A strategy for the UK tax system

With the tax system taking almost £4 for every £10 earned in the economy, getting tax design wrong can be hugely costly. Yet the level and quality of debate on tax policy is inadequate; there has rarely been any clear sense of direction from governments; and expensive and damaging mistakes have been all too common.

In many areas of public policy, governments have habitually set out long-term strategies for change – in education and transport, for example. But no recent government has set out a tax strategy. The consequences of lacking a coherent vision for the tax system have repeatedly been illustrated, not least in the previous Labour government’s experience of a succession of ill-thought-through reforms that were introduced and later abolished – including CGT taper relief, the 0% rate of corporation tax and the 10% starting rate of income tax – at great political as well as economic cost. And there have been equally indefensible – albeit more politically successful – sins of omission, such as the spineless failure of successive governments to update council tax valuations in England and Scotland that are still based on 1991 property values.

The Mirrlees Review

With this in mind, the IFS launched a fundamental review of tax policy under the chairmanship of Nobel laureate Sir James Mirrlees, to identify what makes a good tax system for an open and developed economy in the 21st century and to suggest how the UK tax system could be reformed to move in that direction.

The final report of the Mirrlees Review, Tax by Design, was published last year (available via www.lexisurl.com/jSMwe). At its core is the concept of a progressive, neutral tax system. Each of those three words – progressive, neutral and system – is important.

First, the tax system should be considered as precisely that: a whole system. The right tools should be chosen to address each objective: not every tax needs to be green or progressive, as long as the system as a whole is. And the different taxes (and benefits) need to fit sensibly together. For example, personal and corporate taxes need to fit together such that the form in which income is received does not imply very different amounts of tax paid. Otherwise, some forms of activity are favoured over others and people are led to alter the legal form of their activity for tax reasons rather than underlying commercial considerations.

Second, seek neutrality – treat similar activities similarly. A neutral system will tend to be fairer, be simpler, and help to minimise economic distortions. Exceptions will occasionally be justified – to deal with the costs of smoking or pollution, for example – but they should be limited and carefully designed.

Third, achieve progressivity as efficiently as possible. Quite how progressive the system should be is a question for governments and electorates. But the chosen degree of redistribution should be achieved while minimising undesirable effects on people’s behaviour. That means relying on the rate schedule of personal taxes and benefits – rather than inefficiently distorting the tax base – to achieve redistribution. It also means designing that rate schedule using what we know about how people respond to incentives, to minimise the extent to which the tax system reduces employment and earnings.

These perhaps innocuous-sounding principles turn out to have far-reaching implications for the design of the tax system. Starting with this high-level view of the desirability of a progressive, neutral system, the Mirrlees Review arrived at a series of recommendations for the shape of a ‘good’ tax system. These are set out in the left-hand column of Table 1, while the many aspects of the UK tax system that fail to live up to this ideal are detailed in the right-hand column of the table. Our main proposals for reform are summarised in Table 2.

It is impossible in a short article to explain how all these proposals would work and fit together, or to do justice to the wealth of analysis underlying them. But it should be clear how most of them are coherent with the broad principles we have just enumerated and would result in far more efficient and effective taxation – taking the UK tax system much of the way towards being a progressive, neutral system.

Long-term reform

The package of reforms we propose is undoubtedly radical. Our recommendations are intended as a direction for long-term reform, and most of the specific proposals are not changes that could be made rapidly. And there is no getting away from the political difficulty associated with some of the proposed changes. But there is also no getting away from the enduring costs of failure to reform.

We would not expect any government to agree with all of our proposals, but it would be helpful for all concerned with tax to have a much better idea than we do of what sort of long-term direction the Chancellor would sign up to. The Coalition government has taken welcome steps towards improving the way in which tax policy is made, including publishing a Corporate Tax Road Map, consulting on proposals and publishing draft legislation earlier, setting up the Office of Tax Simplification, providing more analysis of tax reforms in Budget documentation, having policy costings audited by the Office for Budget Responsibility, and the very act of setting out in a series of documents how tax policymaking is to be conducted. But we are still waiting for the government to set out a comprehensive strategy for the tax system as a whole.

Paul Johnson, Director, Insitute for Fiscal Studies

Stuart Adam, Senior Research Economist, Insitute for Fiscal Studies