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(Aug 12, 2008) T030000 Explanation of Tax Model

Overview of the Tax Policy Center Microsimulation Model

August 12, 2008

A large-scale microsimulation model of the U.S. federal tax system produces the Tax Policy Center’s revenue and distribution estimates. The model we have developed is similar to those used by the Congressional Budget Office (CBO), the Joint Committee on Taxation (JCT), and the Treasury's Office of Tax Analysis (OTA).

The model is based on data from the 2004 public-use file (PUF) produced by the Statistics of Income (SOI) Division of the Internal Revenue Service (IRS). The PUF contains 150,047 records with detailed information from federal individual income tax returns filed in the 2004 calendar year. Additional information on demographics and sources of income that are not reported on tax returns is obtained through a constrained statistical match of the public-use file with the March 2005 Current Population Survey (CPS) of the U.S. Census Bureau. The statistical match with the CPS also generates a sample of individuals who do not file income tax returns ("non-filers"). By combining the dataset of filers from the PUF (augmented by demographic and other information from the CPS) with the dataset of non-filers generated by the statistical match with the CPS, we can carry out distribution analysis on the entire population rather than just the segment that files individual income tax returns.

The tax model consists of two components: a statistical routine that “ages” or extrapolates the 2004 data to create a representative sample of both filers and non-filers for future years; and a detailed tax calculator that computes the individual income tax liability for all filers in the sample under current law and under alternative policy proposals. The calculator also computes the employee and employer shares of payroll taxes for Social Security and Medicare.

Aging and Extrapolation Process

For the years from 2005 to 2019, we "age" the data based on Congressional Budget Office (CBO) forecasts and projections for the growth in various types of income, IRS figures on the growth in the number of tax returns, and Bureau of the Census data on the composition of the population. We use actual 2005 through 2006 data when they are available. A two-step process produces a representative sample of the filing and non-filing population in years beyond 2004. First, the dollar amounts for income, adjustments, deductions, and credits on each record are inflated by their appropriate per capita forecasted growth rates. We use the CBO’s forecast for per capita growth in major income sources such as wages, capital gains, and non-wage income (interest, dividends, social security income and others). Most other items are assumed to grow at CBO's projected per capita personal income growth rate. In the second stage of the extrapolation, the weights on each record are adjusted using a linear programming algorithm to ensure that the major income items, adjustments, and deductions match aggregate targets. For years beyond 2004, we do not target distributions for any item; wages and salaries, for example, grow at the same per capita rate regardless of income.

Tax Calculator

Based on the extrapolated data set, policy options may be simulated using a detailed tax calculator that captures most features of the federal individual income tax system, including the alternative minimum tax (AMT). The model reflects major income tax legislation enacted through early 2008, including the Economic Stimulus Act of 2008, The Tax Increase Prevention Act of 2007, the Pension Protection Act of 2006 (PPA), the Tax Increase Prevention Reconciliation Act of 2005 (TIPRA), the Working Families Tax Relief Act of 2004 (WFTRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the Job Creation and Worker Assistance Act of 2002, and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Major provisions of EGTRRA and JGTRRA modeled include changes in marginal tax rates, the new 10 percent tax bracket, credits for children and dependent care, itemized deduction limitations, personal exemption phase outs, the AMT, education incentives, retirement and pension measures, and the marriage penalty provisions, which increased the standard deduction, 15 percent bracket, and earned income tax credit for married couples. We also model JGTRRA's changes to the taxation of dividends and capital gains.

Recent Model Enhancements

Within the past few years, we have enhanced the tax model's capabilities in four important ways. First, using data from the Survey of Consumer Finances (SCF), the Survey of Income and Program Participation (SIPP), and the PUF, we estimated contributions by individuals to various tax-deferred retirement savings plans. This allows us to examine the revenue and distributional effects of the retirement savings initiatives in EGTRRA and other retirement-savings reform options, including an expansion of the saver’s credit.

Second, we added an estate tax module to the tax model. This extensive effort involved using data from the SCF to estimate the assets and liabilities of individuals in the tax model database. Combined with a detailed estate tax calculator, this allows us to determine the expected estate tax liability of all individuals upon death. The estate tax module allows us to estimate the revenue and distributional implications of various estate tax reforms, a capacity that no one else outside of government currently has.

Third, using data from the Medical Expenditure Panel Survey (MEPS), the Consumer Expenditure Survey (CEX) and the American Housing Survey (AHS), we created detailed estimates of the consumption expenditures of individuals in the tax model database. This work gives the TPC the ability to estimate the distributional impact of comprehensive reform options such as a Value Added Tax (VAT) that move the tax system from an income base to a consumption base. In addition, the upgrade will allow us to provide distributional estimates of hybrid income-consumption tax systems such as the Growth and Investment Tax plan endorsed by the President’s Advisory Panel on Federal Tax Reform.

Fourth, we improved our distribution tables significantly. We developed two new measures of income for classifying individuals. These new measures better reflect individuals’ ability to pay. One measure, cash income, is similar to the measures currently employed by Treasury, the JCT, and CBO and includes nontaxable pensions, Social Security, fringe benefits, and other items not reported on tax returns. The second measure, economic income, is a more comprehensive measure still that includes unrealized income from capital, such as capital gains on unsold assets, and is similar to that used by the Treasury Department from the early 1980s until 2001.

We have also begun distributing the burden of the corporate income tax to individuals in our tax model database. This means that our distribution tables now measure the impact of the individual and corporate income tax, payroll taxes for Social Security and Medicare, as well as the estate tax, thus providing a more complete picture of the distribution of federal tax burdens. In addition, we now have the ability to create tables that examine the effects of various financing options on the distribution of winners and losers from tax changes.

In 2008, we expanded the standard set of distribution tables we produce for policy proposals and legislation to include the distributional impact on several subgroups of the population: single, married filing joint, and head of household tax units; tax units with children; and elderly tax units.

In early 2008, the Tax Policy Center completed a major update of its microsimulation model of the federal tax system. We incorporated more recent data by updating the tax model database from the 2001 to the 2004 public-use file (PUF) of tax returns produced by the IRS. Along with updating to a new PUF, we performed a new statistical match with the March 2005 Current Population Survey. We updated the tax model's estate tax module to incorporate the latest data on estate tax filers from the Statistics of Income Division of the IRS. We updated the retirement savings module to be consistent with the new 2004 data. We also expanded the retirement module to include the capability to model the revenue and distributional implications of implementing automatic enrollment in IRAs and 401(k) retirement plans. This latest version of the tax model also includes refined imputations of itemized deductions, such as charitable contributions and home mortgage interest, for “non-itemizers”, i.e. those who claim only the standard deduction on their tax return. These imputations allow us to model the distribution and revenue implications of proposals to replace certain credits with deductions.

Also included in the latest version of our microsimulation model is a completely overhauled and expanded education module. Using data from the October 2003 and October 2004 CPS, as well as the National Postsecondary Student Aid Study (NPSAS), we impute student status, characteristics, and education expenditures on to the tax model database. This allows us to model current tax incentives for education, such as the HOPE and Lifetime Learning Credits, and the deduction for higher education expenses, as well as to examine the revenue and distributional implications of combining or modifying these tax programs. We are also able to model current spending programs such as Pell Grants, and examine the revenue and distributional effects of changes to the Pell Grant rules.