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 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Practical Microsimulation Modelling

 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Practical Econometrics

Series editors
Jurgen Doornik and Bronwyn Hall

Practical econometrics is a series of books designed to provide accessible and

practical introductions to various topics in econometrics. From econometric
techniques to econometric modelling approaches, these short introductions
are ideal for applied economists, graduate students, and researchers looking
for a non-­technical discussion on specific topics in econometrics.

Books published in this series

An Introduction to State Space Time Series Analysis

Jacques J. F. Commandeur and Siem Jan Koopman

Non-­Parametric Econometrics
Ibrahim Ahamada and Emmanuel Flachaire

Econometric Methods for Labour Economics

Stephen Bazen

A Practical Guide to Price Index and Hedonic Techniques

Ana M. Aizcorbe

Practical Microsimulation Modelling

Cathal O’Donoghue
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Practical
Microsimulation
Modelling
Cathal O’Donoghue

1
OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

1
Great Clarendon Street, Oxford, OX2 6DP,
United Kingdom
Oxford University Press is a department of the University of Oxford.
It furthers the University’s objective of excellence in research, scholarship,
and education by publishing worldwide. Oxford is a registered trade mark of
Oxford University Press in the UK and in certain other countries
© Cathal O’Donoghue 2021
The moral rights of the author have been asserted
First Edition published in 2021
Impression: 1
All rights reserved. No part of this publication may be reproduced, stored in
a retrieval system, or transmitted, in any form or by any means, without the
prior permission in writing of Oxford University Press, or as expressly permitted
by law, by licence or under terms agreed with the appropriate reprographics
rights organization. Enquiries concerning reproduction outside the scope of the
above should be sent to the Rights Department, Oxford University Press, at the
address above
You must not circulate this work in any other form
and you must impose this same condition on any acquirer
Published in the United States of America by Oxford University Press
198 Madison Avenue, New York, NY 10016, United States of America
British Library Cataloguing in Publication Data
Data available
Library of Congress Control Number: 2021935786
ISBN 978–0–19–885287–2
DOI: 10.1093/oso/9780198852872.001.0001
Printed and bound by
CPI Group (UK) Ltd, Croydon, CR0 4YY
Links to third party websites are provided by Oxford in good faith and
for information only. Oxford disclaims any responsibility for the materials
contained in any third party website referenced in this work.
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Dedicated to my peers and students in the microsimulation community

OUP CORRECTED PROOF – FINAL, 26/06/21, SPi
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Preface

This book describes the lessons that I have learnt over the course of developing
my skills as a microsimulation modeller and co-­generating knowledge and
experience with Ph.D. and master’s students and with industry clients.
While I have built many models over the course of my career, the research
in this book draws on lessons from four models:

• SWITCH–the tax-­benefit microsimulation model of the Economic and

Social Research Institute, in Dublin, Ireland (Callan et al. 1996)
• EUROMOD–the European tax-­benefit model (Immervoll et al. 1999;
Immervoll and O’Donoghue 2009; Sutherland and Figari 2013)
• LIAM–Lifecycle Income Analysis Model (dynamic microsimulation
framework) (O’Donoghue et al. 2009; de Menten et al. 2014)
• SMILE–Simulation Model of the Irish Local Economy (spatial micro-
simulation model) (O’Donoghue et al. 2012)

Figure 0.1 describes my knowledge-­tree equivalent to a genealogical tree

of these models and their link to earlier models in the literature.

Dynamic Static
USA UK AUS Spatial

1960’s Orcutt 1961

1970’s DYNASIM I/II

TAXMOD
1980’s CORSIM LIFEMOD IFS Taxben
PENSIM
DYNACAN POLIMOD
HARDING
1990’s SWITCH
DYNAMOD
SVERIGE

SAGEMOD
LIAM EUROMOD
POLISIM PENSIM2
EU Leeds
2000’s MIDAS x 3
DYNASIM III APPSIM

SMILE

LIAM2

Figure 0.1 Model Knowledge Tree

 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

viii Preface

These models span many of the main methodological areas of micro-

simulation modelling, covering static, dynamic, cross-­country, and spatial
­models. Starting with static modelling, which ignores behaviour, time, and
place, the first model I worked on was the SWITCH static microsimulation
model at the Economic and Social Research Institute, in Dublin, Ireland,
working with Tim Callan and his team to develop and use the Irish SWITCH
static tax-­benefit model (Callan et al. 1996). This work was heavily influ-
enced by the Institute for Fiscal Studies’ Taxben model (Blundell et al. 2000).
Extending the dimensionality of the modelling to incorporate the time
dimension in a dynamic microsimulation model, I developed a dynamic-­
cohort model LIAM (O’Donoghue 2002) during a Ph.D. at the London
School of Economics (LSE), under the supervision of Celia Phillips and Jane
Falkingham. LIAM built upon the family of dynamic-­cohort models devel-
oped at the LSE for the UK (LIFEMOD, Falkingham and Hills 1995) and
Australia (HARDING, Harding 1993). This model was also influenced by the
work of Steve Caldwell at Cornell University (where I had the pleasure of
spending some time during the course of my Ph.D.), who developed the
CORSIM model (Caldwell 1996). Caldwell’s model is a direct link to the first
microsimulation models in the field, when he partnered with Guy Orcutt
(Orcutt et al. 1958; Orcutt 1960) on the DYNASIM model at the Urban
Institute, Washington DC, in the early 1970s.
Caldwell had a particular way of building very sophisticated models with
relatively limited resources, working with Ph.D. students and with partners
in other countries. One of these partnerships was with the Canadian govern-
ment to build the DYNACAN model, along with Rick Morrison and his
team (Caldwell and Morrison 2000). The joint meetings between CORSIM–
DYNACAN teams were one of the leading fora for the exchange of know­
ledge in dynamic microsimulation modelling at the time.
I also worked with Holly Sutherland’s team at the Microsimulation Unit, in
the Department of Applied Economics, University of Cambridge, together
with partners such as Tony Atkinson and Francois Bourguignon, to create a
cross-­country microsimulation model, EUROMOD (Atkinson et al. 2002).
Other partners, such as Gert Wagner at the Deutsches Institut für
Wirtschaftsforschung (DIW),1 provided a link back to the cutting-­edge Sfb3
models in Germany in the 1980s (Galler and Wagner 1986). In addition, the
early version of the EUROMOD framework was developed together with
Herwig Immervoll, who now heads up microsimulation analysis at the OECD
(Immervoll and O’Donoghue 2009), although later versions are more flexible

