Building on the data diagnostics covered in the previous section, we now proceed to

describe some standard forecasting techniques.

Unconditional models (trend analysis, extrapolation)

Unconditional models use data from past tax revenues to predict future tax
revenues. The advantage of these techniques is that they are relatively quick and
easy to implement as they do not depend on the analysis of relationships between
the variable of interest (tax revenue) and other economic indicators.

Conditional models (effective tax rate model, linear regression)

Conditional models are generally more formal and involved. These models
estimate the relationship between tax revenue and other relevant economic
variables and use the estimated parameters of this relationship to forecast tax
revenue. These models are conditional as they depend on variables other than tax
revenue.

In this section, we start with unconditional models, which focus on the trend

component of the time-series data. This is because establishing trends is an important
first step for projecting revenue. The main idea is to use data for past tax revenues to
predict future tax revenues. The advantage of these techniques is that they are not
dependent on the analysis of relationships between the variable of interest (tax
revenue) and other economic indicators. As such, they are referred to as unconditional
models.

Part of the forecaster’s task is to assess properly which form of trend the data may
exhibit. In general, many of the tools used in forecasting work best when the trend
displays some degree of linearity. While this might hold in certain instances, other cases
may require the researcher to transform the data to ensure such linearity. For example,
a time series could exhibit an exponential trend that would need to be "linearized" using
a logarithmic transformation, before being analyzed using standard statistical
techniques. Furthermore, as was mentioned, forecasters must account for structural
changes that may cause trends to vary over time.

Below is a table summarizing the key differences between unconditional and conditional
forecasting models:

The idea behind unconditional (trend) models is to extend a time series into

the future using information gathered about that series from its past
observations. If you can identify any underlying past trends and patterns,
these can then be used to extrapolate the time series forward to generate
forecasts. Implicitly, finding such trends involves smoothing the data to limit
the effects of random variations.
This type of unconditional trend analysis is well suited for cases where tax
revenues (as well as changes in tax laws) are relatively stable. For example,
certain subnational governments use this approach to forecast non-tax
revenues (such as license fees) or tax revenues that have grown steadily over
time, such as local property taxes. 

In this type of trend analysis, the tax revenue forecast, T ft+1, is a function of past tax
revenue observations, Tt-s, where n ≤ s ≤ t. Mathematically, the forecast is expressed
as follows:

In the following sections, we will explore the most common approach for
determining the increment used to forecast revenues in future periods:
the multiplicative trend approach. We will also introduce some key forecast
assessment statistics that can be used to evaluate the performance of
forecasting models.

Multiplicative trend models assume that the growth rate from one period to
the next is relatively stable over time. In this way, past values of tax revenue
growth are regarded as a reliable predictor of future tax revenue growth, and
can therefore be used to forecast future levels of tax revenue:

A forecast of future tax revenue growth can also be generated using the
average of past growth rates over a given time period. A moving (or rolling)
average creates a series of averages over specific periods of time and is a
practical way of smoothing out the data:
where n is the number of years over which past growth rates are being
averaged. This formula uses the unweighted averages of past growth rates.
However, weights can be applied to past growth rates to increase the
importance of tax revenue growth experienced in certain time periods (for
example, the more recent past) over others.

Multiplicative trend models can be used relatively easily and quickly to

generate different sets of forecasts under different assumptions even when
there is limited data. For example, your forecasts will differ if you:

 Use averages over past growth rates for time periods of different length, n. A 5-year
average growth rate is likely to lead to different forecasts to a 10-year average
growth rate.
 Change the weights applied to past growth rates.

However, multiplicative trend models have at least two main weaknesses:

 First, the average growth rate may be sensitive to extreme values,

especially with small samples, which is likely to affect forecast quality.
 Second, controlling for external factors that may affect tax revenue, such as
tax policy shifts or large swings in commodity prices, is difficult. Conditional
models may be better suited to account for such external factors. This will
be the subject of the next section.
PROS and CONS of the ETR approach
PROS and CONS of the Coverage Factor METHOD

The previous subsection provided an introduction to the linear regression

technique called ordinary least squares. In practice, one key decision faced
by a researcher is the choice of the independent variable(s). 
Recall that an independent variable is a variable on the right-hand side of the
estimated equation and is believed to be related to (and could therefore help
explain variation in) the dependent variable on the left-hand side. 

In the context of this course, the dependent variable, tax revenue, can be
related to different variables. The table below provides examples of
independent variables that may be included in a linear regression for different
types of tax revenue. This is by no means an exhaustive list but should help to
give an idea of the sorts of variables that have been used in academic
research.

