Sir James Mirrlees and optimal tax systems

To paraphrase the nineteenth century British Prime Minister Lord Palmerston, only two people have ever understood the tax system: One went mad and the other died. Indeed, one of the few people to have properly understood the tax system was the Nobel Prize winning economist Sir James Mirrlees, who died earlier this week. Mirrlees was best known in academic circles for his work on decision making under uncertainty for which he won the Nobel Prize in 1996, and his most insightful work was his 1971 paper on optimal tax systems in which he showed how and why there was a trade-off between equity and efficiency.

The paper is mathematically dense but it had a huge impact on information economics by introducing models with asymmetric information into contract theory. Until the late-1990s the results of these models were not closely connected to empirical tax studies and had little impact on tax policy recommendations. But a number of authors, including Peter Diamond and Thomas Piketty have since connected Mirrlees’ model to practical tax policy.

He was thus the obvious choice to head up a review of the UK tax system commissioned by the Institute for Fiscal Studies almost a decade ago. It was a follow-up to the Meade Committee report of 1978 which was concerned with the question of how the tax system impacted on the wider economy by distorting incentives. Thirty years later, the IFS noted that the tax system had evolved in a piecemeal fashion “rather than by strategic design” and that it had not adapted to changes in the general economic environment in which it applied. Moreover, as the IFS pointed out, “tax design has not benefited as much as it could from advances in theoretical and empirical understanding of the way features of the system influence people’s behaviour.”

Mirrlees and his colleagues took an in-depth look at the state of the UK tax system “to identify reforms that would make the tax system more efficient, while raising roughly the same amount of revenue as the current system and while redistributing resources to those with high needs or low incomes to roughly the same degree.” They noted that the UK system is “unnecessarily complex and distorting” with tax policy “driven more by short-term expedience than by any long-term strategy” in which policymakers did not seem to grasp the extent to which individual agents change their behaviour in response to changes in tax incentives. This was a damning indictment and it is still true today, with a myriad of small changes having come into effect since the report was published which impact on the way people and companies behave.

The report noted in particular that income inequality had widened, particularly during the 1980s, but that merely soaking the rich was not necessarily the way to go. In any case, corporate and capital gains taxes are at least as important as income taxes in terms of their wider impact, and certainly the combination of all three is likely to be more critical than looking at one in isolation. In this sense the Mirrlees Review took a far more wide ranging view of tax issues. Indeed, a key recommendation was that the complex benefits system should be harmonised with income taxation, in order to increase work incentives for the lower paid (something which the government has tried – and failed – to achieve with the Universal Credit System).

The report also noted that the corporate tax system favours debt finance over equity finance which in turn has increased the reliance on debt, and recommended an allowance for corporate equity (ACE) be introduced into the corporate tax system. Taxation of savings is another aspect requiring radical reform. Savings in the UK are subject to double taxation, with income tax levied on the original income from which the saving is generated and again on interest income derived as a result. With the government having for many years exhorted individuals to save more, this is an obvious anomaly. The Mirrlees Review thus recommended that standard bank and building society accounts should be entirely free of tax. Neither of these recommendations has been implemented (though the interest on bank accounts these days is so low that tax is negligible).

I was heartened by the Mirrlees Review when I first looked at it almost a decade ago because it was an accessible review of the state of the tax system, which looked at how the various parts fitted together without delving into the politics of taxation. It is a shame, therefore, that many of its recommendations have not been implemented. Perhaps it was the right report at the wrong time, with governments then too preoccupied with the day-to-day task of reducing deficits to pay much attention to reforming the tax system itself. Perhaps the passing of Sir James Mirrlees offers us another opportunity to revisit what I believe to be an outstanding piece of work, and to think again about some of its conclusions.

Would I lie to you? Part 2

For all the trials and tribulations which the British media have over the years elevated to the status of great political dramas, none has had the resonance of Brexit – an episode in which the political establishment appears to have lost its collective reason. In many ways, it is reminiscent of the McCarthy era in the US 70 years ago when a political ideologue used the legal process to conduct a witch hunt against those who did not share his extreme distaste for communism. As in the McCarthy era, a small coterie of politicians has hijacked the British parliamentary process and appears intent on delivering their version of an ideologically pure Brexit whatever the cost to the British economy.

Wikipedia defines McCarthyism in a wider sense as “the practice of making accusations of subversion or treason without proper regard for evidence.” Elements of that definition certainly apply to Brexit: Indeed, some of the more rabid commentators even accused those seeking to minimise the impact of a hard Brexit as treasonous – notably this Daily Mail article, lest we forget. Those advocating Brexit not only pay no regard to the evidence – they make up their own. It was bad enough to lie during the referendum campaign but now that we are seven months away from the UK’s EU departure, they are still at it!

