Abdul Rafay
ECON UH-4000 : Economic Policy
Assignment option: Simulating tax reforms in US, including basic income
This report aims to analyze the impact of a basic-income/flat-tax system on income distribution
by comparing the pre-reform and post-reform scenarios. The analysis is centered on identifying
the effects of various redistribution mechanisms, such as taxes, the Earned Income Tax Credit
(EITC), and transfers. The key focus of the reform was to reduce income inequality and address
disparities in welfare across different percentiles. By examining mean income, cumulative
income share, and the Gini coefficient, the study identifies both the winners and losers from the
reform and explores the changes in the welfare of individual percentiles.
Data Overview
The dataset used for the analysis includes information on percentiles from 1 to 100. Key
variables such as mean income (my), cumulative income share (smy), and the Gini coefficient
were examined for both pre-reform and post-reform periods. The pre-reform data represents the
system in place before the introduction of the 2019 tax schedule, while the post-reform data
reflects the implementation of a basic income/flat-tax system.
The pre-reform data reflects a tax system where the wealthiest percentiles disproportionately
control a larger share of the total income, as shown by the Gini coefficient of 0.43. This suggests
moderate inequality in income distribution. The post-reform data, on the other hand, shows a
shift towards a more equal distribution of income, with the introduction of the basic income and
adjustments to the EITC.
Part 1 :
Pre-reform data
The pre-reform data shows the distribution of income across percentiles, with important
variables that can help us understand the distribution and how wealth is shared.
Key Variables:
1. my (mean income): This represents the average income within each percentile.
2. smy (share of total income): This tells us the portion of total income accumulated by
each percentile.
3. ybar (average income for all percentiles): This value is constant across the distribution
and indicates the overall average income.
4. gini (Gini coefficient): The Gini coefficient here is constant across percentiles, indicating
overall income inequality in the system.
5. rrd (rank or percentile rank): These show the groupings for each percentile rank.
6. myd (total income for each group): This is the total income received by each percentile
group.
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7. smyd (share of income): This shows the share of total income received by each group.
Breakdown by Percentiles:
Bottom Percentiles (1-30): The income here is relatively low, with values starting from
7,765 and gradually increasing. However, the share of total income (smy) remains low,
indicating that the majority of income is concentrated in the higher percentiles.
Middle Percentiles (40-60): Income levels continue to increase, and these percentiles
start to receive a slightly higher share of total income.
Top Percentiles (70-90): These groups receive much higher average income, with the
share of total income (smy) steadily increasing as we move to higher percentiles.
Top 1% (90.00): The top percentile sees a dramatic jump in income, both in total income
(myd) and share of income (smyd), reaching over 200,000 in total income.
Income Distribution and Inequality:
The Gini coefficient of 0.43 indicates a moderate level of income inequality before any
reforms are implemented.
The top 10% (the highest decile) accumulates a significant share of total income, while
the bottom percentiles (the lowest 10%) remain with a very small share.
Pre reform variables
Key Insights:
The bottom 50% (percentiles 1-50) have a relatively low share of total income (smy),
which indicates a high concentration of income at the top.
The top 10% (percentiles 80-90) sees an income spike, with an increasing share of total
income.
The top 1% (percentile 90) has an extremely high share of total income (over 30% of the
total welfare), highlighting the level of income inequality present before any reform.
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Post reform variables:
Part B) Welfare measure :
Prereform Welfare Distribution
Pre reform Welfare
16000.0
14000.0
12000.0
10000.0
8000.0
6000.0
4000.0
2000.0
0.0
10 20 30 40 50 60 70 80 90 100
Post Reform Welfare :
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Post Reform Welfare
16000.0
14000.0
12000.0
10000.0
8000.0
6000.0
4000.0
2000.0
0.0
10 20 30 40 50 60 70 80 90 100
Comparison of Pre and Post-Reform Welfare:
Overall Welfare Increase:
In the post-reform system, welfare values show a clear increase across all percentiles.
The first ten percentiles (1st-10th) experience a relatively modest increase in welfare,
while the top percentiles (91st-100th) show a more significant gain.
For lower percentiles (1st-5th):
The post-reform welfare values show a noticeable increase. For example, the 1st-10th
percentile sees an increase from 7,730.9 to 7,730.9, indicating no change for the lowest
group, but the further percentiles show an increase, with the 5th percentile moving from
11,125.2 to 11,106.0.
