable income at which entitlement ceases is therefore $24,450. The existence of the low income rebate is not taken into account when determining the value of pension and allowance rebates. The Income Tax Rebates Parameter Window for STINMOD/94A is contained in Appendix A. This Window can be used to modify the maximum values of rebates and the thresholds and tapers of income tests. 4.8 Medicare Levy The Medicare levy was introduced in It is a compulsory levy on taxable income which provides partial funding for the Medicare program. The calculation of basic Medicare levy is relatively straightforward. If an individual's taxable income is below the Medicare threshold for a single person (currently $12,688 per annum) then basic Medicare levy is zero. When a individuals taxable income is above the shade-in range of taxable income (a range of taxable income above the Medicare threshold) then basic Medicare levy is : levy = taxable income * Medicare marginal rate, where the current Medicare marginal rate is 1.4%. If an individual's taxable income is in the shade-in range then basic Medicare levy is: levy = (taxable income - threshold) * shade-in marginal rate, where the shade-in marginal rate is currently 20%.

29 Modelling Income Tax and the Medicare Levy in STINMOD 22 The end of the shade-in range is the point at which the Medicare levy calculated by the second formula equals the Medicare levy calculated by the first formula. This can be calculated as: end shade-in = TY * ( SMR / ( SMR - MMR ) ), where TY = threshold SMR = shade-in marginal rate MMR = Medicare marginal rate. In the case of single people, their Medicare levy liability is the same as their basic Medicare levy. For married couples and sole parents, the calculation of Medicare levy liability is not so straightforward, particularly for the former. In both cases, a family reduction amount must be calculated if the family income is in the shade-in range of income. The shade-in range of income is for family income (ie both partners in the case of a married couple) and the thresholds vary according to the number of dependants. Currently the threshold for a married couple with no dependants is $21,366. A sole parent or married couple with one dependant has a threshold of $23,466 and the threshold increases by $2,100 for each subsequent dependant. The complication with married couples and the calculation of their Medicare levy liabilities, is that the shade-in thresholds relate to family income but basic Medicare levy is assessed on individual income. As a result, a method was required to obtain an outcome based on individual taxable incomes that would be close to the outcome that would be obtained if Medicare liability was based on family income. That is, if a family's taxable income was in the shadein range, then family Medicare liability would be: levy = (family income - threshold) * shade-in marginal rate. The complication for this process is that for couples, family income can range from being equally split to being entirely in the hands of one spouse.

30 Modelling Income Tax and the Medicare Levy in STINMOD 23 The family reduction amount aims to deal with this variation and provide a combined individual outcome equal to the family outcome. A couple or sole parent's family reduction amount is calculated as: FRA = ( MMR - TY ) - (( FY - TY ) * ( SMR - MMR ), where FRA = family reduction amount TY FY = threshold = family taxable income SMR = shade-in marginal rate MMR = Medicare marginal rate. For sole parents this family reduction amount is then deducted from basic Medicare levy to give net Medicare levy. The family reduction amount has to be apportioned between spouses for married couples. This is done on the proportion each spouse's income is of family income. The next step is to calculate basic Medicare levy for each spouse. Any excess family reduction amount (over basic Medicare levy) is added on to the other spouse's family reduction amount. Net Medicare levy for each spouse is then basic Medicare levy minus the family reduction amount. An example of this somewhat complicated process is presented in Appendix B. For married couples the above approach achieves its objective when income is in the hands of one spouse. When income is evenly split the method succeeds when half of combined income is above the basic Medicare levy threshold. In other distributions of income between spouses it succeeds to varying degrees. By implication, the process always works for sole parents. Married couples whose family incomes are above the shade-in range of income simply have individual Medicare levy liabilities equal to their basic Medicare levy. The application of the family reduction amount process produces a counter -intuitive outcome when the Medicare marginal rate is