Earlier this month, former cabinet minister Peter Lilley argued that the UK had nothing to fear from a no-deal Brexit because “WTO terms are designed to provide a ‘safety net’ ensuring all members can trade without discrimination.” Lilley claims to know what he is talking about because “as Trade and Industry Secretary, I spent 10 days incarcerated in the Heysel Stadium negotiating the Uruguay Round which set up the WTO.” That’s a bit like saying if you incarcerate someone in Ornenburg’s Black Dolphin Prison for 10 days, they will emerge with an intimate knowledge of Russia.

In fact, the WTO fallback option is not much of an option at all. Brexiteers seem to believe it confers some special status which will allow trade to continue much as it does today. But if it is such a great deal, why do countries seek free trade agreements which confer considerably greater benefits? As Alan Winters pointed out in a blog post, “since the WTO came into being, 243 new Free Trade Agreements have come into operation … None of this suggests that 'WTO terms' are viewed generally as a satisfactory option.” Even the head of the WTO has suggested it is “unlikely” the government will have agreed tariffs and quotas with all other member countries by next March.

And most Brexit supporters clearly do not understand the most favoured nation clause. This merely defines the lowest possible set of barriers that a country will be prepared to offer all other WTO members. It does not mean that the EU will offer the UK any concessions that it is not prepared to offer the likes of Russia, China or the US. In fact, Lilley’s article is full of economic nonsense, as Winters points out. Amongst the highlights was the claim that “we will be free to join the Trans-Pacific Partnership.” Wonderful: Except the TPP does not even exist as it was nixed by Donald Trump soon after he came to office. Moreover, “without a trade deal, Parliament will reject any Withdrawal Agreement offering the EU £40bn … That leaves Britain £40bn better off, and ends our annual £10bn net contribution immediately[1] – boosting our GDP, balance of payments and public finances.” It is hard to know whether this is a deliberate parody or just plain stupidity. My own calculations suggest a no-deal Brexit imposes costs which are roughly three times the monetary savings – a view which is broadly in line with the literature estimates.

Then of course, there is Brexiteer-in-chief, Jacob Rees-Mogg who suggests that the UK could maintain an open Irish border but still impose checks “as we had during the Troubles” – a suggestion that is as laughable as it is offensive. In a functioning democracy, the near half of the electorate which voted against Brexit could expect some parliamentary representation. But the opposition Labour Party has refused to oppose the Conservatives which have taken back control of Brexit policy despite being a minority government. Labour leader Jeremy Corbyn is widely seen as a Brexit supporter and in a TV interview last week he refused six times to answer the question whether he believes the UK would be better off outside the EU.

To compound the sense of the absurd the government last week issued a series of reports on how various sectors should prepare in the event of a no-deal Brexit. Although DExEU claims that leaving without a deal “remains unlikely given the mutual interests of the UK and the EU,” the fact that it has seen fit to issue such a series of papers suggests it is taking the prospect seriously in the wake of EU pushback against the Chequers plan. There is no reassuring news in the policy papers which effectively highlight all the things that the experts said would happen in the event of no deal (more red tape, higher compliance costs and a need to stockpile in key areas such as medicines). Whatever happened to “they need us more than we need them”?

In short, Brexit is a looming disaster of the government’s own making compounded by the failure of the opposition to set out a credible alternative. It is hard to shake off the suspicion that it represents a coup by right-wing Conservatives desperate to grasp this one chance offered by a non-binding referendum. But heed the lessons of history: Like Brexit, public support for McCarthyism only ever peaked at around 50% in January 1954. Within six months public support had dwindled to only 34%. Joe McCarthy himself was censured by the Senate at the end of 1954 and he was dead within three years.

As William Bennett, noted in his 2007 book America: The Last Best Hope, “The cause of anti-communism, which united millions of Americans and which gained the support of Democrats, Republicans and independents, was undermined by Sen. Joe McCarthy ... his approach to this real problem was to cause untold grief to the country he claimed to love ... Worst of all, McCarthy besmirched the honorable cause of anti-communism. He discredited legitimate efforts to counter Soviet subversion of American institutions.”

A similar epitaph may yet be written for Brexit: genuine concerns about the EU undermined by the efforts of Brexit supporters. But a no-deal Brexit is like McCarthy unleashing the nukes to solve the Soviet problem. And even he was not that stupid.

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[1] Didn’t the leavers claim the cost savings would amount to £350 million per week, or £18bn per year? Saving £10bn per year amounts only to £192 million per week.

