Analysing the effects of tax-benefit reforms on income distribution: a decomposition approach

Abstract

To assess the impact of tax-benefit policy changes on income distribution over time, we suggest a methodology based on counterfactual tax-benefit simulations. Changes in inequality/poverty indices are decomposed into three contributions: changes in the tax-benefit structure, changes in nominal levels of market incomes and tax-benefit money parameters, and all other changes, including shifts in market income inequality and demographic composition. The policy effect can be evaluated conditionally on base-period data or end-period data; it is also possible to average the two measures, which corresponds to an application of the Shapley value method as reinterpreted by Shorrocks (Decomposition Procedures for Distributional Analysis: A Unified Framework Based on the Shapley Value, University of Essex and Institute for Fiscal Studies, Wivenhoe Park, 1999). The decomposition is used to quantify the relative role of policy changes on inequality/poverty trends in France and Ireland in the 1990s. When end-period data are not available, e.g., for forward looking analysis of possible reforms, the base weighted decomposition helps to extract an absolute measure of the impact of tax-benefit changes on income distribution as evaluated against a distributionally neutral benchmark; in our application, it is not significantly different from the policy effect stemming from the Shorrocks-Shapley decomposition. Estimates of this type are derived to assess recent policy changes in twelve European countries.