For forecasting time series, it is important to understand the concept

of stationarity when it comes to time series. For the purposes of this course,
a (covariance-)stationary series possesses three main characteristics over
time:

 Constant mean

 Constant variance

 Constant autocovariance

You have already been introduced to the concepts of the mean and variance.
To understand the autocovariance, we need to define the covariance. The
covariance measures the joint variability between two time series, Xt and Yt;
that is, the extent to which they covary. A positive covariance indicates that,
when Xt is above its mean, Yt also tends to be above its mean. A negative
covariance indicates that, when Xt is above its mean, Yt also tends to be below
its mean. If the covariance is zero, then there is no relationship between the
two series. However, for a single time series, Xt, we may also consider the
covariance between different vintages of this series, or autocovariance. In
other words, it captures whether a given observation, e.g. , Xt-n, has an
influence on another observation of the same variable at a different time,
e.g. , Xt-n. For a stationary series, constant autocovariance means that the
covariance between Xt and Xt-n equals the covariance between Xt-s, and Xt-(n-
s) for any n - s. 

Furthermore, an important implication of the above definition is the property

of mean reversion: when a shock causes a stationary series to deviate from
its long-term mean, this series tends to revert to its mean over time. In other
words, shocks have temporary effects. In contrast, shocks have permanent
effects on nonstationary time series. Such variables do not exhibit the
property of mean reversion and, therefore, tend to drift away from their means
for lengthy periods (or indefinitely).

For the purpose of this course, a stationary series should look relatively flat,
meaning that it should not follow a deterministic trend, and it should not exhibit
periodic fluctuations. Furthermore, its mean and variance should be constant
over the considered time frame. Finally, a stationary series should not
meander away from its long-term mean for extended periods.
 https://www.imf.org/en/Publications/SPROLLS/world-economic-outlook-databases

How to Forecast Tax Revenue

Let us use the results from the regression estimated in the second video to
forecast tax revenue. Recall that the equation we estimated took first-
differences of both the log of tax revenue and the log of GDP and was
specified as follows:

Using the estimated coefficients, predicted values for GDP, and current
observations for both GDP and tax revenue, the forecast of the log of tax
revenues can be recovered as follows:

Using our estimates, we find that:

Our econometric model predicts that aggregate tax revenue will reach PHP
2,301 billion in 2017 in the Philippines.

This estimate can be refined in a number of ways, for example, by including

other variables that have useful predictive power for tax revenue. But as
noted, the forecaster needs to remain vigilant for model specification issues
such the size of the sample and the various characteristics of the time series
being used. In other words, forecasters must always acknowledge these in the
course of their analyses. Various tests should be conducted throughout the
process to ensure as much robustness as possible, including, for example,
formal testing of stationarity and co-integration.

Nevertheless, linear regressions can be powerful tools for forecasting tax

revenue. However, it would be wise to use more than one methodology to
generate multiple revenue forecasts and compare the results. This would help
a forecaster to build confidence in their tax revenue projections.

Indirect taxes are taxes on goods and services. Important examples include

consumption taxes, such as the VAT, import duties, or excise taxes. These
taxes are called indirect taxes because they are not directly paid to the tax
administration or other imposing entity.

Direct taxes are taxes on income and wealth. The most important examples
include the personal income tax and the corporate income tax. Wealth taxes,
inheritance taxes, or property taxes are also examples of direct taxes. These
taxes are directly paid to the imposing entity and often, they depend on the
particular circumstances of the person paying the tax.

This module presents techniques to estimate two key quantities for indirect
taxes:

 A baseline forecast is an estimate of future revenue in the

absence of policy changes.
 The costing of a policy proposal is an estimate of the revenue
effect if a specific tax parameter is changed. 
The skills needed to derive these quantities are similar, which are an
understanding of:

 How the tax at hand works (Economic theory)

  What type of data lends itself for quantification (Data)
 How econometric techniques can be used to refine predictions
(Estimation and model verification)

Let's see an example of applying these skills for import duties. Click on the
plus sign to see a description.

Differences in terms of data requirements and statistical techniques:

 Baseline forecasts rely on macro variables, such as GDP or the

aggregate value of imports. Macro-variables are available for many
periods; and third parties, such as statistical agencies or the central
bank, often provide forecasts of these variables for the future. From
a statistical point of view, the baseline forecast is computed in a
time-series context. 
 The costing of policy changes typically requires granular data,
such as household surveys or administrative information. A good
proxy tax base captures the size of the affected tax base as close
as possible. Granular data is often not available for as many
periods and external predictions of these tax bases rarely exist.
From a statistical point of view, the costing of policy changes is
computed using micro-models with less focus on time dynamics. 
What is the optimal number of distinct empirical models one should rely on? 

There is no one-size-fits-all solution, but there are a few criteria that should
guide this decision:

 The revenue potential of buckets. Computing additional forecasts is

associated with additional costs. If the tax bases covered in an additional
model generate limited revenue, it might be worthwhile to lump these bases
together with other bases into another model that predicts more revenue. 

