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

Presentation to Fundacion Ramon ArecesPaul Johnson

25/09/2014

© Institute for Fiscal Studies

Tax By Design: The Mirrlees Review

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© Institute for Fiscal Studies

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© Institute for Fiscal Studies

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





• Replace current property taxes with a single tax proportional to property value

– and based on current price





• 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© Institute for Fiscal Studies

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 parentPartner not working, no children Partner not working, childrenPartner working, no children Partner working, children

Average PTRs for different family types 3

0%

40%

50%

60%

70%

0 100 200 300 400 500 600 700 800 900 1000 1100 1200

Employer cost (£/week)

Single, no children Lone parentPartner not working, no children Partner not working, childrenPartner 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


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

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© Institute for Fiscal Studies

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


EmployedSelf-

employedSmall

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© Institute for Fiscal Studies

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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