Time to tidy the tax mess

20th November, 2010

Given the importance of the subject, there isn’t much debate about the fundamentals of taxation. Fundamentalism, yes: on the right, the idea that all tax is theft and that any cut in tax rates will raise revenue; on the left, the idea that the country’s fiscal – and indeed social – problems could be solved quite simply if only the government had the courage to tax the rich more heavily.

(For context: the top 5 per cent of UK earners take in a quarter of the country’s income and pay almost half of all income tax; the top 1 per cent make 12.5 per cent of income, and pay over a quarter of all income tax. Make of that what you will.)

But fundamental principles, no. Instead, we have the increasingly frequent pageant of Budget day, in which the chancellor of the exchequer juggles statistics and pulls rabbits out of hats, while the media scrabble to explain who wins and loses from the performance.

Earlier this month there was a performance of a very different kind when a procession of heavyweight economists, led bythe Nobel laureate Professor Sir James Mirrlees, presented the results of a fundamental review of British taxes by the Institute for Fiscal Studies, the first such exercise for more than 30 years. The results are a bracing blast of fresh air, which deserves to scour away some of the tax junk that has accreted over the decades.

For example, at the top of the income distribution, marginal tax rates rise to 40 per cent, then 60 per cent, fall back to 40 per cent and rise again to 50 per cent – the effect of gradually withdrawing tax allowances above an income of £100,000 a year. In fact the situation is more baffling than that, because national insurance contributions are payable at various rates on wages, but not on income from other sources.

At the bottom end of the income scale the situation is even more cluttered and implicit tax rates are even higher: one case study, for a lone parent, shows take-home income rising, in cliffs and plateaus, from about £220 to about £300, as the parent earns between zero and £230. The marginal tax rate there is around 80 per cent, and in some cases the interaction of benefits is even more baffling.

The broad conclusions of the Mirrlees review are easily summarised: it would be possible to raise the same amount of tax, with roughly the same redistribution of income, more efficiently. There would be fewer loopholes, fewer losses from people making decisions explicitly designed to reduce tax, and fewer arbitrary distinctions between people who deserve to be treated similarly.

One principle that can’t be emphasised enough is that redistribution is a function of the tax system as a whole, not of any particular tax. At the moment, low or zero-VAT rates on items such as food, books, and domestic fuel distort what we buy and encourage us to waste energy in the name of redistribution. This is silly: better to let the income tax system do the redistribution and keep VAT broad and simple. Income tax should also absorb national insurance, which has long been an arbitrary, distorting and opaque parallel income tax.

Not every recommendation of the Mirrlees review tends towards simplicity. For instance, the review advocates tweaking child tax credits, national insurance contributions and the pension system with the aim of giving parents with school-age children and people over 55 and under 70 much stronger incentives to work.

Utopian ideas of tax design must bow both to the messy reality of law and accounting, and to political convenience. Yet the Mirrlees review makes a compelling case that even if tax will never be fun, it could be somewhat simpler and much more effectively collected. The government should take note.

Also published at ft.com.

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