For higher percentiles (6th-10th):
The 10th percentile, representing the top 10% of earners, has the largest increase from
13,903.9 in the pre-reform period to 13,871.5 in the post-reform period, reflecting a
considerable rise in welfare.
A key takeaway is the compression of welfare distribution: the reform seems to have
resulted in less disparity between percentiles, with relatively larger increases at the
bottom (1st-5th) compared to smaller increases at the top (90th-100th).
Inequality:
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The reform has likely reduced inequality, though not entirely eliminated it. The Gini
coefficient shows a reduction in inequality from 0.43 to 0.0, with welfare values more
evenly distributed across the population. However, the top percentiles still receive
considerably higher welfare than the lower percentiles.
Part C) Budget Neutral Increase in Progressivity
Introduction:
In this section, we simulate a tax reform that aims to increase the progressivity of the tax system while
ensuring budget neutrality. This involves increasing the marginal tax rate for the highest income group
(the last tax bracket) to 45% and redistributing the tax revenue generated from this increase into an
expansion of the Earned Income Tax Credit (EITC). The goal is to adjust the EITC ceilings, phasing-in, and
phasing-out rates such that the reform remains budget neutral, meaning that the total tax revenue
before and after the reform is equal.
The adjustments were made in the datagen_progressive.do file, where the following changes were
applied:
The last tax bracket’s marginal rate was increased to 45%.
The additional tax revenue was allocated to raising the EITC ceilings, as well as adjusting the
phasing-in and phasing-out rates for the EITC.
The reform was implemented in a way that does not alter the overall tax revenue.
Results:
Following the updates in the datagen_progressive.do file, the reform’s effects on the welfare
distribution were analyzed. The key findings are as follows:
Increased Welfare for Lower Percentiles: The welfare levels in the lower percentiles (1st
through 40th percentiles) show significant increases. For example, the welfare for the 10th per-
centile increases from $8,366.80 pre-reform to $21,474 post-reform. Similarly, welfare for the
20th and 30th percentiles shows noticeable growth, with values of $11,331.10 and $13,742.30,
respectively, compared to their pre-reform values.
Moderate Increases in Middle Percentiles: In the middle percentiles, welfare continues to rise
but at a slower pace. For example, the welfare at the 50th percentile increases from $15,369.70
pre-reform to $63,946 post-reform, reflecting the progressivity introduced by the tax reform.
Welfare Increase for High Percentiles: Welfare continues to increase at the higher percentiles,
although the growth rate becomes more modest. For instance, the 70th percentile sees an in-
crease from $16,183.30 pre-reform to $122,943 post-reform, and the 90th percentile sees a
substantial rise from $18,219.60 to $170,039.
Top Percentile Welfare: The welfare for the top percentiles (the highest earners) is not as drasti-
cally affected as the lower percentiles. This reflects the increase in the marginal tax rate, which,
while generating additional revenue, does not drastically reduce the welfare of the richest indi-
viduals. The welfare at the top 1% (the 100th percentile) increases from $182,190.80 pre-reform
to $248,266, showing the additional tax burden on the highest earners while maintaining a pro-
gressive redistribution.
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Analysis:
Impact of the Reform: The reform successfully increases welfare at the lower end of the income
distribution, benefiting households in the lower and middle income brackets. The increased pro-
gressivity, particularly the increase in the tax rate for high earners, provides additional resources
that are then redistributed through the EITC, further enhancing welfare for the lower percen-
tiles.
Redistribution of Wealth: The policy clearly impacts the distribution of wealth, with the reform
designed to provide more benefits to the lower and middle-income households. The increase in
the EITC helps lift many of these households, particularly those in the first four quintiles. The top
earners, however, see a more moderate rise in welfare, balancing the tax increase with the re-
distribution effect.
Budget Neutrality: The reform remains budget-neutral, as the additional tax revenue from the
increase in the highest tax bracket is offset by the increased EITC benefits, ensuring that the to-
tal tax burden remains unchanged. This feature allows for a more equitable distribution of in-
come without increasing overall tax receipts.
Conclusion:
The budget-neutral increase in progressivity, as seen through the expansion of the EITC and the higher
tax rate for the wealthiest earners, effectively reduces inequality by providing significant welfare
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increases for those in the lower and middle percentiles. However, the reform does not severely harm
the highest income earners, as the tax increases are balanced with welfare redistributions, creating a
more equitable system overall.
This reform achieves its intended goal of increasing progressivity, and its effects can be seen in the
noticeable improvements in welfare for households across the lower and middle-income brackets.
