Chapter 3

Chapter 3

ECONOMIC MODELLING

Economic modelling of macroeconomic effects

3.1 An economic model is a representation of an economic system. In applied economics a model is likely to be expressed in a computer program in which data (the `input') are processed and manipulated to produce results (the `output').

3.2 Model building usually consists of two main stages. The first is to develop the structure of the model, setting out what factors affect which variables. The second, using econometrics, [1] is to estimate the actual strength of the relationship postulated.

3.3 In estimating the economic effects of a change in policy or some other external factor, the model is 'shocked' by varying one or more of the parameters.

3.4 Two Australian models are the MONASH Model [2] and the Murphy Model. [3] These two models were pitted against each other during the debate surrounding the introduction of a goods and services tax (GST) which will commence on 1 July 2000. The models produced different results.

3.5 The hallmark of a good model is the accuracy of its predictions. No one is yet in a position to assess either model on this criterion, however, because the actual impact of the GST is as yet unknown.

3.6 Both the MONASH and Murphy models are computable general equilibrium models. This means that they follow the impact of external changes all the way through the economy. It is the branch of economics that is the most technical and least accessible to the non-professional - even a definition of general economic equilibrium is difficult to formulate. The main difference between the MONASH and Murphy models is the different elasticities they assume - the differences in the estimated strength of relationships between economic variables.

3.7 The concept of economic equilibrium suggests that market forces are in balance, that there is equality between the demand and supply for each commodity.

3.8 General equilibrium analysis is distinguished from partial equilibrium analysis by the requirement that the price of every good is free to vary and that all markets must clear. In partial equilibrium theory a specified part of an economy is analysed while the influences impinging on this sector from the rest of the economy are held constant.

3.9 General equilibrium models are designed to provide projections rather than predictions. That is, over the projection period factors outside of the model (natural disasters, new inventions, mineral discoveries and so on) will have their own economic effects. General equilibrium models estimate the economic impacts of policy changes, rather than trying to predict the state of the economy at some time in the future.

The revenue neutrality requirement for the Review of Business Taxation

3.10 The terms of reference for the Ralph Review of Business Taxation required its recommendations to be revenue neutral in respect of the outcome from reforms to taxation of income from investment and from changes in the capital gains tax.

3.11 The Ralph Report concluded that the total package of business measures (those proposed in ANTS and those recommended in the Ralph Report) is significantly revenue positive against the revenue generated by the current legislation and practices.

3.12 It did, however, caution that although the revenue estimates are based on the best available data and methodology it is not realistic to attach a high degree of precision to individual revenue estimates because the data upon which the estimates are based are often seriously inadequate. In addition it is necessary to make judgments regarding behavioural changes by taxpayers in response to a measure and these are often not easily judged.

3.13 History has shown that estimates relating to new tax measures, such as capital gains tax, can sometimes be significantly in error and understate the revenue actually raised. At the 22 October public hearing, the committee learnt that the estimate of what the capital gains tax would raise was between $500 million and $600 million, but what was realised was much more than that, and was in the billions very quickly. [4] It is also true that the revenue losses from avoiding tax by converting income into capital gains may be underestimated. In terms of revenue outcomes for this proposal it is clear that estimates of the position and the revenue impact will vary with the application of different economic models and assumptions. The extent to which differences between estimated and actual revenue outcomes for one measure will be offset by those for other measures will influence the margin of error surrounding the overall revenue position reported for the package of reform measures.

3.14 On balance, the Ralph Report concluded, revenue estimates are likely to understate the overall positive impact on revenue of the recommended package, possibly to a significant extent. [5]

Modelling underpinning the Ralph Report and the Government's response

3.15 The aim of the modelling done for the Review of Business Taxation was to estimate how the proposed reforms might affect the distribution of economic activity between different industries. It was not intended to estimate the impact of the reforms on the overall level of economic activity and consequently does not include the anticipated growth dividend in the modelling results.

