The perfect tax system

Offices of the IFSYou might think that the days of the glorious, all-knowing economist are behind us, in the midst of savagely bleak times at least partly caused by economistic hubris. But clearly there’s still a space in our hearts to hear economists reaching truths unseen by others, at least for the salvation of baseball in the film Moneyball. And in late 2011, a select group of economists – overseen by the unimpeachable Institute of Fiscal Studies – launched the Mirrlees Review, a wholesale year-long investigation of the tax and benefits system in Britain. In this post, I sum up the review’s conclusions (with a social policy slant), and highlight some problems with it.  As Lawrence Summers says, the Review “should be read by anyone who cares about the future of taxation – that is anyone who cares about the future of government.”

Some readers might recognise the name ‘Mirrlees’, referring to James Mirrlees who won the Nobel Prize in Economics in 1996 and who led this review – funded by top UK academic funding agencies, and coordinating an editorial team of primarily British economists, plus the president of NBER in the US.  The review also harks back to an influential IFS review led by the similarly Nobel prize-winning James Meade in 1978. Put simply then, this is a group of people who are as smart and dispassionate as anyone in economics, benefitting from a series of commissioned reports and commentaries by an even-wider set of super-smart economists.

The review’s findings

Even just summarising the concluding – 20th – chapter of the review is a challenge in a few hundred words, but there are several recommendations of particular interest to the Inequalities community (p495-6).

1. “Introduce a single integrated benefit”It might seem slightly surprising for a taxation review to include the benefits system, but they (rightly) see the two as indivisible, given that the withdrawal of benefits is experienced as an additional tax. They rehearse the usual claims that the benefits system is far, far too complicated and “creates serious disincentives to work for some people” (p480, 482) and needs simplification – suggesting that the current Government’s Universal Credit is a step in the right direction.

2. “Merge income tax with employee (and ideally employer) National Insurance Contributions”: Currently many people believe that the separate streams of national insurance contributions (NICs) that are removed from their pay packets go directly to pay for the core aspects of the welfare state, particularly the NHS (see Hills 2003 for an excellent discussion). As the Review notes, this is a fiction – both in the idea that NICs are hypothecated (i.e. legally limited to particular purposes), and that most of the spending goes on the NHS (primarily they go into pensions). Mirrlees et al cite an earlier paper uncomplimentary describing this as “an exercise in deceiving voters” (p471), that moreover creates “unnecessary complexities and inconsistencies” (p481-2). Intriguingly, they also suggest having lower taxes for people who are particularly sensitive to high taxes, such as mothers of older children and 55-70 year olds.

3. “Remove nearly all the current zero and reduced rates and, where possible, exemptions from VAT”: Sales taxes like VAT are regressive, in that they take up a greater share of the spending of poorer than richer people. This is currently partially offset by zero rates of VAT for certain essentials like food, water, books, and kids’ clothes – a practice only fully shared by Ireland (p484). The Review strongly dislikes these anomalies; their view is that “not all taxes need be progressive as long as the overall system is” (p472). So they model a uniform level of VAT combined with income tax cuts and benefit increases that affects people equally when looking across people’s lifetimes (p484).

4. “Introduce a rate-of-return allowance for substantial holdings of risky assets (e.g… rental property) so that only ‘excess’ returns are taxed”: The Review sees a critical goal to be a simplified, consistent tax system that by its very nature makes avoidance less attractive and makes the economy more efficient. This change would be a way of changing the tax base so that income from different sources is taxed equally, treating savings as future income and taxed at the appropriate point, and encouraging investment (p474-5).  As a benefits rather than tax research I have to say that I’m unsure why the normal rate of return on capital should be untaxed as a point of principle (p488), and equally unsure about the implications for inequality, but it seems important. And it’s used in Norway (p489).

5. “Look to introduce a comprehensive lifetime wealth transfer tax”: The transfer of wealth between generations leads to an ‘inequality of life chances…that arise[s] by accident of birth’ (p477-8). A lifetime wealth transfer tax is both the most efficient and most equitable way of doing this (p490) – unlike the current system of taxing estates after death – and has been recommended by many others (e.g. the Fabians taxation commission, Karen Rowlingson’s work).

