Teresa Chance
Central Policy - Freedom of Information
1C/25
100 Parliament Street
London SW1A 2BQ
By email to:
Lisa Evans
Tel
[[FOI #29155 email]]
Fax
020 7147 0666
Email
Date
6 April 2010
www.hmrc.gov.uk
Our Ref
FOI 1200/10
Your Ref
________
Dear Ms Evans,
Freedom of Information Act 2000
I am writing to confirm that HMRC has now completed its search for the information
you requested on 17 February 2010. I apologise for the delay in responding. You
asked:
I would like to request the schema for the HMRC computable general
equilibrium (CGE) model
A copy of the information is enclosed.
The information supplied to you continues to be protected by the Copyright, Designs
and Patents Act 1988. You are free to use it for your own purposes, including any
non-commercial research you are doing and for the purposes of news reporting. Any
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Yours sincerely
Teresa Chance
HM Revenue and Customs
Computable General Equilibrium Model
Specification and Applications
The HMRC CGE model is a large scale, multi-sectoral, dynamic model calibrated to the UK
economy. It uses the software package GAMS/MPSGE to evaluate the economic and
distributional effects of policy decisions. It is based on National Accounts data and aims to
simulate the structural relationships of the economy. It provides results for 45 household
types, split by income quintile and 9 types of household composition. It incorporates an 11-
sector split of the economy, which can be aggregated from a choice of 123 sectors for more
detailed results. The CGE model is being continually updated to meet UK developments,
and has been used in HMRC for 7-8 years.
What is the CGE model typically used for in HMRC?
• See the impact of a policy change on the economy as a whole, including the impact
on the tax base and tax yield
• Economic and distributional impacts of tax policy.
• Impact of a change in one tax on revenue from other taxes
• Evaluating the incidence and excess burden of taxation.
• We are generally asked to provide economic analysis of the wider impacts of tax
policy on different variables including: welfare & efficiency, GDP and sectoral output,
prices and employment, household income by cohort, government revenue,
production and consumption.
Applications
The CGE model can be applied to a wide range of tax and non-tax policy changes, including
non-marginal changes and those with no historical precedent.
The model is continually being
developed, and supplementary modules are added to enable the modelling of specific policy
changes.
Non-Tax policy
Recently we have developed an environmental sub-module to analyse the economic
implications of environmental policies for the Department of Energy and Climate Change
(DECC). Specifically we have fed into the analysis of the Renewable Energy Strategy and
Emissions Trading Scheme, looking at the long term Marco-economic costs (in particular the
GDP impact) of both polices.
Tax Policy
The model incorporates around 95 per cent of tax revenues, and therefore is ideally suited to
the economic analysis of tax policy changes. The CGE model is typically used for the
analysis of Budget and PBR measures – and as such we will often be working to tight
deadlines. The outputs provided by the model are used by policy customers and are used in
the policy making process. We will generally provide analysis of the long term impact on
GDP (by component), welfare and household income of different tax policy changes.
What are the key assumptions?
A1. A fundamental underlying assumption is that markets are in equilibrium, which
means that the amount of a good supplied equals the amount that is
demanded, with prices adjusting to ensure this remains so. This holds for all
goods and services, as well as labour and capital.
A2. The model assumes that government expenditure is fixed. In other words, no
prior assumption is made about how revenue changes affect spending
decisions, which is thought to make the model more transparent.
A3. Households and firms are assumed to be rational and forward-looking, i.e.,
taking decisions based on information they have now and what they expect to
happen in the future.
A4. The CGE model is an open economy model that accounts for flows of foreign
direct investment (FDI) and international trade. The flows of imports and
exports and the level of FDI adjust in the model in response to policy changes.
A5. An element of market power is introduced to the model, which varies by sector,
according to a standard index of concentrations. This means that firms in the
same sector are able to differentiate their goods from the competition, which
allows them some control over the prices they charge and can explain why
imports are preferred over domestically produced goods from the same sector.
This can be switched off to analyse classical “perfect competition” scenarios, if
desired.
A6. Labour and capital (factors of production) can be substituted in the production
process depending on the effect the policy change has and the supply and
demand for these factors in each sector. Factors are assumed to incur costs
when they move from one industry to another, which means it can take longer
for these resources to be put to the most efficient use following a shock to the
economy. Some capital stock is assumed to be specialised for the industry it is
in and can’t be used elsewhere, and workers experience a temporary loss in
productivity when they move to a new sector as it takes time for them to retrain.
A7. The CGE model is set-up so that the output grows at 2.75% per annum in-line
with HMT assumptions of the long-run underlying rate of economic growth.
What the CGE model does not assume is any policy response to a given
change in the economy. So for instance, if demand in the economy rose
significantly in response to a policy change and caused prices to rise, no
inflation adjusting response from the Bank of England is specified. However,
such effects can be built in and compared if desired.
A8. Capital Adjustment Costs:
Following Uzawa (1969) capital installation costs
depend on the gross rate of investment relative to the existing capital stock.
Given the level of investment, the cost of new capital decreases when the
capital stock increases and vice versa.
The installation cost function is given by:
⎛
J ⎞
I =
J ⎜1
t
+φ
⎟
t
t
2
K
⎝
t ⎠
Rapid changes in the capital stock are costly and the speed of adjustment is reduced
when installation costs increase.
A9. Imperfect Competition:
The model applies the Lerner Index of market power to set endogenously the price
mark-up over marginal cost. This is then set equal to the perceived elasticity of
demand.
P −
MC
1
=
P
ε
As firms are trying to protect mark-ups, a firm’s behaviour will be determined by the
preservation of its mark-up, and rival firms’ actions or the behaviour of new entrants
will be implicit in this decision making process.
Each sector has a fixed conjectural variation parameter which determines within-sector
responses to the leading firm’s behaviour.
