Paul Johnson - 'Indicaciones para una reforma tributaria: lecciones del Informe Mirrlees'

Tax By Design: The Mirrlees Review
Presentation to Fundacion Ramon Areces
Paul Johnson
25/09/2014
© Institute for Fiscal Studies

The review
• Five year programme of work led by Prof Sir James Mirrlees
• Built on a large body of economic theory and evidence.
– Inspired by the Meade Report on Taxation.
• Commissioned papers on all the main topics, with
commentaries, collected in Dimensions of Tax Design.
• Published Tax by Design in 2011

The need for the review
• More than 30 years since the Meade review
• Most advanced countries raise somewhere around £4 in every
£10 earned in the economy in tax
– This inevitably has big effects on the economy, on inequality, on
people
• There is far too little high quality debate
• Governments do not tend to formulate tax strategy explicitly
– Evaluation is almost unheard of
– (Big) mistakes happen
• There is huge scope to make the system simpler, fairer and
more efficient

What we did (and didn’t) do
• Based on economic theory
• Determinedly empirical
• Looking at long term solutions
– A direction for reform, not a blueprint for tomorrow

• We did not take a view on the “right”
– Level of tax
– Degree of redistribution
• Rather ask what is the most efficient structure for any required
level or degree of redistribution

• We did not take a view on the “right”
– Level of tax
– Degree of redistribution
• Rather ask what is the most efficient structure for any required
level or degree of redistribution
• We did not explicitly address the (hugely important) political
barriers to rational change

Some examples of bad policy in the UK
• Look at this marginal rate structure

Income tax and employee NICS marginal
rates 2015-16 (married, non-working spouse, 2
children)
Notes: Marginal rate of income tax and employee’s National Insurance Contributions. Thresholds are
expressed in 2014-15 prices using the CPI. Assumes employee contracted into State Second
Pension.

• Capital Gains Tax at 10% while top income tax rate was 40%
– Huge avoidance opportunities

• Zero rate of corporation tax for small businesses (briefly)
– Mass incorporation

• Tax rates on employees, self employed, companies still very
different

• Tax rates on employees, self employed, companies still very
different
• Property taxation based on 1990 values

A progressive, neutral system:

• Works as a system
– E.g. corporate and personal taxes should fit together
– Not every tax needs to achieve everything

• Is broadly neutral
– Doesn’t discriminate between similar activities except under very
limited conditions

• Is broadly neutral
– Doesn’t discriminate between similar activities except under very
limited conditions
• Achieves progressivity as efficiently as possible

The rest of the presentation
• Will provide a broad outline of conclusions about each part of the
system
• Will then focus on taxation of earnings and of capital income
– Will try to draw out the important links between them

What we have
• Does not work as a system
– Lack of joining up between income tax and NI
– Personal and corporate taxes

What we have
• Is not neutral where it should be
– Inconsistent savings taxes with normal return often taxed
– Corporate tax system that favours debt over equity

What we have
• Is not well designed where it should deviate from neutrality
– A mass of different tax rates on carbon
– Failure to price congestion properly

What we have
– Lack of joining up between income tax and NI,
• Is not well designed where it should deviate from neutrality
– A mass of different tax rates on carbon
– Failure to price congestion properly
• Does not achieve progressivity efficiently
– VAT zero rating a poor way to redistribute
– Taxes and benefits damage work incentives more than necessary

Our proposals
• Treat the system as a whole
– Integrating NI and income tax
– Aligning tax rates across employment, self employment and profits

Our proposals
• Move towards neutrality
– Widening the VAT base
– Not taxing the normal return to capital

Our proposals
• Whilst proposing sensible deviations from neutrality
– Imposing a consistent tax on GHG emissions and on congestion
– Imposing zero rate of VAT on childcare

Our proposals
• Whilst proposing sensible deviations from neutrality
– Imposing a consistent tax on GHG emissions and on congestion
– Imposing zero rate of VAT on childcare
• Achieve progressivity through the direct tax and benefit system
– Recognising constraints imposed by responses to incentives
– Taking account of lifetime welfare

