Simulating fiscal drag

[JohnGWS]

The SA Treasury's new budget includes not addressing fiscal drag, for the second year running in our history as a modern state. In the context of an aggregate consumer inflation rate of approximately 5% for the past three years, this translates into an annual real increase in personal income taxes, which are already high even by developed country standards. Assuming aggregate wage increases are less than perfectly indexed to inflation - a reasonable assumption given the slow pace of growth in the economy - my approach to simulating fiscal drag is to shock payroll taxes by 3% per annum as follows:
"tau_payroll": [0.03],

One can debate the quantum of the shock, elsewhere, but in general is this approach correct?

[SeaCelo]

I’m still struggling with the link to the payroll taxes. Can you write up an argument why this is the correct simulation? @JohnGWS

[JohnGWS]

My post was more of a question than a statement, but here is more information from my side. Since the model is real, not nominal, purely nominal wage increments equate to zero real wage increase in the model. On the other hand, real tax brackets will steadily 'advance' on payroll earners, leading to annually incremented real payroll taxes if there is no adjustment for fiscal drag. My approach is to model this with tau_payroll in the absence of any better ideas. If anyone has a better approach I'd be keen to hear it.

• Of course this assumes that inflation is always present in the model horizon, which is a reasonable assumption.
• The quantum - 3% - is not something I'm concerned with at this point. If the approach is correct I'll do an additional analysis to estimate the best level for tau_payroll.

[SeaCelo]

@JohnGWS Are you asking this to improve the calibration of the model?

[JohnGWS]

No it is a conceptual issue to verify the accuracy of my simulation approach.

[NadiaMatulich]

Hi guys! Maybe I can help here! Perhaps it may be useful to add, the latest national budget did not adjust payroll tax brackets to reflect inflation, i.e., effectively increasing real taxes. I think John is trying to figure out the best way to model it- i.e., how to translate bracket creep into the model. @JohnGWS it looks like that is the right variable but that the 'effective real increase' would need (as you say) external work to figure out the exact size of the shock- this would be my gut instinct. The documentation says that there's a linear structure in OG-ZAF, vs a progressive structure in OG-CORE, so only one parameter to shock in OGZAF (https://eapd-drb.github.io/OG-ZAF/content/calibration/taxes.html). SARS has detailed income tax data which might help with the calibration of a progressive tax structure (I don't have a chance to deep dive on this at the moment, but can have a look at it towards the end of the year). The quick method- shock tau_payroll. The long method- deep dive on SARS data so we can integrate progressive taxes into the framework, but very open to alternative suggestions from @SeaCelo or anyone else :-)