 Data availability. At a minimum, a baseline estimate requires information

on historical tax revenue. For example, a forecast of tax revenue from
cigarette excises requires historical information on cigarette-related tax
revenue. 

 Homogeneity of buckets. Finally, to increase the accuracy of our

forecasts, the models should cover taxes for which the aggregate revenue is
more stable than its individual components. For instance, if there is
substitution in the consumption of cigars, cigarettes, and other tobacco
products, a prediction of total tobacco consumption is likely more accurate
than the sum of three separate forecasts.

Definition of Taxes on International Trade

Taxes on international trade are levied on imported goods and, in some

cases, on exported goods. Except for natural resource rich economies, which
sometimes apply duties on unprocessed commodity exports to support
domestic value creation, export duties are less frequent in practice. 

In this section, we will focus on analyzing taxes from import duties. Taxes
on import duties are also referred to as customs duties or trade tariffs. 

The total value of imported goods and services recorded in the national
accounts is often an appropriate proxy tax base for taxes on international
trade. If forecasts of imports are not available, GDP can also be a valuable
proxy for the value of imported goods and services.
The national accounts variable for total imported goods and services differs
from the true tax base of import duties for two main reasons:

 First, import duties are generally not applied on services and some
countries do not apply duties on certain goods either. In contrast,
the national accounts variable captures the total of all imported
goods and services. 
 Second, the national accounts record imports in purchaser prices,
which is the actual price paid by the final consumer. Import duties,
on the other hand, are applied on the price of the good at the
border, the CIF-price, thus exclusive of taxes, as well as domestic
trade and transport margins. 

The actual tax base is therefore likely much smaller than the national
accounts variable would suggest. However, if the difference between the
actual tax base and the proxy tax base remains stable over time, aggregate
imports are nevertheless a suitable proxy to estimate revenue from
international trade taxes. 
Computing the baseline forecast for Thailand
Let’s compute a baseline forecast for international trade revenue in Thailand.
In Thailand, like in many other countries, the importance of international trade
taxes has declined over time: while taxes on imports accounted for around 9
percent of total revenue in 2005, they only generate some 4 percent of total
tax revenue today. 

We use the effective tax rate approach to derive a baseline forecast. Recall
that this approach estimates revenue as the product of an effective tax rate
and a forecast of the proxy tax base:

For simplicity, we assume that a prediction of the proxy tax base, which is
imports of goods and services in this case, exists. All we need to focus on is
to obtain a forecast of the effective tax rate and multiply this rate with the
forecast of imports of goods and services. 

We will use two approaches for forecasting the effective tax rate:

 Simple linear regression. Observed trends in the historical

effective tax rate can be extrapolated using a linear regression. 
 Exponential smoothing. Exponential smoothing is an extension of
a weighted average that takes account of potential trends. 

You will find the data and functions used in the video in the file Baseline
forecast import duties.

Data for costing estimates

Customs administrations record on a detailed product level the value of

imported products, the country of origin, and the revenue collected. This is the
key information source for understanding the revenue effect of trade tax policy
changes. 

WTO members use the Harmonized Commodity Description and Coding

System, also known as the Harmonized System (HS), to identify products.
The HS system comprises about 5,000 commodity groups, each of which is
identified by a unique six-digit code. For example, this is what the HS
code 090111 tells us:

 The first pair of digits provides broad information about the type of
product:  09 covers coffee, tea, mate, and spices.
  The next pair of digits offers additional information about the product: 0911: Coffee,
whether or not roasted or decaffeinated; husks and skins; coffee substitutes
containing coffee in any proportion

 Finally, the last pair of digits provides more detailed information about the product’s
characteristics: 090111: Coffee; not roasted or decaffeinated.

Computing the revenue effect of changing an import duty in Thailand

Now we can quantify a hypothetical policy change for Thailand’s import duties.
Let’s assume that the Thai government planned to raise the import tariff on
copper by 5 percentage points, from 2.2 percent to 7.2 percent, from 2016
onwards. What is the revenue impact of this policy proposal?

In general, the revenue effect of a policy change is the product of the affected
tax base and the change in the tax rate:

In our case, Basei  is the value of copper imports and the tax rate difference (t  new-t  old) is
5 percentage points. Two issues are important to note:

 In practice, many policy changes are not becoming effective right away, with
obvious implications on revenue. Delayed entry-into-force dates require
adjustments to revenue estimates.