1 German Institute for Economic Research.

 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Preface ix

and powerful (Sutherland and Figari 2013). Extensions of EUROMOD

involved collaborations with Andre Decoster to incorporate modelling con-
sumption and indirect tax (Decoster et al. 2010), and also collaborations
with Ugo Colombino to incorporate labour supply (Colombino et al. 2010).
Extending microsimulation modelling to incorporate the spatial dimen-
sion, I developed, on returning to Ireland, SMILE, working in partnership
with Graham Clarke and Dimitris Ballas of the University of Leeds (Ballas
et al. 2005). SMILE has a focus on rural- and agricultural-­policy analysis
(O’Donoghue et al. 2013). In parallel, my Ph.D. framework, LIAM
(O’Donoghue et al. 2009), was generalized to be applied to other countries
(Dekkers et al. 2010), which eventually led to the development of a new and
faster, more-­powerful framework, LIAM2 (de Menten et al. 2014), with the
methodologies influencing the development of the UK’s dynamic-­
microsimulation model Pensim2, at the Department of Work and Pensions
(Edwards 2010; O’Donoghue et al. 2010).
Progress in research is based on building upon the achievements and
learnings of others. Much of the learning in microsimulation has been by
word of mouth, via interpersonal interactions, or via documentation in con-
ference proceedings or books, many of which are now out of print, such as
the excellent Orcutt et al. (1986).
Without personal interactions with leading figures in this fast-­growing
and relatively novel field, it would have been more challenging for me to
develop these models. In essence, I had to rely largely on an oral exchange of
knowledge and experience. Across the microsimulation field, much of the
knowledge has been transmitted verbally between people on teams, at con-
ferences, and through networks. In developing further, the microsimulation
field faces a challenge to find more-­effective ways of transferring knowledge.
In transferring knowledge, there are two main types of knowledge transfer:

• codified knowledge, where specific knowledge is written down

• tacit knowledge, where more-­abstract information may be more difficult
to transmit

For much of the period since the foundation of the field, knowledge has
been codified mainly through the following forms:

• documentation that aims to facilitate other team members utilizing

the models
• published material, mainly books and conference presentations, which
may have been non-­peer reviewed, had limited coverage, and often
went out of print
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

x Preface

• documents that may have only been available to those who attended an
event and were rarely included in the usual citation indices and search-
able databases
• papers published in peer-­reviewed formats, which were typically in
journals where the focus was on the application rather than the
methodology

A significant proportion of the methods used in the field are not formally
codified, meaning that new models have had to reinvent the wheel and
re­develop existing methods over and over again. Where methods were for-
mally codified, they were often codified in non-­peer-­reviewed technical notes
or discussion papers and thus lack the quality assurance that peer review can
help to achieve. Another issue is that publication in a research-­centre tech­
nical paper or note carries risks associated with the ending of funding, retire-
ment of staff, or the end of the life of a model. Thus, there is a sustainability
risk for the field in respect to its core methodological foundations.
A classic example of this is the methodology in relation to alignment, used
in dynamic microsimulation models. It is a calibration mechanism used to
align simulated totals to external control totals, and has been used since the
1970s. It is, thus, a core methodology within the field. However, there is rela-
tively little documentation or guidance as to how to undertake alignment.
Where it exists, it is published in non-­ peer-­reviewed technical papers
(Bækgaard 2002) as team-­specific internal documentation (Johnson 2001;
Morrison 2006), conference papers (Kelly and Percival 2009; Chénard 2000a),
or in relatively hard-­to-­find volumes based on conferences (Neufeld 2000;
Chénard 2000b). It should be noted that all these references date from 2000
onward, despite the methodology being used since the 1970s. Most are not
peer reviewed and most are hard to find, and, given the dissolution of some of
the teams, are impossible to access. One of the first peer-­reviewed journal art­
icles that aims to assess the performance of a part of the methodology was only
published in 2014 (Li and O’Donoghue 2014). This chapter covers the align-
ment of only a single variable type. Is it any wonder that the meth­od­ology has
received serious criticism (Winder 2000)?
It is arguable that the development of a method cannot be trusted until it
has been road-­tested through publication and rigorous peer review. There is,
thus, a need for a literature to be developed to document, test, and provide
rigorous quality assurance for the alignment of the many other variables that
are found in the literature. The example above cites an issue in relation to one
specific aspect of the methodology. This criticism could be extended to many
other methods used within the field of microsimulation.
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Preface xi

This book is an attempt to codify and describe many of the main tech-
niques utilized in microsimulation modelling, and to present examples of
how they are used.
I am grateful both to my many peers in the field of microsimulation and to
students that I have learned from and taught over the past twenty-­five years.
I am also grateful to helpful comments by anonymous referees and to my
colleague Mary Ryan for extensive comments on the draft document. I hope
this book provides a helpful guide for those wishing to develop models
within the field. I would like to acknowledge the understanding and support
of Rosaleen and Jude as I prepared this book.
OUP CORRECTED PROOF – FINAL, 26/06/21, SPi
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Table of Contents

List of Figures xvii

List of Tables xix

PART I. INTRODUCTION
1. Introduction 3
1.1 Introduction 3
1.2 Types of Microsimulation Models 12
1.3 Overview 23
2. Xlsim: Developing A Software Tool to Assist Training and
Learning In Microsimulation Modelling 25
2.1 Introduction 25
2.2 Theoretical Objectives 26
2.3 Software Evaluation For A Microsimulation Development 31
2.4 Methodology: The Computing Framework Of Xlsim 40
2.5 Summary 45
2.6 Appendix 46

