Tax by Design: The Mirrless Review by Institute for Fiscal Studies
Book about the issues that arise in designing tax systems, and a framework to reason about tax design, with a focus on the UK’s system. Over the last 30 years, there has been a disproportionately large increase in the incomes of the top 1%, as well as increased globalization and complex trade, which has resulted in more complex tax systems. Complexity also arises due to asymmetry in which taxes are politically feasible, but in many cases, they can be simplified, as a poor understanding of tax systems can lead to cumbersome and senseless arrangements and make us worse off.
An ideal tax system should have several desirable properties. We would like to tax people according to their lifetime income and be progressive so that those with higher incomes are taxed more (although the book does not prescribe what level of redistribution is best, which is a political question). The tax system should be “neutral”, ie, treating people with similar situations in a similar way — taxes should not be different depending on whether you are married or not, or if you’re employed vs self-employed. The tax system should also be simple in order to avoid loopholes and tax avoidance. Finally, it should incentivize the right behavior and not discourage people from working; sometimes, taxes can also send signals to behaviors, such as in taxes on environmental damages.
Taxes are necessary to redistribute wealth in a country, but they can also incentivize people to work less, leading to a loss of revenue for the government. Therefore, the two factors need to be carefully balanced. Labor elasticity (working less when taxes are high) tends to be more pronounced for women with children and less for men. It is possible to introduce other information besides income for taxation purposes, but this incentivizes people to change their status to optimize for lower taxes, eg, they may decide to have more or less children, change their marriage status, or pretend to be more disabled than they really are.
When analyzing income tax, just looking at the income tax alone can be misleading because there are benefits, credits, etc. The EMTR (Effective Marginal Tax Rate) and PTR (Participatory Tax Rate) basically show the actual total tax rate, taking into account allowances, credits, benefits, etc. In the UK, there is a complex overlap of credits and benefits, which can sometimes lead to absurd situations when analyzed from an EMTR and PTR: at times, the EMTR can be very high when benefits are tapered off as income rises, which disincentivizes people from working. The top tax rate should be capped at 50%, as beyond that, people may choose to avoid taxes or leave the country entirely. It is better to have an integrated system for handling different types of taxes and benefits to avoid obscuring the effective income tax rate. The UK has the NIC system (similar to social security), it is similar to income tax but not identical in all situations, but leads to confusion about the actual tax rate. Having an integrated system reduces administrative burden and avoids “gaps” when switching between benefit types.
Value Added Tax (VAT) is a different type of tax that taxes consumption instead of income; this is better than taxing transactions, which would discourage trade. It is possible to reduce tax for poor people by taxing some goods (like raw groceries) less than restaurants, but it is a crude instrument for wealth redistribution. Poor people spend more of their income on goods, so it affects them more as a proportion of their income. VAT can also be selectively applied to products like alcohol and tobacco that people should consume less of.
VAT is a complex tax to administer as it requires every company in the supply chain to maintain an audit trail of how much they have paid and charged. Each company only pays tax on the difference in value added; exemptions mean that the final product is not charged VAT, but the final retailer still has to pay VAT on the inputs, which incentivizes to have more of the supply chain in-house instead of buying from others. It is usually more favorable to have zero-rated products, meaning the entire supply chain is not affected by VAT. However, zero-rating VAT leaves room for fraud and tax evasion by exporting goods (generally zero-rated), leading to “carousel schemes” where a company exports an item and then imports it again to avoid paying VAT.
Taxing VAT for financial services has some issues because the customers don’t have to pay for a bank account, but they receive the services provided, so there are special rules for handling VAT for financial services. There is a good argument for broadening the VAT base and taxing most items under VAT: when goods are zero-rated or exempt, it creates distortions depending on the classification of which goods are taxed and which are not, and also it’s beneficial because it taxes expenditure instead of income, which tends to be smooth over a lifetime.
In environmental taxation, rather than generate revenue, the primary purpose is changing behavior for activities that harm the environment. Two methods are commonly used: cap-and-trade systems and the tax system. In a cap and trade system, there is more control over total amount of carbon emissions, whereas the tax system provides more certainty for companies about how much it will need to pay pay for a specific amount of emissions. A combination of both methods is often used. A problem with the carbon tax is that it can be regressive, as low-income individuals tend to spend a higher proportion of their income on energy. To address this, credits are often given to compensate for the tax for low-income people.
