Integrating Microsimulation Tax Functions into a DGE Macroeconomic Model: A Canonical Example

Examine the effects of a cross-the board cut in tax rates by ten percent. We are integrating a detailed miscosimulation model of taxes at the individual level with a large-scale overlapping generations model to generate a dynamic tax-scoring model. Doing so requires estimating tax functions across age and ability types based on the output from the detailed microsimulation model. Doing so allows us to consider changes to the tax structure that would otherwise be impossible to implement in our OLG model. We use a large-scale OLG model with 100-period lived agents of 7 different types with earnings potentials callibrated to US data on earnings from the full-sample IRS dataset. We solve a model with no aggregate shocks, but with idiosyncratic mortality risk using the time-path iteration method pioneered by Auerbach and Kotlikoff. We apply our approach to a canonical example of tax policy change—a 10-percent cut in statutory marginal income tax rates with a doubling of the standard deduction. We find that such a tax cut increases GDP by about 1.4 percent in the long run. Accounting for these macroeconomic effects of the tax change results in the an offset of about 53 percent of the static cost of the tax cuts.