 Large tax rate changes can lead to behavioral responses, with indirect effects on
revenue. In practice, the direct revenue effect, which disregards behavioral
responses, is larger and typically gives a good approximation of the overall effect.
We will neglect behavioral responses in this section, but show how they could be
captured in the next section

You will find the data we use in the following video in the file Costing

Excise taxes are levies on specific goods and services. They are often applied
on goods with negative externalities, which means that the consumption of
these goods imposes costs on society which are not reflected in the market
price. An example of a negative externality is the consumption of gasoline,
which reduces air quality and thus impacts the health of all. In other cases,
countries use excise taxes to discourage the consumption of addictive goods,
to increase the progressivity of the tax system, or simply to raise revenue. 

Excise taxes have three attractive features: 

 First, if they are used to correct for negative externalities, excise taxes can
raise a country’s welfare, regardless of the amount of revenue they
generate. 

 Second, excise taxes are an effective revenue generator when levied on

addictive goods, such as tobacco, alcohol, or gambling, because the
consumption of these products is relatively unresponsive to price changes. 

 Third, excise taxes are generally easy to administer, as they are collected
on imported goods at the border and from a small number of licensed
domestic producers. 

Data for computing baseline forecasts

The tax base of excises is either the value of a good or a quantity. The proxy
tax base should be chosen accordingly: nominal consumption forecasts, as
recorded in the national accounts, are a suitable proxy tax base to forecast
aggregate excise tax revenue from ad-valorem taxes. In contrast, real
consumption forecasts would be better suited to estimate revenue from
specific excise taxes. 

The level of aggregate consumption differs from the excisable base for at
least two reasons:

1. Many goods are not subject to excises. Excises should be used selectively
on products with negative externalities. 

2. Aggregate consumption is reported in consumer prices, which include retail

margins and consumption taxes. In contrast, excises apply on ex-factory or
CIF prices.  
Where excises are applied only on a few selected products, or the lion share
of excise revenues is linked to a single product, aggregate consumption might
be too crude a measure for approximating the true tax base. For instance, if
most excise tax revenue is linked to the taxation of tobacco, cigarette
consumption would be a better proxy tax base for forecasting revenues. 

Computing a baseline forecasts for tobacco excise revenue in France

France relies on a combination of specific and ad-valorem excises to tax

tobacco consumption. In 2017, the specific tax was EUR 1.2 per cigarette
pack while the ad-valorem rate was 0.51 percent of the ex-factory price.
Excises on tobacco products accounted for around 20 percent of total excise
tax revenue over the past 20 years, or slightly more than 0.5 percent of GDP
(see Chart 1)
The following video compute a baseline forecast for French tobacco revenue
using the coverage factor approach.

Disaggregated data for the costing of policy changes

To compute revenue effects of policy changes requires granular data on the
value and/or quantity of excisable goods. Key data sources used in these
quantifications are administrative data and household surveys.

Administrative data provide the most reliable information source to quantify

the effects of policy changes. Depending on whether the excisable good is
imported or produced domestically, we would draw on different databases:

 For imported excisable goods, the customs administration records

the value, in CIF prices, and the quantity on a detailed HS code
level. 
 For domestically produced excisable goods, the central excise
administration records granular information on the quantity and the
value in ex-factory prices. 

Household surveys provide useful information to capture excisable goods that

are primarily consumed by households, such as tobacco and alcohol. These
surveys can be complemented with data on price indices that statistics
agencies provide as part of their Consumer Price Index publications. 

However, household surveys are less suited to capture the tax base of
excisable goods that are also consumed by firms, such as gasoline.
Moreover, household survey data may provide a poor basis when individuals
consume a substantial share of excisable products from illegal sources that do
not generate tax revenue.
Computing the revenue effect of excise policy in France
The following video estimates the revenue impact of a policy change that was
implemented in France. Specifically, in 2017, France increased both its
specific and ad-valorem excises, leading to an increase in tobacco-related
revenue by almost EUR 500 million. 

How would you estimate the revenue effect of the policy change summarizes
in Table
1? 

The video illustrates how to incorporate the effect from changed consumer
prices on tobacco demand. Table 2 summarizes elasticities from the empirical
literature for the most common excisable goods. For instance, tobacco
demand decreases by between 0.3 percent and 0.7 percent for each percent
increase in the price of tobacco. The response is more pronounced for alcohol
excises while alcohol consumption is less elastic to price changes. 

Definition

The Value-Added Tax (VAT) is a tax on the domestic consumption of goods

and services. It applies to all domestic sales, irrespective of whether the
goods are sold to a final consumer or another business. However, businesses
registered for the VAT can claim back, or credit, the tax they paid on
intermediate inputs. The only tax not getting refunded is the tax imposed on
final consumption and unregistered or exempted businesses. The VAT is thus
equivalent to a retail sales tax with a multi-stage collection mechanism.