3.16 Mr Chris Murphy of Econtech conducted the modelling with assistance from the Department of Industry, Science and Resources and the RBT secretariat.

3.17 The modelling was conducted in two stages. The first was to estimate the change in taxes paid by industries as a result of the business tax reforms and the second involved entering these estimates into Econtech's MM303 model to estimate the extent to which they might alter the pattern of industry production. MM303 models the production of over 300 commodities by 107 industries.

3.18 The results of the modelling were included in the Ralph Report as a guide to how the impact of the reforms might differ across particular industries. It does not indicate the overall impact of reforms on the level of activity for individual industries.

3.19 The major conclusion of the Ralph Report modelling is summarised as follows:

3.20 The modelling of the estimated changes in long-term production for different industries indicated that the effects of reform on any particular industry are not likely to be markedly different across all industries.

3.21 The changes in production are relative to what would have happened in the absence of the reforms and, as noted above, do not include the general increase in production from the growth dividend expected by Mr Murphy and the Ralph Committee to flow from the recommendations in the Ralph Report.

3.22 Mr Murphy presented evidence to the committee at its public hearing on 12 November 1999 based on modelling industry effects of the Ralph Report recommendations and the Government's response of 21 September and 21 October 1999.

3.23 His results were that the combination of the ANTS reforms and business tax reforms put the four sectors of agriculture, mining, manufacturing and finance and insurance 'well ahead' (2.6 per cent, 7.2 per cent, 3.3 per cent and 1.9 per cent respectively). In addition, he concluded that the recommendations of the Ralph Report 'really make very little difference to the industry impacts from ANTS. The reason for that is that the Ralph package is only one-eighth the size of ANTS.' [8]

3.24 In looking only at the impacts of the recommendations in the Ralph Report, Mr Murphy modelled the move to a 30 per cent company tax rate and the elimination of accelerated depreciation. He applied assumptions concerning elasticities of substitution for labour and capital (0.75) and between seven types of capital with a variation in tax lives (0.5). He modelled a representative project that used all of the different types of capital in the proportions they are used in the economy.

3.25 He also looked at the sensitivity of the estimates of elasticities he used in respect of the substitution between labour and capital and found that the GDP gain may be as low as $1.15 billion and as high as $2.17 billion per annum. Similarly the range of elasticities of substitution between different types of capital provides estimates of between $1.58 billion to $1.75 billion per annum. His main conclusion was that the capital stock in the long term (10 years) increases by 4.6 per cent.

The Dixon modelling

3.26 The original intention of the committee was to obtain an analysis of the broad macro-economic consequences of the recommendations in the Ralph Report. Professor Peter Dixon, Director of the Centre for Policy Studies at Monash University, was commissioned by the committee to undertake such analysis. In his report to the committee he advised the committee that to reach firm conclusions about the likely effects of the Ralph Report proposals would require considerably more time than the ten days allowed for the preparation of the report.

3.27 Professor Dixon's report considered three recommendations of the Ralph Report:

He thought it reasonable to take this approach because their implementation does not depend on the implementation or non-implementation of the other recommendations.

3.28 Professor Dixon constructed a hypothetical project and sought to ascertain if such a project would be financed, or would be attractive to different classes of investors, including Australian residents and non-residents. He considered that the post-tax rate of return would be the key to determining if a project would be financed, and not the pre-tax position. The post-tax rate of return depended on the pre-tax characteristics of the project together with the taxation rules and the characteristics of the financier. For these purposes Professor Dixon made certain tax, dividend, retention and interest assumptions.

3.29 Professor Dixon reached tentative conclusions on the basis of work able to be completed as follows:

3.30 In evidence Professor Dixon confirmed that in his assessment capital stock would decrease over the long term. 'In the long run you wind up in a position where you actually have less capital in the economy that you otherwise would have had.'

3.31 Professor Dixon also indicated that his findings would not be the same if he had modelled the impact on small business because accelerated depreciation is not being abolished for such taxpayers. He considered that he would need to do some calculations in this area to be more definite in his conclusions, particularly in respect of the matter of the effect it may have on the long-term negativity his findings to date have produced.