PART II. STATIC MODELS

3. Anti-­Poverty Policy 63
3.1 Introduction 63
3.2 Policy Design: The Design of social Transfer 64
3.3 Data Issues: Creating the Base Dataset 71
3.4 Validation: Hypothetical Families 74
3.5 Measurement Issues: Poverty Efficiency 76
3.6 Simulation: Introducing An Anti-­Poverty Instrument 85
4. Redistribution and Income-­Tax Reform 88
4.1 Introduction 88
4.2 Policy Context: Structure of Income-­Tax Systems 89
4.3 Data Issues: Net to Gross Imputation 95
4.4 Validation: External Data 98
4.5 Measurement Issues: The Distributional Impact of Taxation Analyses 100
4.6 Simulation: Modelling Taxes and Contributions 106
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

xiv Table of Contents

PART III. BEHAVIOURAL MODELS

5. Labour-­Supply Behaviour 115
5.1 Introduction 115
5.2 Policy Context: In-­Work Benefits 121
5.3 Data Issues: Preparation of Data For Labour-­Supply-­Choice
Modelling122
5.4 Validation: Derivation of Unobserved Residuals for
Simulation131
5.5 Measurement Issues: Replacement Rates 133
5.6 Simulation: Modelling the Behavioural Impact of Increasing
an In-­Work Cash Transfer 140
6. Indirect Taxation and Consumption Behaviour 150
6.1 Introduction 150
6.2 Policy Context: Indirect Taxation 152
6.3 Data Issues: Linking Income and Expenditure Surveys 153
6.4 Measurement Issues: Modelling A Behavioural Response 157
6.5 Simulation: Income and Indirect Taxation 165
7. Environmental Taxation 173
7.1 Introduction 173
7.2 Policy Context: Environmental Taxation 175
7.3 Data Issues: Modelling Pollution 177
7.4 Measurement Issues: Direct and Indirect Impacts of
Environmental Taxation 178
7.5 Simulation: Welfare Impact of A Carbon Taxation 181

PART IV. DYNAMIC AND SPATIAL MODELS

8. Decomposing Changes in Inequality Over Time 191
8.1 Introduction 191
8.2 Policy Context: Decomposition Of Inequality 193
8.3 Data Issues: Income-­Generation Model 194
8.4 Measurement Issues: Shapley-­Value Decomposition 205
8.5 Simulation: Oaxaca–Blinder–Bourguignon Decomposition 206
8.6 Validation Issues 210
9. Pension Reform and Life-­Course Distributions 213
9.1 Introduction 213
9.2 Policy Context: Pensions and Ageing 214
9.3 Data and Modelling Issues 216
9.4 Validation: Alignment 225
9.5 Measurement Issues: Inter-­Temporal Redistribution 228
9.6 Simulation: Distribution Of Income Over The Life Course 230
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Table of Contents xv

10. Spatial Inequality 239

10.1 Introduction 239
10.2 Policy Context: Spatial Inequality And Poverty 241
10.3 Data Issues: Matching Spatial Data and Micro-­Data 243
10.4 Validation: Conditional Independence and Spatial Calibration 251
10.5 Measurement Issues: Spatial Inequality 260
10.6 Simulation: Modelling The Spatial Distribution of Income
in Ireland 261

References 267
Index 297
OUP CORRECTED PROOF – FINAL, 26/06/21, SPi
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

List of Figures

0.1 Model Knowledge Tree vii

1.1 Sources of Complexity in Policy Design and Evaluation 6
1.2 Enhanced Complexity in Inter-Temporal and Spatial Microsimulation
Models7
1.3 Unemployment Trap from Means Testing 8
1.4 Poverty Trap 9
1.5 Reducing the Poverty Trap 10
1.6 Hypothetical Model 13
1.7 Static Tax-Benefit Model 15
1.8 Labour-Supply Behavioural Models 17
1.9 Consumption-Behaviour-Based Models 18
1.10 Environmental Models 19
1.11 Decomposing-Inequality Model 21
1.12 Dynamic Microsimulation Models 22
1.13 Spatial Microsimulation Models 23
2.1 Model Structure 45
2.2 Parameter Worksheet 53
2.3 The Command Sheet 56
3.1 Social-Benefit Modules 65
3.2 Replacement Rates 69
3.3 Means Tests 70
3.4 UK Tax-Benefit System 75
3.5 Sensitivity of Poverty Line to Assumptions 81
3.6 The Efficiency of Social Transfers 84
3.7 Monthly Gross-Income Budget Constraint of Benefit Simulations
on Couple with Two Children 86
4.1 Tax Allowances and Credits 92
4.2 Gini Coefficient 102
4.3 Redistribution and Progressivity 103
4.4 Tax and Social-Insurance Contributions 107
4.5 Monthly Net-Income Budget Constraint of Benefit Simulations on
Couple with Two Children 107
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

xviii List of Figures

4.6 Lorenz and Concentration Curves 109

4.7 Average Tax Liability for Joint and Individual Taxation for Single-Earning
Married Couples 110
4.8 Marginal Effective Tax Rates for Joint and Individual Taxation 110
5.1 Equity-Efficiency Trade-Off 116
5.2 Non-Linear Budget Constraint (Unemployment and Poverty Traps) 124
5.3 Hours Distribution 143
5.4 Budget Constraint for Couple with Children 144
5.5 Distribution of Marginal Effective Tax Rates 145
5.6 Marginal Effects for Income and Hours for Model 1 148
6.1 Budget Elasticities 169
6.2 Budget Shares 170
6.3 Own-Price Elasticities 171
7.1 Structure of an Environmental Microsimulation Model 174
7.2 Efficient Pollution Abatement for a Single Polluting Firm 175
8.1 National Accounts and Employment Rate 1996–2016 195
8.2 Change in the Budget Constraint 2004–12 205
8.3 Sensitivity of Order of Simulation on Change in Gini Coefficient 2007–12 210
8.4 Inequality Pathways 2007–12 211
9.1 Age-Group-Profile Structure of Those in Employment 232
9.2 Employment Rate of Those Aged 16–65 232
9.3 Cohort Employment Rate 233
9.4 Simulation Properties of Employment 235
9.5 Simulation Properties of Employment Model 3 236
9.6 Simulation Properties of Employment 237
9.7 Employment Profile 238
9.8 Lifetime Distribution of Disposable Income 238
10.1 Simulated Average-Equivalized Household Disposable Income at the
District Level 263
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