An ideal VAT taxes all goods and services which are consumed domestically
at a single rate. Designed in this way, the VAT presents four main
advantages: 

 First, by taxing all goods and services, the VAT generates substantial revenue,
also if consumption is taxed at a low rate.

 Second, by taxing all goods and services at the same rate, the VAT does not
distort consumption decisions. 

 Third, by allowing business to claim back VAT paid on intermediate inputs, the tax
does not distort production decisions.

 Fourth, the fractional collection of the VAT reduces the risk of revenue leakage. 

Almost all VAT systems deviate from a single rate policy in two important
respects: some supplies are exempt while others are taxed at a reduced
rate.

 VAT exemption. A supply is said to be exempt when it is not subject to the

VAT. Producers of exempt supplies do not charge VAT on outputs, nor do
they get refunded for VAT paid on intermediate inputs.

Exemptions distort production decisions and reduce the VAT’s efficiency.

This is so because unrecoverable input VAT becomes a marginal production
cost for exempt suppliers which is passed on to consumers in the form of
higher prices.

Notwithstanding these concerns, small businesses below some turnover

threshold should be, and are commonly, exempt, because administrative
and compliance costs outweigh the revenue and efficiency gains of
subjecting their supplies to VAT.

 Reduced rates. VAT systems sometimes apply reduced rates on selected

goods and services, often to alleviate the tax burden on the poor. Rate
 reductions eliminate the problem of tax cascading as intermediate input VAT
can be fully recovered. However, distributional concerns can be more
efficiently addressed with targeted spending policy or the personal income
tax. 

The VAT is levied on a “destination basis”, meaning that taxes are collected
where the good is consumed. As a result, all exports should be, and are
commonly, taxed at a rate of zero, or “zero-rated”. 

Data for computing baseline forecasts

Both the expenditure and the production approach to computing GDP provide
insights on a country’s VAT base. The expenditure approach describes the
economic product of a country as the sum of private consumption,
investments, government expenditure and net exports:

Private consumption, C, is a suitable proxy tax base for the VAT. However,
depending on the VAT system in place, the actual VAT base may be broader
and also apply on government consumption of goods and services, which
would be covered in G, and spending on residential property, which is covered
in I. 

The production approach expresses GDP as the sum of value added across
sectors plus taxes less subsidies. A clean VAT without exemptions is
equivalent as a tax on all value added. GDP at basic or producer prices thus
may also serve as a suitable proxy tax base.

In summary, the following variables are potential candidates for a proxy tax
base:

 Private consumption
 Private and public consumption
 GDP minus net exports
  GDP at basic prices
Computing a baseline forecasts for VAT revenue in Austria
We next use the aggregate data to compute a baseline VAT forecast for
Austria.

Austria taxes domestic consumption at a standard rate of 20 percent. Some

supplies are taxed at reduced rates of 12 or 10 percent, while others,
including financial services, education and healthcare are exempt. The VAT
accounts for roughly 28 percent of total tax revenue.

The following video will forecast VAT revenue using both an effective tax rate
and an elasticity-based approach. It is assumed that several proxy tax
variables are made available by external institutions. 

Data for the costing of policy changes

Policy costings for the VAT can exploit two information sources:

Input Output tables provide a detailed description of the supply and use of

goods and services within an economy (but should not be confused with
supply use tables, as the supplementary “quick introduction to IO tables”
explains) . Product-level IO tables depict an optimal data source for the
costing of VAT changes, as they provide a comprehensive picture of the VAT
base. However, some statistical agencies only compute industry by industry
tables, which are less useful since VAT legislation is specified at the product
level. Moreover, the computation of IO tables is resource intensive, implying
that the latest available table will often be several years old. 

Household surveys provide another valuable data source, which often

provides more granular consumption information. The main drawback of
household survey is that sometimes they do not provide information on
government consumption or on intermediate consumption in the production of
exempt supplies, two sources that generate revenue. Another issue is that
such datasets include overseas spending, which are not part of the VAT base,
and exclude foreigners domestic spending, which are part of the VAT base.
This is problematic in countries where tourism represents a large economic
sector.  For approximations of the base it is important to note that household
surveys are measured in purchaser prices and thus inclusive of the VAT.

Costing a VAT Policy Change in Austria

Austria exempts 5 groups of products:

 Supplies provided for the public interest;

 Supplies related to finance, insurance and investment activities;
 Supplies related to gambling activities;
 Supplies related to immovable property; and
 Supplies carried out by small entrepreneurs.

Not all of these supplies are exempt in all instance. For instance, the letting of
immovable property is generally exempt from VAT, but the letting of
immovable property for residential living purposes is taxed at a reduced rate
of 10 percent. Similarly, advice given for financial investments is taxed while
margin-based transactions are exempt. 

In this video, we evaluate the revenue impact of eliminating the exemption of

financial services using a product-by-product IO table. 

