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.
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