List of Tables

2.1 Microsimulation Functionality of Different Software Tools 33

2.2 Characteristics of Different Software 34
2.3 General Structure of Tax Benefit Rules Worksheet 51
3.1 Benefit Rules 85
3.2 Poverty-Efficiency Statistics 87
4.1 Contribution and Tax Rules 106
4.2 Progressivity and Redistribution 109
5.1 CCT or In-Work Transfer Payment 127
5.2 Choice Attributes for CCT 128
5.3 Data Selection for Labour Supply 142
5.4 Multinomial Logit for Labour-Participation-Supply Model 146
5.5 Conditional Logit for Labour-Supply Model 147
5.6 Simulation of a 50-Per-Cent Increase in the Level of Payment of an
In-Work Benefit 149
6.1 Budget Shares 167
6.2 Budget Elasticities 167
6.3 Frisch Parameters 168
6.4 Own-Price Elasticities 168
6.5 Distributional Statistics 171
6.6 MRC 172
7.1 Ratios of Carbon Dioxide and Energy to Expenditure by Fuel 179
7.2 Fuel as a Share of Expenditure by Decile 182
7.3 Percentage Direct and Indirect Increase in Prices of Consumption Goods
Due to Carbon Tax 183
7.4 Distribution of Share of Expenditure Type 184
7.5 First-Round Impact of Carbon Tax (Carbon Tax as a Proportion of
Expenditure)184
7.6 Own-Price Demand Elasticities 185
7.7 Tax as a Percentage of Total Expenditure and Disposable Income 186
7.8 Change in Expenditure on Goods as a Result of Indirect Carbon Tax
(as Percentage) 186
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

xx List of Tables

7.9 Percentage Change in Carbon Emissions by Decile 187

8.1 Changes in the Distribution of Equivalized Disposable Income 2007–12 203
8.2 Occupation and Industry Share 2007–12 204
8.3 Distributional Characteristics of Market Income 204
8.4 Regression Coefficients by Education 2007–12 207
8.5 Decomposing Change in Gini Coefficient of Equivalized Disposable Income 208
8.6 Equivalized Household Income under Different Pathways 209
8.7 Decomposing Change in Gini Coefficient of Equivalized Disposable Income 212
10.1 Urban Versus Rural Market and Disposable Income 264
10.2 Between- and Within-Group Inequality by Income Component 264
OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

PART I
INTRODUCTION
OUP CORRECTED PROOF – FINAL, 26/06/21, SPi
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

1
Introduction

1.1 Introduction

Public policy design increasingly expects and relies upon a body of evidence
to make decisions. Better evidence can produce better and more focused
policies. It can allow for better targeting of resources, improving the cost of
achieving a particular policy objective, or improving the effectiveness of a
policy for a given resource. Targeted policy interventions require better
information on who is affected, how they are affected, and where those who
are affected are located. For example, a transfer programme targeted at a
group that are generally poor, such as the elderly, may cost more than an
instrument that is targeted on the basis of income, and so is targeted spe­cif­
ic­al­ly at the poor. However, this targeting or means testing may introduce
negative incentives. Thus, designing effective policy requires a micro-­based
unit of analysis, containing information on how a policy will affect in­di­vid­
uals differentially.
While there is a large range of methodologies utilized in undertaking
evidence-­based policy analysis, they can be classified broadly into the fol­
lowing categories:

• Ex-­post analysis (Heckman et al. 1999; Todd 2007; Vedung 2017;

Benhassine et al. 2015), focusing on evaluating the impact of a policy
after it has been implemented.
• Ex-­ante analysis, assessing the potential impact before roll out (Hertin
et al. 2009; Figari et al. 2015; De Agostini et al. 2018).

Increasing use is being made of pilot initiatives using randomized experi­

ments and then evaluated using ex-­post methods, for example in the case of
the main worldwide pilot projects for child-­related conditional cash-­transfer
programmes (see Gertler 2004; Fernald et al. 2008; Pearce and Raman 2014;
Haskins and Margolis 2014). However, political constraints and/or time or
resource constraints frequently do not allow this to take place. Thus ex-­ante
simulation-­based methods are often used for public policy design as they are
cheaper, being undertaken on a computer without incurring large piloting
Practical Microsimulation Modelling. Cathal O’Donoghue. Oxford University Press. © Cathal O’Donoghue 2021.
DOI: 10.1093/oso/9780198852872.003.0001
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

4 Introduction

costs. They are less accurate than ex-­ post methods as the structure of
­behaviour may change in response to policy instrument or they may be
based upon historical data. However, the methodology may be the only one
pos­sible in many circumstances.
Microsimulation modelling is a potential simulation-­based tool with a
micro-­unit of analysis that can be used for ex-­ante analysis (O’Donoghue
2014). It is a micro-­based methodology, typically utilizing micro-­data units
of analysis, for example taking surveys or datasets containing micro-­units
such as households, individuals, firms, and farms, etc. It is a simulation-­
based methodology that utilizes computer programs to simulate public
­policy and economic or social changes on the micro-­population of interest.
While microsimulation models have taken firms (Eliasson 1991; Buslei et al.
2014) or farms (O’Donoghue 2017) as the micro-­unit of analysis, most have
carried out analysis at the level of individuals or households (see Mot 1992;
Sutherland and Figari 2013)
As a research field, microsimulation has its roots in the work of Guy
Orcutt (1957, 1961). However, it was only the advent of the personal com­
puter in the 1980s and the availability of micro-­data that have allowed the
field to develop. Whether formally defined as microsimulation modelling or
not, micro-­based, ex-­ante simulation-­based analysis is now used extensively
around the world for policy analysis and design.
There have been a number of survey articles written such as Merz
(1991, 1994), Mot (1992), Martini and Trivellato (1997), Bourguignon and
Spadaro (2006), Dekkers and van Leeuwen (2010), and Anderson and Hicks
(2011). Generally, Sutherland (1995) covered static models; Klevmarken
(1997) behavioural models; O’Donoghue (2001), Zaidi and Rake (2001),
Spielauer (2007), and Li and O’Donoghue (2013) dynamic models; Rahman
and Harding (2016), Rahman et al. (2010), Hermes and Poulsen (2012),
Tanton and Edwards (2013), Tanton (2014), and O’Donoghue et al. (2014)
spatial models; Creedy and Duncan (2002), Creedy and Kalb (2005), and
Bargain and Peichl (2013) labour supply models; Figari and Tasseva (2013) a
special issue on the cross-­country EUROMOD model; Brown (2011) health
models; and Ahmed and O’Donoghue (2007), Cockburn et al. (2010), and
Bourguignon et al. (2010) covered macro-­micro models. The O’Donoghue
(2014) handbook brings together developments across a variety of different
areas. Given the growth in microsimulation over the past twenty years, there
is a need for a text book to assimilate this literature and describe the develop­
ment and implementation of current practice in the microsimulation field.
Public policy is broad, with many objectives and associated targets.
Microsimulation modelling can in principle be applied to assess the micro
impact of many policy areas, subject to data availability and to the capacity
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