3.32 The committee is mindful of Professor Dixon's statements that his conclusions are tentative and are derived from modelling three of the Ralph Committee's recommendations, based on one hypothetical project. It notes Professor Dixon's opinion that it would be technically feasible to make a detailed and convincing quantitative analysis of the Ralph proposals, given more time, and his frustration that so little time was allowed for his work on a project of such significance. There are obvious difficulties in drawing conclusions from such a limited study.

3.33 Professor Dixon estimates an increase of aggregate capital of 0.25 per cent in the short term and a decrease in aggregate capital between 0.25 and 0.4 per cent in the long run with a concomitant reduction in the incentive to invest. The Dixon model produced an increase in aggregate tax on investment, which conflicted with the views of Treasury.

3.34 The results achieved are due in good part to the removal of accelerated depreciation and the detrimental impact that such a measure had on the particular project that Professor Dixon modelled, which assumed an asset life of 20 years.

3.35 The Ralph Report and Treasury claim that the net effect of the abolition of accelerated depreciation and the decrease in the company tax rate is a reduction, not an increase, in the total tax wedge. [10]

Summary comments on modelling

3.36 A key differentiating factor between the results of the MONASH and Murphy models appears to be the underlying project modelled. There appeared to be no disagreement between all parties as to the validity of the underlying economics involved, as Treasury made very plain. [11]

3.37 The tax effect appears to be the reason for the difference in results. Professor Dixon's model produced a tax increase and the data used in the Ralph Report estimated a tax decrease. Treasury attributed the difference in results to the comparably long assumed effective life of the asset of twenty years in the project modelled by Professor Dixon and speculated that using a three to seven year asset life as Treasury had done would produce results on the other side of zero. The result of this would have been more compatible with those in the Ralph Report.

3.38 The dilemma for the committee is in identifying the correct economic variables and, as the expert witnesses have put to the committee, there is no clear right or wrong in this area. The challenge is to find the right balance - drawing on the best available but seriously inadequate data, choosing from a variety of acceptable methodologies and, using valid underlying economics, to make a judgment regarding behavioural changes in response to each measure.

Growth dividend

3.39 The Government's growth dividend is an estimate of the increase in GDP attributable to the Government's proposed business tax reform, reflecting an increase in Commonwealth tax revenue.

Informed judgment or modelling? The Government's response

3.40 The Ralph Report indicated that at the most fundamental level the growth dividend is simply one aspect of the behavioural responses typically taken into account when developing revenue estimates for particular tax measures. However, the effects of behavioural responses are extremely difficult to estimate.

3.41 The Ralph Committee did not commission a study of the likely impact of the proposed business tax reforms on Australia's economic growth because it concluded that such studies typically involve models requiring a large number of assumptions that are difficult to validate. In addition overseas experience has shown that alternative models can give markedly different results.

3.42 The Ralph Report concluded that a growth dividend of 3/4 per cent of GDP by 2009-10 is likely to be conservative and this would deliver additional Commonwealth revenue of $650 million by 2004-05. However, in order to ensure that the overall outcome of the recommendations was clearly conservative, only $500 million of the expected revenue gain was included in the revenue estimates. Similarly, contributions to revenue in the earlier years were also scaled back. The expectation is that the recommendations will significantly reduce compliance costs, however, a compliance dividend was not included in the revenue estimates but was identified as further supporting the case for a significant growth dividend.

Conflicting estimates

3.43 Professor Peter B Dixon and Maureen T Rimmer of the Centre of Policy Studies, Monash University, hold a view contrary to that expressed in the Ralph Report. They have concluded that it is technically feasible to successfully model the likely impact of the business tax reforms on the growth of the economy by running a MONASH [12] simulation of the effects of an increase in capital taxation combined with the effects of a compensating reduction in other taxes. Such analysis would however, take some three months and obviously the short reporting deadline associated with the committee's inquiry has prevented the completion of such analysis.