Earnings taxes should be progressive, coherent
and reflective of behavioural responses
• Move to a transparent and coherent rate schedule
• Introduce a single integrated benefit
– Ensuring benefits fit together
– Reducing administrative burden and complexity
– Reducing the marginal rates faced by some low earners
• Focus on strengthening work incentives for those who are most
responsive:
– Those aged 55 to 70
– Those with school age children

Earnings taxes should be progressive, coherent
and reflective of behavioural responses
• Move to a transparent and coherent rate schedule
• Introduce a single integrated benefit
– Ensuring benefits fit together
– Reducing administrative burden and complexity
– Reducing the marginal rates faced by some low earners
• Focus on strengthening work incentives for those who are most
responsive:
– Those aged 55 to 70
– Those with school age children
• Merge income tax and NICs

The normal return to saving should not be taxed
full labour income tax rate should be applied to above normal
returns
• Returns on ordinary interest bearing accounts should be
excluded from tax altogether
• Current expenditure tax basis of pension taxation should be
maintained
• A rate of return allowance should be available for substantial
holdings of risky assets
• Tax rates on income and capital gains should be equalised
• We would like these reforms to be accompanied by a more
effective tax on wealth transfers

Indirect taxes should be applied much more
uniformly
• Remove nearly all zero and reduced rates of VAT
– with a compensation package that addresses work incentives as
well as distributional concerns

uniformly
• Replace current property taxes with a single tax proportional to
property value
– and based on current price

uniformly
• Replace current property taxes with a single tax proportional to
property value
– and based on current price
• Introduce a tax equivalent to VAT on financial services

Environmental taxes should be focussed on the
underlying externality
• There should be a consistent price on carbon emissions
– through an extended EU ETS and a tax on other emissions
• Congestion charging needs eventually to replace most of current
fuel duty

Environmental taxes are also a mess
Implicit carbon taxes, 2009-10 (Excluding VAT subsidy of domestic energy)

Business taxes should lead to neutrality
between sources of finance and income
• An Allowance for Corporate Equity would align treatment of
equity and debt finance
• Treatment of employment, self employment and corporate
source income should be aligned
• Tax on business property should be replaced by a land value tax

These are radical changes
• A strategy for the long term
• Involving a lot of winners and losers
• And much work to be done

These are radical changes
• A strategy for the long term
• Involving a lot of winners and losers
• And much work to be done
• But the potential gains are enormous

Some big messages for policymakers
• Always think about the system as a whole
• Don’t deviate from neutrality unless there is a very clear reason
– Hurdles need to be high

• Always use good evidence on behavioural effects
– And evaluate policy

• Be clear what redistribution you want
– Think about the lifecycle

• Recognise economic change
– And the role of particular groups of taxpayers

– And the role of particular groups of taxpayers
• Don’t succumb to the tyranny of the status quo

Some specifics
• Taxation of earnings
• Capital taxation

Taxation of earnings
• Should be transparent, coherent and progressive
• Should be designed in light of understanding the shape of the
income distribution and responses to work incentives
• Direct tax/benefit system should do much of required
redistribution

Taxation of earnings
• Should be transparent, coherent and progressive
• Should be designed in light of understanding the shape of the
income distribution and responses to work incentives
• Direct tax/benefit system should do much of required
redistribution
In designing the system we must account for:
1. Key margins of adjustment to tax reform
2. Measurement of effective tax rates
3. The importance of information and complexity
4. Evidence on the size of responses
5. Implications from theory for tax design

Average EMTRs for different family types
40% 50% 60% 70% 80%
0 100 200 300 400 500 600 700 800 900 1000 1100 1200
Employer cost (£/week)
Single, no children Lone parent
Partner not working, no children Partner not working, children
Partner working, no children Partner working, children