Introduction 5

to quantify the impact of the policy. This book will focus primarily on
­pol­icies associated with the distribution of income such as poverty, income
in­equal­ity, and labour supply incentives. These are the areas in which the
methodology has seen most use over time. However, there are also many
other areas in which the methodology has been widely used, particularly in
the areas of transport (Miller 2014), health (Schofield et al. 2014), urban
planning (Waddell et al. 2003), and farm-­level modelling (O’Donoghue 2017;
Shrestha et al. 2016).
Microsimulation models can be produced in different programming
en­vir­on­ments. Relatively simple models can be programmed in Microsoft
EXCEL, while more sophisticated models use statistical software such as SAS
or Stata, or programming languages such as C++, VB, and Java (Hancock
1997). There are no specific software packages for undertaking microsimula­
tion, but a number of frameworks have been used to build m ­ odels for differ­
ent purposes, for example the EUROMOD (Immervoll and O’Donoghue
2009), MODGEN (Spielauer 2011), and LIAM2 (De Menten et al. 2014)
frameworks.
Other modelling methods, such as computable general equilibrium
­models (CGE) (De Melo 1988; Van Ruijven et al. 2015), overlapping gen­er­
ations models (OGM) (Lambrecht et al. 2005; Bommier and Lee 2003), or
agent-­based models (Tesfatsion and Judd 2006; Gatti et al. 2018), in­corp­or­
ate behaviour in a more detailed or consistent way than microsimulation
models, but typically do not have the same heterogeneity of population or
detail in relation to policy. Linking these models with microsimulation
­models can generate some of the advantages of both methods, illustrated by
attempts to link more detailed behavioural models such as CGE (Cockburn
et al. 2014) with microsimulation models.

1.1.1 Complexity and Microsimulation Models

As a modelling framework, microsimulation modelling is a mechanism of

abstracting from reality to help us understand complexity better. Figure 1.1
outlines potential sources of complexity in a static, single-­ time-­period
microsimulation model.
In the context of policy design and evaluation, complexity can take the
form of:

• population structure
• behavioural response to the policy
• policy structure
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6 Introduction

Population

Policy Behaviour

Figure 1.1 Sources of Complexity in Policy Design and Evaluation

These levels of complexity themselves interact with each other, resulting in

a degree of complexity that is difficult to disentangle without recourse to
a model.
Consider first the dimension of complexity, for example policy complexity
or the range of different policy or socio-­economic impacts. Many microsim­
ulation models try to replicate the fine detail of legislation in their simula­
tions, as opposed to a more generic form of simulation. These include the
areas of tax and benefit policy, indirect taxation, health policy, pension pol­
icy, rural policy, transport policy, or macroeconomic change. Different geo­
political contexts may influence the nature of the policy complexity. For
example, the set of policies simulated in an OECD country may be different
to those simulated in a developing country, with the former typically having
a greater reliance on income-­related systems such as income taxation and
means-­tested benefits, and the latter being more reliant on consumption-­
based taxes and in-­kind instruments.
The next dimension of complexity in relation to population is whether an
analysis takes place on a population with limited or extensive heterogeneity.
Many analyses focus merely on the impact of policy on typical families,
abstracting almost entirely from population complexity, such as the OECD
tax-­ benefit model based upon workers at the average production wage
(Immervoll and Pearson 2009). Another dimension of population complex­
ity considered is the unit of analysis. Some microsimulation models have
taken businesses such as firms (Buslei et al. 2014) or farms (O’Donoghue 2017)
as the micro-­unit of analysis, however most have carried out analysis at the
level of individuals or households (Bourguignon and Spadaro 2006).
The third dimension of complexity is behaviour. Many policies are ex­pli­
cit­ly aimed at influencing behaviour, as in the case of work incentives, in-­
work benefits, or environmental incentives. Models that abstract from
behavioural response are known as static microsimulation models, while
models that incorporate behaviour include labour participation and supply,
consumption decisions, benefit take-­up, tax evasion, transport decisions, or
farm- and firm-­level investment decisions.
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Introduction 7

Inter-temporal Microsimulation Models Spatial Microsimulation Models

Population Population

Behaviour Policy Behaviour Policy

Time Place

Figure 1.2 Enhanced Complexity in Inter-­Temporal and Spatial Microsimulation Models

In the case of models that incorporate either spatial dimensions

(O’Donoghue et al. 2014) or inter-­temporal dimensions (Li and O’Donoghue
2013), the level of complexity is further increased (Figure 1.2). Land use and
spatially targeted policy or spatially targeted socio-­economic effects require
spatial models. Analysis of policies which depend upon long-­term contribu­
tion histories, such as pensions and long-­term care policy, or require long-­
term repayments (as in the case of education financing), utilize inter-­temporal
or dynamic models.
Finally, across all dimensions there may be an interest in understanding
the performance of policies in different country contexts. Multi-­country
models and comparative analyses have been developed to analyse such ques­
tions of differential complexity.

1.1.2 Population Complexity

Policy analysis frequently tries to understand how a policy will impact the
‘average’ family. The OECD’s average production worker examination of com­
parative tax and social policy is an example of such analysis (Pearson &
Scarpetta 2000; Burlacu et al. 2014). However, familiarity with micro-­data
makes one realize that there is in fact no average family, such as a single-­earner
couple with children and living on the average wage. For example, looking at
the structure of the Irish population in 2005 using the Survey of Income and
Living Conditions, there are 33.5 per cent of the population living in house­
holds defined as a couple with children. Of these, 13.1 per cent are single-­
earner couples and of these less than 2 per cent have earnings at or close to the
average wage. Thus, the so called ‘average’ contains only a tiny fraction of the
population, reflecting the high degree of heterogeneity-­derived complexity
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

8 Introduction

within the population. Decomposing into other dimensions, such as time or

income source, further add to this complexity. For this reason, policy analysts
require micro-­datasets containing representative samples of the population.