A version of the excel file shown in the video can be downloaded below. You
may notice a correction in this Excel file compared with what is shown on the
video. The new input VAT is EUR 820 million instead of EUR 813 million. This
is because the tax rate applied on the use of financial services in exempt
sectors should be 20% (i.e. the VAT rate on financial services). In the video,
the tax rate that is applied is based on the VAT rate for inputs into financial
services and thus incorrectly reflects the reduced rate for accommodation.

It is important to understand the difference between tax credits and

deductions. In a progressive tax system, a deduction will result in a tax
reduction based upon the marginal tax rate of the taxpayer. For example, at
15% marginal tax rate a dollar of deduction is worth 15 cents, while at 35% tax
rate a dollar of deduction is worth 35 cents. This results in a higher tax
reduction for a high-income taxpayer vis-à-vis a lower income taxpayer for the
same amount of deduction. Tax credits, on the other hand, provide the same
relief regardless of the income of the individual.

Let’s start this section by providing an overview of different techniques that

are commonly used to forecast income tax revenues, both for PIT and CIT.  
Macro-aggregate model is a method for forecasting aggregate tax revenue as a
function of macroeconomic aggregates. As discussed in Module 2, the model requires
time-series data on income tax revenue and the proxy tax base to establish the relation
between the two, and the projected growth rate of GDP or the proxy tax base to forecast
the income tax revenue.

Monthly-receipt model is a simple yet functional tool to project short-term revenues

from income taxes, as it captures seasonal effects of tax. The model requires primarily
monthly tax collection data and projected either GDP growth or the growth rate of other
proxy tax base to forecast collections. The growth factor it uses is a weighted average
of two growth rates: (1) the actual growth of the year-to-date tax collections as
compared with that of the same period in the previous fiscal year, and (2) the projected
growth of tax base proxies, with the weights being the fraction of the number of months
for which taxes have been collected for the former and the number of remaining months
for the latter.

Micro simulation model is based on annual tax returns, which can be supplemented
by other data that do not exist in the tax returns. For example, to analyze an expanded
definition of taxpayer based on age criteria, or to analyze an expanded definition of
income or new deductions which are not reported in existing tax records, those data
would need to be merged into the tax database. Micro simulation model makes
calculations about the taxpayer population, by focusing on a detailed application of the
tax law to the structure of the tax base for each taxpayer. The main advantage of micro
simulation modeling thus lies in its capacity not only to forecast revenue, but also to
perform revenue and distribution analysis of proposed tax policy changes.
Microsimulation can also simulate interactions between different component of the tax
system. This is highly relevant for income taxes and valuable for policy analysis.
In the following units, we will apply aggregate techniques to forecast PIT revenue under
a no-policy change scenario, and CIT revenue.

The techniques outlined in Module 2 can be used to forecast income tax

revenues, including both PIT and CIT. A summary of these methods is
discussed below, including the unconditional forecast approach, effective tax
rate (ETR) or coverage factor approach, and tax elasticity approach. You are
encouraged to refer to Module 2 as needed.

Unconditional forecast
These methods rely on determining the underlying trend of the series and
then applying this trend to forecast into the future. Refer to Module 2.3 for
more detail.

ETR/Coverage factor approach

In the ETR approach we use a proxy tax base and the ETR to produce
revenue forecasts. We also saw in Module 3 that the ETR can be
decomposed into the coverage factor (θ) and the statutory tax rate (τ). As
discussed in Module 2, total wage and salary receipts can be used as the
proxy base for PIT, whereas Gross Operating Surplus (GOS) can be used as
the proxy tax base for CIT. For more detail, please refer back to Module
2.4.1 and Module 3.3.3.

Tax elasticity approach

Historical data series of income tax revenues reflect both the impact of
increases in the tax base (income, expenditure) and discretionary changes in
tax system (rates, exemptions). Since we aim to forecast the baseline PIT
without any policy change, we need to adjust tax revenue series by separating
the increases in revenues caused by automatic growth in tax base from the
increases that occur due to discretionary changes. Normally the budget
speeches provide estimates of revenue impact of tax policy changes, which
can be subtracted from the historical PIT revenue. This adjustment process
sequentially eliminates the effects of policy changes on revenue collection
produced, and is typically done following the proportional adjustment
approach described in Module 3.1.3.

With the adjusted tax revenue (APIT), the next step is to specify a functional
relationship between the adjusted PIT revenue data and the proxy PIT base
using regression analysis (OLS):

where APITi is adjusted PIT revenues for time period i and Bi is the proxy tax
base in year i; α and β are constants (intercept and slope) to be estimated. As
both variables are expressed in log terms, the coefficient of lnBt (β1) directly
yields tax elasticity to be estimated. 