Would I lie to you? Part 1

According to former US President Ronald Reagan, the nine most terrifying words in the English language are “I’m from the government and I’m here to help.” Indeed over much of the past 40 years, Anglo Saxon economies have tried to shrink the size of the state in the belief that the markets are more efficient at allocating resources. In a narrow sense this may be true since the private sector has an incentive to generate the lowest cost solution in order to maximise profit.

But it is increasingly evident that rolling back the state does not always generate outcomes that are in the interests of wider society. The Private Finance Initiative (PFI) in the UK has incurred billions of pounds in extra costs to deliver infrastructure projects for no clear benefit. Indeed, recent PFI contracts – for schools, hospitals and other facilities – are between 2 and 4 per cent more expensive than other government borrowing, and involve significant additional fees. There is also widespread criticism that the chief executives of formerly publicly-owned utilities receive huge salary packages whilst not delivering any improvement in services.

In other words, the ideological basis of Anglo Saxon economic policy over the past four decades is not all it is cracked up to be. The model took a massive hit following the financial crisis of 2008 and governments around the world are still struggling to cope with the changed economic and political realities. Efforts to resume business as usual have struggled to gain traction and governments are increasingly struggling to retain the trust of their electorates. We see it in the populist surge across Europe and in the conduct of US politics, and it is evident in the rise of strongman administrations in places such as Turkey and the Philippines. In some ways the perception of government failure is unfair – in other ways not. But the widening gap between the perceptions of politicians and the electorate is both unfortunate and dangerous.

It is unfortunate because in western democracies politicians are representatives of the people. They are us and we are them – something that is too often forgotten by the body politic. It lies within the power of the people to change the status quo. In France, this led to the formation of a new political party which in the space of a year had propelled Emmanuel Macron to the presidency, although it has proven more difficult to replicate this strategy elsewhere. But the widening gap between people and politicians is also dangerous because it creates space for populists who advocate simplistic solutions to complex problems. The inability of the established political powers to counter these problems runs the risk that nominally sensible politicians will be forced to ape populist measures in order to stay relevant, thus taking politics in an unfortunate direction. Moreover, when the populist solutions are shown to have failed how will electorates respond?

Despite the strains which have been placed on western economies in recent years, they have just about managed – and so far, at least, rather better than in the 1930s. But continued fiscal austerity threatens the social fabric in ways that will only become evident in the longer-term. Greece and Ireland have emerged from a period of EMU-imposed belt-tightening, which has left the Greeks in particular significantly worse off. And I have long pointed out that the fiscal austerity imposed in the UK is outright regressive as it takes the axe to welfare spending. But for an example of how fiscal austerity can be taken to unacceptable limits, recall the experience of the city of Flint in Michigan.

To summarise, Flint had suffered huge employment losses over a period of many years as GM, the city’s main employer, cut back on local jobs. This adversely affected tax revenues and by 2011 things were so bad that the governor of Michigan declared a state of financial emergency, appointing an emergency manager to cut costs to the bone. Alongside such measures as reducing the size of the police and fire departments, the authorities decided in 2014 to cut costs by switching the city’s water source from Lake Huron to the heavily polluted Flint River. In order to save yet more cash, the authorities opted not to add anti-corrosion agents to the water which would have prevented the pollutants from causing lead to leach into the town’s water supply.

Despite mounting evidence to the contrary, officials continued to deny that the drinking water in Flint was unsafe. When Dr Mona Hanna-Attisha published her work in September 2015 highlighting the health risks associated with high lead concentrations in the drinking water, her research was initially ridiculed. A Michigan Department of Environmental Quality spokesperson accused her of being an "unfortunate researcher … splicing and dicing numbers" and causing "near hysteria.” But she was right and they were wrong. As a result, huge amounts of extra spending were required to replace pipes and ensure a supply of clean drinking water until the operation was complete, and criminal proceedings were launched against a number of officials involved in the scandal. Ironically, the cost of adding anti-corrosion agents to the water in the first place would have cost only around $36,500 per year versus an estimated $97 million over three years to replace the plumbing.

This is a classic example of short-sighted policies that are consistent with the Bluffocracy. By focusing only on one policy objective – saving money – the authorities ignored the non-pecuniary costs associated with their strategy. Worse still, the authorities failed to address residents’ concerns – the very people who they are supposed to represent. When this happens on a national scale you get politicians like Trump filling the gap. A decade ago, we were concerned with market failure as the global financial system tottered on the brink of disaster. Today, we are more concerned with government failure and nowhere is this more evident than in the case of Brexit – the subject of my next post.

