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.