Assuming that reliable forecasts of the tax base Bft+1 are available, the final
step to generate a PIT revenue forecast is by plugging the estimate of the
elasticity ( ) into the following equation:

where %∆Bft+1 is the percentage changes in the forecasted tax base relative to
current-period tax base, defined as %∆Bft+1 = (Bft+1 - Bt) / Bt . When multiplying
with the PIT tax elasticity, the second term in the bracket shows the additional
change in future PIT revenue due to changes in the future tax base. In many
countries, forecasts of proxy tax bases and its components are usually
available as prepared by the Ministry of Finance. Likewise, the IMF publishes
multi-year projections of the core components of GDP in the World Economic
Outlook (WEO) for the vast majority of countries. 

A microsimulation model for the PIT has three essential components:

(1) historical data based on individual or family annual income tax returns,
supplemented by surveys to cover additional information that are not in the tax
records. (2) data projection, using historical data and income tax
parameters from the existing tax laws and regulations. The growth factors for
projection into the future are also necessary; and (3) tax calculator and
output summary. The tax calculator calculates individual tax liability and
simulates the impact of proposed policy changes on the tax liability of an
individual. The accompanying output summary then summarizes the overall
impact of proposed policy changes by aggregating over all taxpayers.  

The basic structure of a microsimulation tax model remains more or less the
same, regardless of the tax being analyzed. This module addressed only
income tax model, as this is their most common use for analyzing taxes. But
microsimulation models can be used to analyze other taxes such as excise
taxes or value added taxes. Analysis of CIT is structurally and conceptually
similar to analysis of PIT, but somewhat more complex. Some of the particular
problems related to use of microsimulation models with CIT are discussed
in Section 4.6.  

Advantages of microsimulation modeling approach

 It models interactions among different provisions in a complex tax

system.
 It provides more flexibility than time-series forecasting techniques,
which rely on past trends (despite frequent changes in tax law) to
extrapolate future tax revenues.
 It performs simulations using individual-level data, which makes it
possible to examine subgroups of the population, such as low-
income earners or families with children.
 It allows for evaluation of how hypothetical changes to the tax
system would affect total tax revenues and the distribution of taxes.
Disadvantages of microsimulation modeling approach

 To build a functioning microsimulation model is both time and

resource intensive, as it requires a lot of data and many parameters
estimated from various data sources, which are frequently not easy
to reconcile. In particular, as microsimulation models are based on
past data, sometime with a substantial delay given the amount of
time and resource required for updating, it tends to make the
underlying historical database more outdated than typical macro-
level statistics.
 It is difficult to take into account the way taxpayers respond to
certain policy changes and how this would impact on revenue
collection. For example, when there is a proposed increase in the
top PIT rate, individuals may respond by working less, or reporting
their income in other forms that are taxed at a lower rate. The
model calculation ignores these behavior responses and their
associated impact on tax liability.
 Results in sequential applications of provisions may depend on the
order in which the sequence of tax parameter changes is applied
 (“path dependence”), which is also not captured in a typical
microsimulation model.

In summary, microsimulation models, like all models, are simplifications of

reality and the results should be interpreted with care, bearing in mind the
strengths and weaknesses of the model.

Stratified Sampling: why and how?

Why? For model tractability, particularly if the microsimulation model is
implemented in Excel, we would often need to work with a sample (subset) of
the data. If the size of population is reasonably small, then we can directly
work with the population data. Otherwise, we can reduce the sample size by
drawing out a stratified sample of the population data.

A simple random sample is the most straightforward sampling strategy. It

works well for many sampling problems. But the more diverse the population
being sampled, the larger the sample size necessary to achieve a
representative sample. Thus stratified sampling of the population is required in
countries with large taxpayer populations.

How? How the stratification of the population is defined is an empirical

question. In general, taxpayer gross income is the single most important
variable for stratification of the population since gross income is more closely
related to tax liability than is any other single variable. In addition, higher
income taxpayers not only pay a disproportionate share of total tax, but they
also exhibit more diversity than lower income taxpayers.

In a stratified random sample, each stratum is sampled at a different rate. The

highest income stratum is typically sampled at 100 percent and decreasing
sample rates are typically applied throughout the strata as the income range
in each stratum declines. Additional strata may be defined based on other
criteria to ensure that segments of the population which might otherwise be
under-represented are included in the sample, such as residency within
smaller provinces or cities and communities, or the existence of important tax
characteristics, such as various kinds of business or capital income. There is
rarely an absolutely correct or incorrect stratification approach. A new stratum
should be created only to ensure accurate representation of an important sub-
population that might be under-sampled otherwise. In general, fewer well-
chosen strata are better than many poorly designed strata.