Bluffocracy

One of the more refreshing books I have come across in recent months is Bluffocracy by James Ball and Andrew Greenway in which the authors make the point that far too many people making important government or business decisions are not really qualified to do so. It is the perfect riposte to Michael Gove’s 2016 remark that “the people of this country have had enough of experts.” What experts would these be? After all, Gove was at the time Lord Chancellor – an ancient legal position whose primary responsibility is the efficient functioning and independence of the courts. Maybe his stellar legal career following law study qualified him for the post? But his academic studies in English literature followed by a subsequent career as a journalist probably suggests that his knowledge of the legal system was less than many of the hardened criminals who come into regular contact with the judicial process.

It is unfair to single out Michael Gove: Most ministers these days are generalists with little business experience before entering politics. The system of employing generalists does have some advantages. Most high ranking politicians are clearly intelligent people who have the ability to master a large amount of detail very quickly (Boris Johnson would appear to be an exception to this rule, however). As a result they are rapidly able to get up to speed with their brief and look at problems in different ways, which can result in some genuinely innovative policymaking. However, it can also result in some very bad policy outcomes.

Of course, there is nothing new in the idea of the generalist politician – it has been a defining picture of the British landscape for decades. But this is where civil servants are supposed to come into their own. Politicians may be here-today, gone-tomorrow occupants of state office but they are backed by permanent secretaries with years of experience in their field who are able to nudge ministers away from making egregious policy mistakes. Except that these days, civil servants are encouraged to broaden their experience by frequently swapping jobs, with the result that much of knowledge they build up in one role is lost as they go off to do something else.

This highlights one of the main features of our Bluffocracy – a culture of short-termism. Economic policies are often made on the basis of how they will play in the press rather than their economic impact. A case in point is the austerity programme followed by the British government over the past eight years. Continually chipping away at public outlays was always going to lead to damage to the social fabric in ways which were predictable, but which were ignored by a government whose agenda appeared to be geared towards the ideological goal of shrinking the size of the state. Faced with the crisis in the NHS; concerns about police numbers and ongoing criticism of the UK’s defence policy, today’s politicians have an awful lot to do to pick up the pieces.

Another element of the Bluffocracy is the apparent inability of the media to hold the government to account. To use the fiscal policy example once more, the electorate was repeatedly told that the Labour Party had wrecked public finances in 2008 and that if the UK did not put in place measures to cut public outlays, it would end up in the same fiscal position as Greece. Both statements are untrue: The fiscal collapse was due to the economic downturn triggered by the global recession and there was no chance of the UK ending up as another Greece since it issued all its debt in its own currency (and around 75% is domestically owned). Apart from some of the specialist economics journalists, the vast majority of journalists merely parroted the government’s words without probing the statement more deeply. One possible reason for this is that many of the journalists are generalists with no real understanding of the issues they are writing about (True story: I once had to explain to a journalist how to calculate a percentage change).

Seen in this light, Brexit is the logical conclusion of Bluffocracy. The referendum was called by a prime minister who was very able but who tended to have a better grasp of tactics than strategy. David Cameron’s famed ability to get himself out of sticky situations at the last minute – most notably during the Scottish independence referendum of 2014 – gave him a sense of confidence that he did not have to work too hard to get the result he wanted. This policy backfired disastrously in June 2016. Moreover, he was out-bluffed by bluffers who painted a picture of how wonderful life would be outside the EU and how easy it would be for the UK to get the deal it wanted. Not only did large parts of the media not hold the Brexiteers to account, they actually cheered them on.

Even now, as the reality of negotiating with the rules-based EU indicates how difficult Brexit will be, the likes of Jacob Rees-Mogg continue to blithely insist that if his plans are followed Brexit will deliver the long-promised utopia. I am not sure which one of the following statements is true, but one of them is: Rees-Mogg et al perfectly understand the difficulties associated with Brexit but choose to lie about it, in which case they should surely be disqualified from representative office on the grounds of misleading the public. Or they really believe their Brexit fantasies, in which case they should surely be disqualified from representative office on the grounds of incompetence.

But this is the new Bluffocracy in which people can get away with spouting nonsense with very little sanction. As Ball and Greenway wrote in The Spectator: “Can things change? Not in Westminster anytime soon. It’s hard to look at modern frontbenchers and see much hope there in the short-run. As for Whitehall: it is 160 years since the civil service had a genuinely comprehensive look at itself, and an examination is overdue. But if history is any guide, a decent-sized war is probably the only reliable way of getting this done … We will always need generalists to master new situations quickly … But the balance of power has moved too far in the bluffers’ favour — at a time when the country is crying out for some proper expertise. It’s time to reshape our institutions to let the experts in, to reward serious knowledge. We need a system that works, and experts who are willing to join it.”