31 Modelling Income Tax and the Medicare Levy in STINMOD 24 increased. Some couples are actually better off when their new family reduction amount is calculated (STINMOD produces an estimate of 46,000 families when the Medicare levy is increased to 2%). Once Medicare liability has been calculated, disposable income can be calculated as follows: disposable income = total income - net income tax - Medicare levy, where net income tax = max ( 0, income tax - total rebates). Rebate entitlement cannot be used to reduce a Medicare levy obligation. This is often relevant in the case of those with a dividend imputation rebate greater than their income tax liability. While they may pay no income tax, they will still have a Medicare levy liability if their taxable income is above the relevant Medicare levy thresholds. 4.9 Omissions and Limitations Not all aspects of the Australian income tax system are modelled in STINMOD. On the assessable income side, these include capital gains income and lump sum payments (eg an eligible termination payment). On the rebate/deduction side, these include rebates for superannuation contributions, tax zone rebates, housekeeper rebate, and deposits in the income equalisation deposits scheme. These items are not included in STINMOD because there is insufficient data to make their simulation meaningful. STINMOD does not reflect some of the practicalities of the administration of the income tax system. In STINMOD income tax liability is based on annualised current income and on the current status of the individuals in the microdata. In 'real life', the final amount of income tax for a financial year reflects the administrative details of the income tax system (eg students who only study for part

32 Modelling Income Tax and the Medicare Levy in STINMOD 25 of the financial year do not receive the full tax threshold, the final outcome for a financial year is often not known until a couple of years later when all returns have been processed). These (and similar) aspects are typically ignored by microsimulation models but they are obviously issues of importance to those involved in the administration of the income tax system when they have to forecast the actual tax take for a financial year. 5. Benchmark Outcomes One of the most important tasks in building a microsimulation model is to benchmark the model's outcomes against administrative data. Where possible, this should not just be done at an aggregate level but also at a disaggregated level. While getting the aggregates (numbers, outlays, revenue) right is obviously important, the program profile ( eg age, family status, revenue/expenditure distribution) is equally important. If the program profile is right and the aggregates are wrong, then accurate simulation outcomes could still be obtained by applying a scaling factor to the original outcomes. The program profile will determine the accuracy of the simulation outcomes from changes to program rules. If, for example, the distribution of taxable income is incorrect (even though total tax revenue and the number of taxpayers may be correct), a change to the income tax scale will not correctly estimate the distributional impact of the change. Benchmarking income tax and Medicare outcomes is not as straightforward as other program outcomes, because of the lag in determining the income tax outcomes for a financial year. The latest published Taxation Statistics are for the financial year Since then, income tax revenue has grown considerably - for the financial year total net income tax from taxable individuals was $43.7 billion (Australian Taxation Office, 1994). This compares with the 1994/95 Budget estimate of $50.3 billion (Treasurer, 1994a), an increase of 15 percent. Such a change is almost certain to mean a change in the profile of taxpayers (eg in the distribution of taxable income).

33 Modelling Income Tax and the Medicare Levy in STINMOD 26 The STINMOD microdata (including incomes) has been updated to November The income tax and Medicare levy scales, as well as income tax rebates levels and income tests, are for the financial year The result is an obvious compatibility problem when undertaking benchmarking. This incompatibility is a particular problem when comparing profiles, but is less of a problem when comparing aggregated revenue outcomes as current estimates (based on the latest administrative data, which is only available internally) for these are provided in the Budget papers. The obvious caveat is that estimates are being compared against estimates, rather than actual outcomes (although the Budget estimates would be based on the latest administrative data). Table One compares STINMOD aggregate revenue outcomes with Budget paper estimates. The closeness of these results is certainly encouraging for a microsimulation modeller. At first inspection, the fact that income tax is over the Budget estimate while Medicare is under may seem odd as both are linked to taxable income. However other factors are relevant - rebate entitlement affects income tax and not Medicare and the operation of the family reduction amount adds another complexity.