Average PTRs for different family types
30% 40% 50% 60% 70%
0 100 200 300 400 500 600 700 800 900 1000 1100 1200
Employer cost (£/week)
Single, no children Lone parent
Partner not working, no children Partner not working, children
Partner working, no children Partner working, children

Key facts
• Taxes reduce labour supply
– The substitution effect dominates
• This is especially important for low earners
– Responses are greater at the extensive margin (whether or not to
work at all) than at the intensive margin (how many hours to work)
• Interactions with the benefit system create great complexity

The interaction between taxes, tax credits and benefits
Notes: Lone parent, with one child aged between one and four, earning the minimum wage (£5.80 per hour), with no other
private income and no childcare costs, paying £80 per week in rent to live in a council tax Band B property in a local authority
setting council tax rates at the national average

Key facts
• Response are largest for
– Women with school age children
– 55-70 year olds

Employment for men by age, FR, UK and US 2007
Blundell, Bozio and Laroque (2011)

Patterns of work for women in the UK

Key facts
• Response are largest for
– Women with school age children
– 55-70 year olds
• Other responses affecting taxable income matter
– Certainly for the rich
– See the UK experiment with a 52% top rate

The role of social insurance contributions
• One of the biggest problems in the UK system
• Impose a much higher rate of tax on earnings than on other
forms of income
• With NO relationship to benefits payable
– they are not in fact insurance contributions, they are a tax
• Create differences between income from employment on the one
hand and self employment, savings, profits etc on the other
• In the UK context clear need to fully integrate into a single tax on
income
– An alternative is to have a genuine insurance system

Marginal tax rates by legal form, 2014-15
Employed Self-employed Small company
Basic rate 40% 29% 20%
Higher rate 49% 42% 40%

Taxation of savings
• Crucial to the structure of the whole tax system
– Defines the tax base: a consumption tax or a comprehensive
income tax
– Determines extent to which system recognises differences in lifetime
income as opposed to annual income
– Stands at boundary between taxation of personal income and
corporate profits
– Affects total amount of savings and how savings are allocated
across assets
– For individuals affects decisions on how much to save, when to save
and how much risk to take

Guiding Principles
• Minimise distortions to decisions about when to consume
• Treat different forms of saving and investment in similar ways
• Avoid sensitivity to rate of inflation

Household Savings
• Life-cycle perspective: saving = deferred consumption
• Efficiency arguments for not distorting intertemporal consumption
– In other words if you save out of taxed income and then pay tax on the
returns there is a disincentive to save
– The system is not neutral between consumption now and consumption in
the future

Household Savings
• Life-cycle perspective: saving = deferred consumption
• Efficiency arguments for not distorting intertemporal consumption
– In other words if you save out of taxed income and then pay tax on the
returns there is a disincentive to save
– The system is not neutral between consumption now and consumption in
the future
• There are arguments in the other direction
– Saving might itself be an indicator of high earnings capacity
– You may want neutrality between savings and investment in human
capital
– Earnings risk may lead people to over save

Taxing Capital Income
• But actually you just can’t tax income from capital coherently
under a standard income tax
– Capital gains and inflation
• Taxing capital gains only on realisation favours gains over cash
income
– even if realised gains taxed at full marginal rates
• Tax deferral on accrued gains → lock-in effect
• Incentives to convert income into capital gains
– complex anti-avoidance provisions

Neutral Taxation of Savings
• A standard income tax reduces the rate of return earned on
savings, discouraging saving and encouraging consumption
• Two alternative approaches can avoid this intertemporal
distortion
– expenditure tax
– (Normal) Rate of Return Allowance
• These two approaches are broadly equivalent
• Both treat cash income and capital gains equally, and avoid
sensitivity to inflation

• Expenditure tax (EET)
– tax relief for inflows
– tax all outflows
– cf. current treatment of pensions
• Rate of Return Allowance (RRA)
– no tax relief for inflows
– tax relief for normal component of returns
– cf. ACE corporation tax