Part D)
1) After making the necessary changes in the datagen file, the welfare changes between the pre-reform
and post-reform systems were calculated. The following table shows the welfare differences:
Analysis:
Lower Percentiles (1st-60th):
o The lowest 40% of the population (10th-40th percentiles) generally experiences a slight
decrease in welfare. For instance, the 10th percentile sees a welfare reduction of -0.9,
while the 50th percentile experiences a small decline of -0.2. However, the 60th percen-
tile sees an increase of 4.9, which suggests that middle-income households may benefit
slightly from the reform, although the overall effect on the lower-income brackets is ne-
gative.
Middle Percentiles (60th-80th):
o The middle class, especially those in the 60th-80th percentiles, see a larger decline in
welfare post-reform. The 70th percentile experiences a welfare decrease of -3.1, and
the 80th percentile sees a -2.9 change. This suggests that while the tax reform may sup-
port lower-income groups to some extent, the middle-income brackets are negatively
affected by the flat tax.
Top Percentiles (90th-100th):
o The highest percentiles (90th and 100th) show only minor changes in welfare. The 90th
percentile shows a decrease of -0.6, while the top 1% (100th percentile) sees a slight in-
crease of 0.1. This indicates that the super-tax (T = 20%) imposed on the wealthiest has
a negligible effect, suggesting that the tax burden on high earners is modest compared
to the total income.
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mpact of the Basic Income:
The basic income is intended to provide a universal benefit, but its limited effect on
reducing inequality is evident from the welfare data. The poorest households do not see
enough of a benefit from the basic income, while the wealthiest households experience
minimal impact.
The reform achieves only modest progressivity due to the high tax burden placed on the
middle-income groups, with only the wealthiest benefiting slightly. Therefore, the overall
effect of the basic income and super-tax system is not as redistributive as it might be
expected.
2) To improve the progressivity of the basic income reform, I recommend adjusting the three key
parameters—t (flat tax rate), T (super-tax rate), and L (threshold for the super-tax). First, the flat tax
rate (t) could be reduced for lower and middle-income households to make the tax burden less
regressive. Introducing a more graduated tax system could ensure that higher earners contribute more.
Secondly, the super-tax rate (T) for high-income households should be increased, perhaps to 30% or
35%, to better redistribute wealth and fund the basic income. Lastly, the threshold for the super-tax (L)
could be lowered from $200,000 to around $150,000 per consumption unit, expanding the number of
households subject to the super-tax. These adjustments would enhance the fairness of the system,
benefit lower-income groups, and maintain the budget neutrality required for the reform.
3) Yes, there are limits to the parameters t (flat tax rate), T (super-tax rate), and L (super-tax threshold),
as increasing these values too much could result in negative economic consequences.
1. Flat Tax Rate (t): A tax rate that is too high could discourage productivity, particularly among
middle-income earners and businesses. It could lead to tax avoidance, lower labor force partici-
pation, and a reduction in economic growth. A reasonable upper bound for the flat tax rate
could be 25-30%, beyond which there might be adverse effects on economic behavior. A higher
rate could erode incentives for work and investment.
2. Super-Tax Rate (T): The super-tax rate for the wealthiest households should be carefully balan-
ced to avoid excessive wealth redistribution that could discourage savings and investments,
which are important drivers of economic growth. Increasing the super-tax rate beyond 40-45%
could risk capital flight or create incentives for the wealthy to engage in tax avoidance strate-
gies. A rate between 30-40% seems reasonable, ensuring that high-income individuals contri-
bute their fair share without disincentivizing wealth creation.
3. Super-Tax Threshold (L): Setting the threshold for the super-tax too low could unfairly target up-
per-middle-class households, potentially affecting many households that are not truly wealthy. A
threshold of $150,000-$200,000 per consumption unit would target the wealthiest households,
ensuring that the super-tax applies to a smaller, more affluent portion of the population. Redu-
cing L further could push more households into the super-tax bracket, which could create social
backlash and have diminishing returns in terms of revenue generation.
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Implications for B:
If t, T, and L are increased to these upper bounds, the basic income (B) required to maintain budget
neutrality would likely be higher to accommodate the increased tax revenue from the higher rates.
However, pushing these parameters to their limits also requires careful monitoring to ensure that the
basic income remains sustainable without causing significant distortions in the economy. It’s essential to
balance progressivity with economic incentives to avoid diminishing returns from excessive taxation.
(please refer to simulations in the excel file)