1.1.3 Policy Complexity

Public policy often starts with simple objectives, perhaps in response to a

crisis or a specific social-­policy objective. However, unexpected effects or
‘mission creep’ can often lead to a policy becoming more complicated. Take
for example an anti-­poverty strategy. A desire to reform poor laws in Britain
and Ireland saw the introduction of contribution-­ based unemployment
insurance to combat poverty in 1911. However, the cost of extending the
instrument to fill coverage gaps saw the introduction of means-­ tested
un­employ­ment assistance in 1933 (Figure 1.3). This added further complex­
ity, requiring information about the income of an individual, instead of evi­
dence of having paid sufficient social insurance contributions.
As the value of the instrument rose to improve the poverty effectiveness of
the instrument over time, the impact was to increase the proportion of the
population covered by the means-­tested instrument, thus increasing what is
known as the ‘unemployment trap’, whereby individuals are not better off in
work. To counter this, an in-­work benefit, the Family Income Supplement
(FIS)—similar to instruments such as the EITC and Family Credit/WTC in
the US and the UK respectively—was introduced in 1984 (Figure 1.4). This

300
250
200

150
€ per week

100
50
0
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60
–50
–100

–150 Hours per Week

T VAT SIC IT CB UA FIS Net Earns

Figure 1.3 Unemployment Trap from Means Testing

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Introduction 9

300
250
200

150
€ per week

100
50
0
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60
–50
–100

–150 Hours per Week

T VAT SIC IT CB UA FIS Net Earns

Figure 1.4 Poverty Trap

instrument was targeted at families working more than twenty hours per
week, with the objective of reducing the unemployment trap. It too was
means tested at the rate of 60 per ent, however it also extended means testing
higher up the income distribution. At the same time, reforms were made to
take low-­income individuals out of the tax net, but with a relatively high,
marginal tax rate of 40 per cent.
This system of policies, all with relatively straightforward and reasonable
objectives, evolved over time. However combined, this system produced sig­
nificant complexity and unintended interactions. Here, quite a significant
proportion of low-­income families with children faced a withdrawal rate of
60 per cent of the FIS, combined with a marginal income-­tax rate of 40 per
cent and a social-­insurance contribution rate of about 8 per cent, combining
to produce a marginal effective tax rate of 108 per cent (Callan et al. 1995)
(Figure 1.5). This resulted in a ‘poverty trap’ where individuals have no
incentive to increase their working hours even if they wished to, as earning
an extra pound would result in their net income falling by eight pence.
Capturing the detail of actual legal rules, microsimulation models allow for
complex interactions between different policy instruments to be identified.

1.1.4 Behavioural Complexity

Since the 1980s, a significant amount of tax-­benefit policy reform across

the OECD has targeted improved work incentives to counter some of the
problems identified above. However, microeconomic theory identifies
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

10 Introduction

300
250
200

150
€ per week

100
50
0
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60
–50
–100

–150 Hours per Week

T VAT SIC IT CB UA FIS Net Earns

Figure 1.5 Reducing the Poverty Trap

complex competing forces resulting in what is known as a backward-­

bending labour supply curve, as a result of the impact of a substitution
effect, whereby a reduction in the marginal return from labour will
increase the attractiveness of leisure, and an income effect incentivizing
an individual to work more. The net impact of these forces in terms of
labour supply depends upon the relative preferences of the individual,
which may be both idiosyncratic or a function of personal characteristics,
such as the presence of children, their gross wage rate, or age. In addition,
labour-­demand constraints may result in labour-­force outcomes that are
different to desired labour supply.
Combined, these sources of complexity can result in a ‘spaghetti’ of differ­
ent issues. While it may be feasible to use pen-­and-­paper analytical methods
to analyse average or simplistic situations or sets of policies, it is often very
difficult or impossible to disentangle the impacts of more complex policies,
population groups, or behaviours. In such cases, it is often the unintended
consequences that cause the policy maker the greatest headaches, as the
recipients of these consequences are often those who will be most likely to
complain, resulting in negative media coverage and thus undermining the
political support for what may be generally worthy policy objectives. A
microsimulation model facilitates the ironing out of some of these difficul­
ties in policy prior to implementation. Microsimulation allows for the exam­
ination of drivers of behaviour using a static model, as in the case of
replacement rates (O’Donoghue 2011) or marginal effective tax rates
(Mertens and Montiel Olea 2018).
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Introduction 11

1.1.5 Analytical Objectives

In the field of income maintenance policy, and the associated financing of

these policies, what are the dimensions of analysis in which policy makers
are interested?
Cost is often top of the priority list in designing a policy reform, albeit as a
constraint or indirect policy objective due to a limited budgetary envelope.
Targets associated with this objective include public finance indicators of
balance and sustainability. A model with this objective will in general have
the requirement of both (a) utilizing a dataset which is representative of the
population of concern to the policy and (b) modelling the policy in sufficient
detail to be able to undertake accurate costings.
As microsimulation models incorporate a micro-­population, the distribu­
tional impacts of a policy are another primary focus. Models may look at the
distributional impacts of a policy or policy change across different income
categories, either in the case of a vertical redistributive analysis or across dif­
ferent family types in the case of horizontal redistribution. Estimations of the
impact of changes on low incomes, as in the case of a poverty analysis, are
commonplace. The capacity to estimate the numbers of potential winners
and losers as a result of a policy change is also very important, particularly to
politicians.
Policies often have a behavioural dimension. Strategies to reduce labour-­
supply incentives associated with interactions of the tax-­benefit system in
OECD countries are highlighted above (Aaberge and Colombino 2014).
There is a priority objective within policy reform in many developing coun­
tries to add conditionality to other anti-­poverty policy. For example, in the
Bolsa Familia programme in Brazil school attendance of children is a
requirement for eligibility for an anti-­poverty instrument (Bourguignon
et al. 2003; Cury et al. 2016). It thus has multiple objectives, namely increas­
ing education participation and reducing both child labour and poverty. In
order to model these analyses, an econometric behavioural model will be
required, or at a minimum, a capacity for scenario analysis.
Sometimes, the induced behaviour that is targeted relates to consumption.
This may include the achievement of minimum consumption baskets
(Capéau et al. 2014) or the reduction of consumption of goods with negative
consumption such as excessive fatty foods (Cappacci et al. 2012) or polluting
fuels (Labandeira and Labeaga 1999; Berry 2019). This type of model will
require a base dataset that contains consumption expenditures and an
econometric model of consumer behaviour.
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12 Introduction

Poverty and social exclusion can be concentrated in particular places in

addition to being associated with particular socio-­economic characteristics,
such as age, disability, or unemployment. Policy targets in this dimension
include the UK’s target of ‘tackling disadvantage by reviving the most
deprived neighbourhoods, reducing social exclusion, and supporting socie­
ty’s most vulnerable groups’ (Tanton and Clarke 2014). In this case, the
microsimulation model will require spatial coordinates.
A related spatial dimension that is useful in policy development is policy
learning from developments in other countries. It is the basis of comparative
research which has become increasingly important, particularly as part of
the objectives of international organizations. The OECD Making Work Pay
programme focuses on cross-­ country comparisons of tax-­ benefit policy
(Pearson and Scarpetta 2000). Comparative research places challenging
demands on microsimulation models as datasets, and models in different
countries are not necessarily compatible and can require significant work to
be made comparable (Sutherland 2014).
Another dimension of relevance to policy development is time. Some pol­
icies, such as pensions, are affected through the accumulated influence of
labour-­market status and policy change over time. Given increasing life
expectancy, changes in fertility and mortality rates can have long-­lasting
impacts. Thus, the impact of policy changes may be very slow to be visible,
while demographic changes that occur now can have influences a long time
into the future. Interacting with these forces are policy targets to improve
the sustainability of public pension systems and to reduce old-­age poverty
(Li et al 2014).

