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

2. 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 © Institute for Fiscal Studies

3. 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 © Institute for Fiscal Studies

4. 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 © Institute for Fiscal Studies

5. 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 © Institute for Fiscal Studies

6. 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 explicitly address the (hugely important) political barriers to rational change © Institute for Fiscal Studies

7. Some examples of bad policy in the UK Look at this marginal rate structure © Institute for Fiscal Studies

8. Income tax and employee NICS marginal rates 2015-16 (married, non-working spouse, 2 children) © Institute for Fiscal Studies 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.

9. Some examples of bad policy in the UK Look at this marginal rate structure Capital Gains Tax at 10% while top income tax rate was 40% –Huge avoidance opportunities © Institute for Fiscal Studies

10. Some examples of bad policy in the UK Look at this marginal rate structure 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 © Institute for Fiscal Studies

11. Some examples of bad policy in the UK Look at this marginal rate structure 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 © Institute for Fiscal Studies

12. Some examples of bad policy in the UK Look at this marginal rate structure 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 Property taxation based on 1990 values © Institute for Fiscal Studies

13. A progressive, neutral system: © Institute for Fiscal Studies

14. A progressive, neutral system: Works as a system –E.g. corporate and personal taxes should fit together –Not every tax needs to achieve everything © Institute for Fiscal Studies

15. 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 © Institute for Fiscal Studies

16. 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 Achieves progressivity as efficiently as possible © Institute for Fiscal Studies

17. 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 © Institute for Fiscal Studies

18. What we have Does not work as a system –Lack of joining up between income tax and NI –Personal and corporate taxes © Institute for Fiscal Studies

19. What we have Does not work as a system –Lack of joining up between income tax and NI –Personal and corporate taxes Is not neutral where it should be –Inconsistent savings taxes with normal return often taxed –Corporate tax system that favours debt over equity © Institute for Fiscal Studies

20. What we have Does not work as a system –Lack of joining up between income tax and NI –Personal and corporate taxes Is not neutral where it should be –Inconsistent savings taxes with normal return often taxed –Corporate tax system that favours debt over equity Is not well designed where it should deviate from neutrality –A mass of different tax rates on carbon –Failure to price congestion properly © Institute for Fiscal Studies

21. What we have Does not work as a system –Lack of joining up between income tax and NI, –Personal and corporate taxes Is not neutral where it should be –Inconsistent savings taxes with normal return often taxed –Corporate tax system that favours debt over equity 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 © Institute for Fiscal Studies

22. Our proposals Treat the system as a whole –Integrating NI and income tax –Aligning tax rates across employment, self employment and profits © Institute for Fiscal Studies

23. Our proposals Treat the system as a whole –Integrating NI and income tax –Aligning tax rates across employment, self employment and profits Move towards neutrality –Widening the VAT base –Not taxing the normal return to capital © Institute for Fiscal Studies

24. Our proposals Treat the system as a whole –Integrating NI and income tax –Aligning tax rates across employment, self employment and profits Move towards neutrality –Widening the VAT base –Not taxing the normal return to capital Whilst proposing sensible deviations from neutrality –Imposing a consistent tax on GHG emissions and on congestion –Imposing zero rate of VAT on childcare © Institute for Fiscal Studies

25. Our proposals Treat the system as a whole –Integrating NI and income tax –Aligning tax rates across employment, self employment and profits Move towards neutrality –Widening the VAT base –Not taxing the normal return to capital 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 © Institute for Fiscal Studies

26. 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 © Institute for Fiscal Studies

27. 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 © Institute for Fiscal Studies

28. 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 © Institute for Fiscal Studies

29. 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 © Institute for Fiscal Studies

30. 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 Replace current property taxes with a single tax proportional to property value –and based on current price © Institute for Fiscal Studies

31. 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 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 © Institute for Fiscal Studies

32. 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 © Institute for Fiscal Studies

33. Environmental taxes are also a mess © Institute for Fiscal Studies Implicit carbon taxes, 2009-10 (Excluding VAT subsidy of domestic energy)

34. 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 © Institute for Fiscal Studies

35. These are radical changes A strategy for the long term Involving a lot of winners and losers And much work to be done © Institute for Fiscal Studies

36. 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 © Institute for Fiscal Studies

37. 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 © Institute for Fiscal Studies

38. 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 © Institute for Fiscal Studies

39. 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 © Institute for Fiscal Studies

40. 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 © Institute for Fiscal Studies

41. 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 Don’t succumb to the tyranny of the status quo © Institute for Fiscal Studies

42. Some specifics Taxation of earnings Capital taxation © Institute for Fiscal Studies

43. 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 © Institute for Fiscal Studies

44. 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 © Institute for Fiscal Studies

45. Average EMTRs for different family types

46. Average PTRs for different family types

47. 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 © Institute for Fiscal Studies

48. 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 The interaction between taxes, tax credits and benefits

49. 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 Response are largest for –Women with school age children –55-70 year olds © Institute for Fiscal Studies

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

51. Patterns of work for women in the UK © Institute for Fiscal Studies

52. 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 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 © Institute for Fiscal Studies

53. 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 © Institute for Fiscal Studies

54. Marginal tax rates by legal form, 2014-15 © Institute for Fiscal Studies EmployedSelf-employedSmall company Basic rate40%29%20% Higher rate49%42%40%

55. 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 © Institute for Fiscal Studies

56. 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

57. 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

58. 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

59. 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

60. 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

61. Neutral Taxation of Savings 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

62. Neutral Taxation of Savings 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)

63. 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

64. 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

65. 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)

66. Corporate tax receipts © Institute for Fiscal Studies

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

68. 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

69. 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

70. 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

71. 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

72. 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

73. 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

74. 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 –And what you mean by it –Think about the lifecycle Recognise economic change –And the role of different groups of taxpayers This really matters Don’t succumb to the tyranny of the status quo © Institute for Fiscal Studies

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