How to determine the strata, say based on gross income? Again, it’s country
specific. In the population dataset that we use for a hypothetical small low-
income country Eastland, taxpayers in the top decile of gross income
distribution pay more than 25 percent of total PIT revenue, while those in the
decile below pay about 15 percent of total PIT (See the figure below). These
observations are of major importance for microsimulation modelling. Therefore
we divide the taxpayer population into two stratum: those with gross income
above the 80th percentile, and all others below the 80th percentile. For the
high-income taxpayer stratum, we include all of them in the sample, i.e. using
a sampling rate of 100 percent, even though they only account for 20 percent
of the population.
 Distribution of PIT Payments by Gross Income Decile

For the stratum of smaller taxpayers, we use a sample rate of 10 percent,

meaning that every 10th observation in the population within the stratum is
selected and placed in the Sample (database). Therefore, each record in the
sample represents 10 taxpayers in the population, so that the weight of each
record is 10 (100 percent divided by 10 percent). Similarly, the weight of each
record in the large taxpayer stratum is 1. Each record within a single stratum
of a stratified Sample has the same weight as all other records in that stratum.
All calculations done on currency values (such as income or tax) on each
record in the sample are multiplied by their respective weight to estimate the
answer for the population.

Given the nature of revenue forecasting, in most cases the base-year data
lags behind the time period into which the forecast has to be made. At the
same time, analyzing the future effects of the income tax system requires data
that represent the expected demographic and economic characteristics of the
filing population. For this reason, revenue forecasting requires the “uprating”
or “aging” of the base year data into the future. The basic goal of data ageing
is to construct a database that gives an accurate depiction of what the macro-
and micro- economic environment might look like in future years.

The starting point for data ageing is a macroeconomic forecast of the national
economy, usually from a different government agency. This forecast will
usually include aggregate macroeconomic indicators of economic activity such
as wages, interest, and dividends, as well as say the growth rate of population
and general consumer price level.

Tax calculators are application of tax law to taxpayer data. Both tax law and
taxpayer data evolve over time. Tax law changes over time due to policy
reforms. Taxpayer data evolves over time due to macroeconomic factors,
population demographics, and individual circumstances. Both tax law and
taxpayer data may differ in a baseline scenario and reform scenario, so we
need to consider the sources for tax law and taxpayer data under each
scenario. For example, with the aged dataset for 2022 ready, the PIT Tax
Calculator takes individual taxpayers returns and applies the tax code,
yielding an assessment of the total tax payable.

Income Tax Parameters

Tax law under the baseline scenario and under the reform scenario are
derived from different sources and present different challenges in their
derivation. Tax law under the baseline scenario is derived from tax law and
tax forms. The PIT parameters can be looked upon as a tax check list on
which the tax calculator picks up the specified rates/credits/deductions and
matches it against the information provided under the personal history of the
individual to assess the total tax liability. Tax law under the reform scenario is
hypothetical and based on policy proposal.

Corporate Income Tax and Investment

Since interest is deductible, the CIT is a tax on the return from equity
investment. Taxing the return from equity can discourage businesses from
investing. For example, an investment project that is marginally profitable (that
is, a project that is earning a small but positive net present value) can become
unprofitable if a CIT is applied on the project’s earnings. The CIT can also
distort the location decision of firms, because firms may choose to locate their
investment based on tax considerations rather than productivity. Firms may
also shift accounting profits, rather than economic activity, in response to
differences in the CIT rate.

Over the years, tax competition between countries to attract investment has
contributed to a gradual reduction in CIT rates.

CIT rates over time in AE, EM, developing countries

 Source: IMF Fiscal Affairs Department Tax Policy Rates Database

Additional resources
For further information please refer to the IMF Tax Policy Handbook.

Differences between GOS and taxable income include the following.

  GOS includes the profit of all businesses, regardless of whether or not they
are incorporated whereas CIT is applied only to incorporated businesses.
Unincorporated businesses—such as sole proprietorships—are usually
taxed under the PIT regime.

 GOS does not deduct many of the allowable expenses under a typical CIT
regime such as: depreciation, interest payments and rent for land.

 GOS is an aggregate measure, so it adds together profits and losses across

all businesses in the economy. However, the calculation of the CIT base
only allows losses to be offset against profits of the same business (or, in
some jurisdictions, within the same domestic corporate group).

 GOS excludes capital gains and losses from the sale of fixed assets,
whereas such gains may be taxable and losses deductible under the CIT
regime.

A potential way to address these differences is to adjust GOS to get a closer

proxy of taxable corporate profits by adjusting for depreciation, interest
expense, capital gains and losses.

However, in many countries, data on GOS is often not available, so we would

need to use GDP as a starting point. The video below gives an example of
how nominal GDP can be adjusted to get a better proxy of the CIT base.