There’s all sorts of other fascinating changes that I haven’t gone into here – changing the basis of taxing housing from council tax and stamp duty to a tax based on the current value of housing (‘essentially as a substitute for VAT’, p485), and several key suggestions around environmental taxes – so delve into the report yourself if you’re interested.

Problems and critiques

To the IFS’ eternal credit, they encourage transparency, scrutiny and debate in all their work, and the Mirrlees Review is no exception; their house journal Fiscal Studies has a special issue of commentaries. John Creedy’s contribution contains two critiques that I think are particularly strong: the role of values, and the value of an abstract ‘ideal’ system.

Firstly, Mirrlees present themselves as value-free technocrats (for which there is also a recent fashion in Europe…).  For example, in the midst of the recommendations above, they refuse to make firm recommendations on tax and benefit rates as this “would require political value judgements that we are not in a position to make” (p482). As Creedy says (section IV), this is a fiction (to my mind, ‘deceiving voters’ as much as the NIC/tax distinction); their use of optimal tax theory contains both strong and only partially valid assumptions about the nature of human behaviour, and a bias towards the status quo in terms of redistribution. Creedy reports an alternative exercise in New Zealand which explicitly talks about different possibilities and internal disagreement without the working group.

Secondly, Creedy (section VI) points out that the Mirrlees Review “occasionally guilty of favouring an ideal structure, according to stated principles, without sufficient elaboration of its practical difficulties”.  I would go further than this: the Review is an exercise in formal economic ‘rationality’ that takes no account of the real nature of the social world. I should stress at this point that I have little sympathy with the usual economist-bashing: economics is far ahead of much sociology in reflecting on the difficulties of reliable knowledge, and economic models capture part of social reality in a useful way.

But it is only a part. And the value of ignoring the rest of social reality in drawing up a tax system is unclear, particular when ignoring questions of political economy. Will the system be perceived to be legitimate? If we implemented this system, and given long-run political dynamics, what sort of system would we end up with 30 years later? A Christmastime BMJ article called ‘The assault on universalism: how to destroy the welfare state’ focused briefly on the VAT exemption issue, arguing that this will further contribute to the erosion of universalism by putting more pressure on residualised benefits that have to do ever-more to compensate for the regressive nature of the rest of society.

Bizarrely an entire paper on political economy was commissioned for the review, but such considerations can be seen nowhere in the concluding chapter. The Review ends, “It is time for government to grow up and map out a rational course for tax policy.”  But this is not a government ‘growing up’; this is government taking leave of their (political) senses. Yet for all that, the Review is a genuinely useful contribution to public debate, which can – cautiously, critically – be used to think again about some core aspects of tax and benefits.

About Ben Baumberg

I am currently a Lecturer in Sociology and Social Policy at the School of Social Policy, Sociology and Social Research (SSPSSR) at the University of Kent. I also helped set up the collaborative research blog Inequalities, where I regularly write articles and short blog posts. I have a wide range of (too many...) research interests, at the moment focusing on disability, the workplace, inequality, deservingness and the future of the benefits system, and the relationship between evidence and policy. You can find out more about me at http://www.benbaumberg.com
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2 Responses to The perfect tax system

  1. Ben Baumberg says:

    An interesting comment from Richard Murphy in the Guardian, in response to the March 2012 budget – “t’s also extraordinary that the only people who have tried to create such a vision [of tax reform] of late – the Institute for Fiscal Studies in its Mirrlees review – did so in a way so far removed from the political realities of life that they effectively suggested the abolition of corporation tax and its replacement with what would, for all practical purposes, have been an additional 10% VAT rate. No politician could deliver that, from which point onwards its review was a lost cause.”

  2. My suggestion, with an Australian context, is to have flat rate income tax combined with taxable benefits paid to everyone. May not work in America. http://environmentandeconomics.wordpress.com/2014/06/21/remove-class-warfare-from-tax-and-welfare/

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