Drivers of Income Inequality: What Can We Learn Using Microsimulation?

This chapter reviews the use of microsimulation in understanding income inequality. The primary added value of microsimulation models is the capacity to simulate counterfactual income distributions. While much of the literature concentrates on the ex ante simulation of tax and welfare policy reforms and their effect on income distribution, this chapter also discusses the use of simulation techniques to tease out the contribution of different market and policy income sources and personal characteristics. In particular, decomposition techniques combined with microsimulation modeling allow for the interaction effects between these components to be explored in more granular detail, specifically interactions between markets, population characteristics and market incomes, and the interactions of all of these with tax and welfare. This chapter first justifies the use of microsimulation techniques in the study of income inequality. Second, the chapter discusses the gradual methodological developments in understanding the nature of inequality via the simulation of “counterfactual” outcomes using microsimulation techniques. Third, the chapter discusses the latest developments in the field, including nowcasting distributional changes in times of crisis, micro-macro linkages, and decomposing inequality across population groups and across space.

Highlights:
- The unique ability of microsimulation to explore "what-if" scenarios in policy and market income;
- Decomposition techniques that reveal detailed interactions between market forces, population characteristics, and government policies;
- Advanced methods for tracking income distribution changes during economic crises and understanding inequality dynamics in different geographical and demographic settings.