A different type of environmental taxes is those on motor vehicles. The primary cost to society for this is congestion, rather than carbon emissions, but taxing either new cars or fuel usage may not be an accurate reflection of congestion levels. For instance, in rural areas, fuel usage may not result in significant congestion, compared to urban areas. An alternative is localized congestion pricing, which has been implemented in some regions, such as London.
Several way to tax savings are: taxing when the money is earned through income, or when it is withdrawn from a savings account. However, it is generally not advisable to tax a portion of earnings from savings since it can be unfair to those who prefer to consume sooner than save for later — despite the appeal of taxing the wealthy (those who have savings), the tax system should not penalize people who want to save their money for later. An ideal system should be neutral towards different types of savings, in order to not create distortionary pressures that encourage people to hold onto assets to avoid paying capital gains taxes, or move savings towards assets that are hard to tax, like human capital in the form of education.
The current UK system has some flaws since it favors some forms of savings over others, for example, interest-bearing accounts are taxed at a very high rate. A good system is TEE system for most assets (where income is taxed when earned but not taxed when interest accumulates on savings), then an EET system for pensions (where it is not taxed at all until withdrawn from a pensions account). The reason for EET pensions is it allows for the smoothing of the tax burden across a lifetime, as people tend to withdraw from their pensions account when their income is low.
Inheritance tax: this tax is controversial because philosophically it’s unclear whether wealth should be taxed at all. If a decision is made to have an inheritance tax, it’s important to take a principled approach, ensuring that all forms of wealth are taxed consistently — if certain forms of wealth are taxed and others exempt (because they hard hard to tax), it creates a loophole that encourages tax planning.
Land taxation: in theory, land can be taxed at any rate without affecting economic incentives, because land is a pure economic rent. If you tax the land by some amount, the value of the land will decrease by the same amount, but all economic activity will otherwise remain the same. The UK has no land tax but instead has a council tax for owners of domestic property, which is not the same as land. However, the problem with the council tax is that it has not been updated for several decades so that updating it would change the taxes for a lot of people. So it would be politically difficult, since it would increase the tax dramatically for many people, and it is also regressive as the highest-valued properties have the highest deviations from their real values. Thus it is important to do periodic valuations of property, but this is challenging when the property is infrequently sold. We should also tax the above-average gains of property value, and it should be neutral whether the house is rented to somebody else or occupied by the owner because in both cases, it can be viewed as consumption.
Corporate taxation: in theory, it should be treated similarly to personal savings, but there are a lot of subtleties, like avoiding distortions that incentivize corporations to use debt financing instead of equity, for example, to get interest rate deductions. One challenge for corporate taxes is that corporations can range from single-owner to really big international multinational corporations. In the international context, the tax is generally levied at the source, i.e., the country where the goods are produced, but this is economically equivalent to income tax on domestic workers. It might be desirable to have a higher rate of tax for when the income is immobile, making it less likely for the company to relocate to somewhere else for tax optimization, but it’s also bad to set a precedent for corporations to register their subsidiaries in countries with low tax rates.
For small businesses, it’s important to have neutrality between employment, self-employment, and setting up a corporation, as this is a common source of tax avoidance for individuals. For example, individuals may register as self-employed and sell their services to a big company instead of being employed, or they may change labor income to corporate profits and pay themselves dividends. All of these choices give individuals a lot of leeway to select the option with the most favorable tax treatment, so to avoid this, we need to have a consistent scheme that ensures neutrality across all three options.
Overall, this book does a good job of describing the complexity involved in designing a fair and effective tax system. It needs to collect revenue while also being progressive (taxing higher income people more than low-income individuals). It needs to prevent tax avoidance, and “deadweight loss” where players are incentivizes to do things that benefit nobody but is optimal for taxes. One weakness is the book only focuses on the UK system; while it has a lot of general discussion and most of the tax concepts have equivalents in other countries like Canada and the US, they are not really mentioned and only discusses the UK system when it comes to specific details.