1.2 Types of Microsimulation Models

In this section, the types of model considered throughout this book are
introduced.

1.2.1 Hypothetical Family Models

When governments publish their budgetary policy changes, it is often evi­

dent the impact that these policy changes have on hypothetical families.
These are the simplest type of ‘microsimulation model’, as they abstract from
the complexity of the population or their behaviour to try to simulate the
impact of policy on hypothetical families. These models, described in
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Types of Microsimulation Models 13

Hypothetical
Families

Model Framework

Tax-Benefit Routine

Analytical Routines

Figure 1.6 Hypothetical Model

Figure 1.6, typically therefore contain a simple database containing one or

more hypothetical families and generally use a stripped-­down version of the
tax-­benefit system.
As noted, the simplest type of microsimulation model is one that abstracts
from population complexity entirely, analysing the static impact of policy
and policy change on hypothetical families. Burlacu et al. (2014) describe the
main focus of these models which include:

• illustrative purposes
• validation
• cross-­national comparisons
• replacement of insufficient or lack of micro-­data
• communication with the public

Hypothetical family models have been applied to many fields, but the
dominant policy area is that of social security and taxation. Given their rela­
tive simplicity, their geographic spread has been widespread, with the UK,
the US, Australia, and Ireland having the highest share of such models.
Methodologically, the chapter on hypothetical models focuses on a variety of
choices, including the unit and period of analysis, updating, and analytical
output measures, which are common to other types of model, as well as
modelling choices specific to hypothetical models, such as the unit of vari­
ation by which heterogeneity is introduced to hypothetical models.
Due to their simplicity, they are very useful communication devices, as is
evident from their use in media reports. As a developer of models, they are
also specifically useful as validation models for testing components. The
more complex a model, the more difficult it is to validate, so running a simu­
lation on a small set of families can help to identify any bugs. When data are
not available for a particular analysis, as in the case of some life-­cycle
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14 Introduction

analyses, hypothetical family models can be utilized for analysis (Rake

et al. 1999).
Lastly, because of their relative simplicity, hypothetical family models are
extensively used in international comparative analysis. Tax-­benefit calcula­
tions for stylized households have been widely used in international com­
parisons of many different aspects of tax-­benefit systems. Comparing the
situations of similar household types, they provide valuable information
about differences in national systems and illustrate some of the effects of
actual or hypothetical policy changes (Pearson and Scarpetta 2000).
There are, however, problems with this approach because it attempts to
reduce complex tax-­benefit systems to single (or a few) point estimates.1 By
using ‘average household’ characteristics, the analysis is likely to miss many
of the important features of the tax-­benefit system which, although not
applicable to the ‘average household’, may affect a significant part of the
population. The ‘stylized’ approach does, by definition, not take into account
the details of the structure of the population and is thus problematic if used
as a basis for summarizing the actual situation in a given country.

1.2.2 Static Tax-­Benefit Microsimulation Models

A second dimension of complexity that is considered relates primarily to

population complexity (Di Nicola et al. 2015). These models are typically
defined as static models, focusing on the impact of policy change before
there is an opportunity for a behavioural reaction; i.e., the ‘day-­after effect’.
Static tax-­benefit microsimulation models are similar to the hypothetical
family models described above. The primary difference is that they in­corp­or­
ate greater heterogeneity in the population database, typically via representa­
tive samples of the population (Figure 1.7). Static microsimulation models
involve the interaction of population and policy complexity, but abstract
from behavioural response or other endogenous change in the model, and as
such they model the day-­after effect of a policy change. Li et al. (2014) con­
sider the uses and methodological choices of static models.
Like other types of microsimulation model, static tax-­benefit models
examine in detail the policy system with the aim of understanding how pol­
icy impacts at the individual and household level, thus modelling the inter­
action of population and policy complexity. Given the complexity of tax and

1. See Immervoll and O’Donoghue (2009).

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Types of Microsimulation Models 15

Database

Model Framework

Analytical Routines:
RR/METR Tax-Benefit Routine

Output Routine

Figure 1.7 Static Tax-­Benefit Model

Note: RR (replacement rates); METR (marginal effective tax rates).

benefit policy legislation, these models, even ignoring behavioural responses,

can be highly complicated. Being representative of the population, they
require a full representation of the tax-­benefit system. They are sometimes
known as arithmetical models (Redmond et al. 1998).
In terms of their policy focus, while historically tax and social-­security
policy has been the main focus, there is an increasing importance of other
policy areas, particularly in relation to health and social care. The geo­graph­
ic­al spread of these models has increased as the availability of micro-­data has
increased. Given their relative policy complexity and availability of data,
static microsimulation models have proliferated in OECD countries, how­
ever with improved data availability the field has expanded outside of OECD
countries in recent years (Joust and Rattenhuber 2018). In terms of ana­lyt­
ic­al scope, static models focus on distribution and redistribution incidence,
as well as on the drivers of behaviour, even if behaviour is not modelled
endogenously.
Simulating the fine detail of tax-­benefit policy legislation, these static
models are thus in a position to evaluate existing tax-­benefit policies and aid
in the design of new individual schemes or entire systems. They calculate
applicable amounts of each element of the tax-­benefit system in the legal
order, so that interactions between different elements of the system are fully
taken into account. The resulting taxes, benefits, and income measures for
each individual, family, or household are weighted to provide results at the
population level. Such microsimulation models have been developed, and
are in use, in many OECD countries (Li et al. 2014).
By incorporating the interactions of different elements of the tax-­benefit
system, and by taking full account of the diversity of characteristics in the
population, this approach allows a very detailed analysis of the revenue, the
distributional and incentive effects of individual policy instruments, and
the system as a whole. In particular, they provide a powerful means of
 OUP CORRECTED PROOF – FINAL, 26/06/21, SPi