• Both expenditure tax and RRA approach tax ‘excess’ component of
returns (economic rents)
• RRA approach can be viewed as an expenditure tax with deferred
rather than immediate tax relief for saving
– Both achieve uniform treatment of income and capital gains, require
no indexation for inflation, and avoid distortions to composition of
savings
• For safe assets, where excess returns are unlikely to be important,
can simply exempt interest income from taxation (TEE)

Reforming Taxation of Household Savings
• Pragmatic path towards neutrality can combine different
approaches for different forms of saving
• For standard interest-bearing accounts, simply exempt interest
income from taxation (TEE approach; little or no rents)
• Retain this approach also for owner-occupied housing and
limited holdings of other risky assets
• For pension saving, retain basic expenditure tax treatment
• For substantial holdings of other risky assets introduce Rate of
Return Allowance

Wealth Transfers (Gifts and Bequests)
• Strong case in principle for some taxation of receipts, on a
cumulative basis, in the hands of recipients
– a lifetime accessions tax
• Potential to achieve redistribution at limited efficiency cost
– promoting equality of opportunity
• Difficult in practice
• UK inheritance tax is ineffective

Corporate Taxation
• Why have a corporate tax at all?
– Primarily as a backstop to personal taxation
– Also efficient to tax location-specific rents
• Why tax corporate income on a source-country basis?
– Only game in town, given current international practice
– Contrast with VAT (destination) and income tax (residence)

Corporate tax receipts

Problems with Corporation Tax
• Raises cost of capital
• Bias towards debt finance
• True depreciation Vs. capital allowances
• Sensitivity to inflation

Problems with Corporation Tax
• In an open economy with capital mobility, capital goes
elsewhere, and burden borne by domestic workers
– lower capital per worker
– lower output per worker
– lower real wages
• May be more efficient to tax labour income of domestic workers
directly

Reforming Corporation Tax
• Key problems stem from inclusion of normal return on equity-financed
investment in the corporate tax base
• Solved by tax relief for opportunity cost of using equity finance –
Allowance for Corporate Equity (ACE)
• Also eliminates sensitivity to tax depreciation rules and inflation
• Introducing an ACE would reduce revenues from corporate taxes

Welfare Implications
• De Mooij and Devereux (2009) present simulations of a similar
revenue-neutral package, with ACE financed by increase in
consumption tax, at same CT rate
– Investment ↑ 6.1%
– Wages ↑ 1.7%
– GDP ↑ 1.4%
– Welfare ↑ 0.2% of GDP

Small Business Taxation
• These proposals on personal savings and corporate investment
fit together
– ACE corporation tax
– RRA treatment of dividend income and capital gains on shares
– RRA treatment of income from unincorporated businesses
• Suitable alignment of personal and corporate tax rates can then:
– equalise tax treatment of income derived from employment, self-employment
and running a small company
– reduce incentives to convert labour income into dividend
income/capital gains
• Less need to rely on anti-avoidance measures

Reforms to capital taxation could be important
• Often suggested that excessive consumption (too little saving
and investment) and excessive borrowing have contributed to
recent economic problems
• Tax systems in the UK and many other countries favour debt
and discourage saving and investment
• Intelligent tax reform could make an important contribution to
rebalancing the economy, strengthening balance sheets, and
promoting investment and growth

Are these reforms feasible?
• Norway has RRA treatment of shareholder income
• Belgium has corporate tax with ACE allowance
• We need not be condemned to suffer flawed tax treatments of
savings and investment forever
• Although there is no doubt that serious reform will require political
courage

– And what you mean by it
– And the role of different groups of taxpayers
• This really matters
• Don’t succumb to the tyranny of the status quo

We should “have a tax system which
looks like someone designed it on
purpose”
former US Treasury Secretary William E. Simon

Paul Johnson - 'Indicaciones para una reforma tributaria: lecciones del Informe Mirrlees'

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Paul Johnson - 'Indicaciones para una reforma tributaria: lecciones del Informe Mirrlees'