3.44 Mr Murphy of Econtech also differed from the conclusions in the Ralph Report concerning the feasibility of modelling economic growth. He provided the committee with a report based on the RBT model which he had constructed specifically for this purpose. He estimated that the general economic effects of the proposal to cut the company tax rate and abolish accelerated depreciation would be a gain in GDP of 1.5 per cent.

Should the growth dividend be included in the estimates?

3.45 The Ralph Report was of the view that because of the constraint of revenue neutrality imposed upon the Review, it was reasonable to include in the estimates the amount of projected increase in Commonwealth revenues as a result of the business tax reform measures outlined in the Report.

3.46 The economic environment against which the revenue estimates were prepared is the same as that used for the purposes of preparing Budget revenue estimates.

3.47 The issue for consideration is therefore whether a growth dividend of this nature would usually be considered a genuine offset to be included in revenue estimates for budgetary purposes. The committee notes that it is not the accepted budgetary practice to include such a figure.

3.48 However, inclusion of the growth dividend, if one is actually realised, does give a more accurate picture of whether the proposed reforms meet the criteria and constraint of revenue neutrality. As the figures have been included by the Government, it is even more important for the other revenue estimates to be robust.

Size of growth dividend

3.49 The Ralph Report is of the view that the growth dividend figures included in the revenue estimates are conservative. However no evidence was provided to support this assertion. Although Professor Dixon indicated that it was feasible to model a growth dividend he was not in a position to proffer an informed opinion at this stage on the outcome of what any such modelling may produce.

3.50 The committee is, therefore, in the unenviable position of not being able to make a judgment in respect of the existence or size of any growth dividend from these proposals without access to any economic modelling on the subject to provide guidance.

Footnotes

[1] The setting up of mathematical models describing economic relationships.

[2] Since 1993, the Centre of Policy Studies has developed MONASH, a dynamic computable general equilibrium model of the Australian economy designed for forecasting and for policy analysis. Like its predecessor, ORANI, MONASH has a high level of microeconomic detail. Unlike ORANI, it has a strong forecasting ability. The model generates forecasts for 113 industries and 115 commodities, which can be transformed into forecasts for 860 sub-commodities, 341 labour occupations, 56 regions and many types of households. The initial conditions used by MONASH are obtained from an updated version of the 1986-87 input-output tables published by the Australian Bureau of Statistics.

[3] MM2 is a quarterly macroeconometric model of 700 equations used for macro industry policy analysis and forecasting. It has short run Keynesian properties and recognises that financial markets are deregulated and forward looking and has a neoclassical long run which gives an integrated and consistent treatment of investment, employment and pricing decisions in the business sector. MM2 has 18 industry sectors. MM303 is a highly detailed model of the Australian economy, designed to model the long-run effects of micro-economic reforms. It distinguishes 305 separate products by 107 industries.

[4] Evidence, 22 October 1999, p. 51.

[5] Review of Business Taxation, A Tax System Redesigned, 1999, p. 693.

[6] ibid., Section 25, p. 749.

[7] Review of Business Taxation, A Tax System Redesigned, 1999, p. 747.

[8] Senate Finance and Public Administration References Committee, Hansard Transcript of Evidence (hereafter Evidence) , 12 October 1999, p. 191.

[9] ibid., p. 193.

[10] See Mr Smith in Evidence, 12 November 1999, p. 233, Professor Dixon in Evidence, 12 November 1999, p. 238.

[11] Mr Smith, in Evidence, 12 November 1999, p. 233.

[12] A dynamic computable general equilibrium model of the Australian economy designed for forecasting and for policy analysis.

[13] Peter B Dixon and Maureen T Rimmer, Centre of Policy Studies, Monash University, Company taxes, Depreciation allowances and Capital gains taxes: some effects of Ralph, Paper prepared for the Senate Finance and Public Administration References Committee: Inquiry into Business Taxation Reform, 10 November 1999, p. 10.