16 Introduction

performing ‘what if ’ analyses by allowing the analyst to manipulate all

­relevant parameters of the system such as tax rates, thresholds, amounts,
and income concepts (see Redmond et al. 1998).
Static models do not, however, incorporate behaviour, treating simulations
as the first-­
round, ‘next-­day’ effects, before any behavioural response.
Bourguignon and Spadaro (2006) argue that these first-­round effects are ‘a
good approximation of final welfare effect if changes are small enough and
individuals may be thought to operate in perfect markets’. However, when a
large behavioural response might be expected, results will be biased in rela­
tion to the impact of a policy reform. Yet, even though such a ‘static’ simula­
tion cannot measure the direct impact on behaviour of reforms, it can be
used to determine the pressures on behaviour (‘incentive effects’), such as
marginal tax rates and replacement rates (see Figure 1.7).
Bourguignon and Spadaro (2006) also highlight other sources of potential
inaccuracy in this approach, including the ignoring of the production side of
the economy, which may react to changes in tax-­benefit policy. Furthermore,
static tax-­benefit models generally assume that there is no tax evasion and
assume full benefit take-­up.

1.2.3 Behavioural Models: Labour Supply

Many public policies have the objective of changing behaviour in addition to

financing or distributional objectives. Behavioural objectives include the
reduction of work disincentives and the reduction of pollution. It is unsur­
prising, therefore, that part of the field of microsimulation has focused on
behavioural response.
Labour market behaviour in relation to labour supply is one of the most
important areas for behavioural analysis in the microsimulation field.
Aaberge and Colombino (2014) describe the development of the field of
labour-­supply-­focused microsimulation models and methodological choices.
There are three methodologies for modelling labour supply:

• the reduced form approach

• the structural ‘marginalist’ approach
• the random utility maximization approach

Figure 1.8 describes the structure of a labour-­supply microsimulation model.

In many senses, there is an overlap with the static microsimulation model
outlined in Figure 1.7. A behavioural labour-­supply model utilizes a static
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Types of Microsimulation Models 17

Database
Analytical Routines:
RR/METR
Model Framework

Output Routine
Tax-Benefit Routine

Labour Supply
Routine

Figure 1.8 Labour-­Supply Behavioural Models

microsimulation model to simulate the budget constraint associated with

alternative choices. This is required for the econometric estimation of a
labour-­supply utility function, which is then in turn used to model the
behavioural responses of policy changes that are simulated in the static part
of the model.
Labour supply is central not only to modelling behavioural responses, but
also to modelling optimal tax-­benefit systems, with a focus on a computa­
tional approach, given some of the challenges of the theoretical approach.
Combining labour-­supply results with welfare functions enables the social
evaluation of policy simulations (Kleven et al. 2009).

1.2.4 Behavioural Models: Consumption Behaviour

While the modelling of policy measures that depend on current income

(such as direct taxation and social transfers) has been the focus of most of
the models described thus far, indirect taxation or taxation that is a function
of expenditure is also quite important. Capéau et al. (2014) review models
that depend on consumption and indirect tax. Indirect tax is one of the more
important sources of tax revenue in OECD countries and frequently the
most important in non-­OECD countries, while there have been substantial
reforms in the past fifteen years.
Figure 1.9 defines the structure of consumption-­based microsimulation
models. They are similar in structure to a labour-­supply model, however the
base dataset and the policy model are different. The base data requires infor­
mation about expenditures, while the policy algorithm incorporates indirect
taxation such as valued-­added tax and excise duties. The behavioural module
incorporates an econometric model, based on a demand system, that allows
for the consumption response to price changes to be determined.
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18 Introduction

Database

Model Framework

Tax-Benefit Routine Change in Welfare

Consumption
Behaviour

Figure 1.9 Consumption-­Behaviour-­Based Models

Given the choice between changing consumption or savings rates when

prices or taxes of goods change, behavioural assumptions or models (whether
behaviour is explicitly modelled or not) are intrinsic to all indirect-­tax
­models. Methodologically, most current indirect-­tax models take the house­
hold as the unit of analysis, with some extensions into firm-­level units. There
are a variety of welfare analyses that are utilized in indirect-­taxation model­
ling, including the modelling of potential winners and losers, the progressiv­
ity of a reform, and distributional analyses involving both direct- and
indirect-­tax reform.

1.2.5 Environmental Models

The environment as a policy issue has increased dramatically over the past
four decades. Research in this area extends from global challenges, such as
climate change, access to water and soils, ozone emissions, and biodiversity
loss, to issues with a smaller geographical scope, such as water quality and
traffic congestion to the impact of the environment on health. Hynes and
O’Donoghue (2014) describe the use and development of environmental
microsimulation models.
The use of microsimulation modelling in the realm of the environment
overlaps with many traditional areas of such modelling, such as the distribu­
tional incidence of public policies or the impact on behaviour in relation to
the incidence of these policies. Within the environmental and natural-­
resource economics literature, the interaction between human activity and
the environment has also been shown to be strongly influenced by spatial
location. In this regard, the use of spatial microsimulation models has proven
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Types of Microsimulation Models 19

Environmental Policy Model

Environmental Policy Database

Pollution Model Model Framework

IO Model

Tax-Benefit Routine Change in Pollution

Consumption
Behaviour

Figure 1.10 Environmental Models

a useful tool for modelling socio-­economic environmental interactions and

policies.
Figure 1.10 describes the structure of a microsimulation model that is
used to simulate environmental fiscal policy such as carbon taxation. It is
similar in many respects to a consumption-­based model. However, the price
changes that are modelled as part of the policy are different. In dealing with a
carbon tax, the initial price change depends upon the polluting equivalent of
the good consumed. So, for example, coal is more polluting than gas and so
would incur a higher carbon tax. The impact of a carbon tax can be both
direct and indirect. Households purchase fuels which produce carbon emis­
sions, but also purchase other goods and services which themselves have
carbon inputs and so on. Incorporating both direct and indirect effects
requires an input-­output model, which is in effect a map of flows between
different sectors in an economy and can be used to produce these direct and
indirect impacts of the price change resulting from a carbon tax. Once the
price change for household consumption at the detailed level is produced, a
simulation can be undertaken in the same way as a consumption-­tax model.
However, in addition to revenue or budget impact, the impact of the policy
change on pollution outputs can also be modelled.

1.2.6 Decomposing Inequality

Given the capacity to model the incidence of policy on a population, micro­

simulation models have been used to understand in greater detail the way in
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