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Tax system favours more fragile balance sheets, says Mirrlees review

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Corporate tax incentives for debt finance and ‘very low’ taxes on capital gains may have played a minor role in creating or facilitating the financial crisis, according to the Mirrlees review of the UK’s tax system.

The system is ‘inefficient, overly complex and frequently unfair’, said the authors of what the Institute for Fiscal Studies called the ‘deepest and most far reaching’ analysis in more than 30 years.

‘The tax treatment of housing and financial services, the very low taxes on capital gains, and the incentives in the corporate tax system for debt funding over equity funding are all possible culprits,’ the review’s editorial team wrote in Tax by Design, the second of two volumes published last week. The Mirrlees review’s findings were 'launched' last November.

The review recommended an allowance for corporate equity to ‘align treatment of debt and equity and ensure that only “excess” returns to investment are taxed’.

The idea has been ‘around for a while’, the Financial Times Lex page noted at the weekend. ‘But there are two compelling reasons to now take it beyond the theoretical realm. One is the problems caused by piling on debt in the credit boom. The other is that most big companies are in fact currently flush with cash but do not have the confidence to deploy it. Make using the cash cheaper, and the economics will go some way to overcoming the fear.’

Bankruptcy risk

In a chapter on taxing corporate income, the authors noted that the system favoured borrowing over retained profits or new equity as a source of finance, ‘leaving firms more exposed to the risk of bankruptcy’.

They wrote: ‘Borrowing costs are likely to rise as firms become more indebted, and in practice we observe firms using a mix of debt and equity finance. Still, it is unclear why we should want the design of the corporate income tax to encourage companies to have more fragile balance sheets than they would otherwise choose. As a result, more firms are likely to default in an economic downturn than would otherwise be the case.’


The current system imposes ‘unnecessary costs’ on the economy, said Sir James Mirrlees. ‘It reduces employment and earnings more than it needs to. It discourages saving and investment, and distorts the form that they take. It favours corporate debt over equity finance. It fails to deal effectively with either greenhouse gas emissions or road congestion. It could raise as much revenue and achieve as much redistribution as it currently does in far less costly ways.’

Successive governments have failed to set out a coherent strategy for tax, IFS Director Paul Johnson said. ‘A government focused on growth cannot afford to ignore some of the fundamental reforms required to the tax system. That does not mean small gimmicks and one-off allowances; it means a long term, considered and systematic approach to tax policy. This is an approach which has been sadly lacking for many years.’

The review, funded by the Nuffield Foundation and the Economic & Social Research Council, sets out a range of proposals (summarised below) to ‘increase output and welfare’.

Its two volumes are available on the IFS website:

Dimensions of Tax Design (1,347 pages)

Tax by Design (533 pages)


Mirrlees review: main recommendations

Taxes on earnings

Indirect taxes

  • Merge income tax with employee (and ideally employer) NICs
  • End the opaque practice of tapering personal allowances and move to a transparent, coherent
  • rate schedule
  • Introduce a single integrated benefit, getting rid of the very highest effective marginal tax rates
  • (90% and more) faced by some low earners
  • Strengthen work incentives for those whose youngest child is of school age and for 55- to 70- year-olds relative to others
  • Remove nearly all the current zero and reduced rates and, where possible, exemptions from VAT. Introduce a comprehensive package compensating the less well-off on average whilst maintaining work incentives.
  • Retain a destination basis for VAT while ending the zero-rating of exports
  • Introduce a tax equivalent to VAT on financial services
  • Replace council tax and stamp duty land tax on housing with a tax proportional to the current value of domestic property, to stand in place of VAT on housing

Environmental taxes

  • Introduce a consistent price on carbon emissions, through a combination of extended coverage of the EU Emissions Trading Scheme and a consistent tax on other emission sources. This would include a tax on domestic gas consumption.
  • Replace much of the current tax on petrol and diesel with a national system of congestion charging

Taxation of savings and wealth

  • Take interest on bank and building society accounts out of tax altogether
  • Introduce a rate-of-return allowance for substantial holdings of risky assets (eg. equities held outside ISAs, unincorporated business assets, and rental property) so that only ‘excess’ returns are taxed
  • Tax capital income and capital gains above the rate-of-return allowance at the same rate
  • schedule as earned income (including employee and employer NICs), with reduced rates for dividends and capital gains on shares to reflect corporation tax already paid
  • Maintain and simplify the current system of pensions taxation, ending the excessively generous treatment of employer contributions and replacing the tax-free lump sum with an incentive better targeted at the behaviour we want to encourage
  • At least remove the most obvious avoidance opportunities from inheritance tax and look to introduce a comprehensive lifetime wealth transfer tax

Business taxes

  • Introduce an allowance for corporate equity into the corporation tax to align treatment of debt and equity and ensure that only ‘excess’ returns to investment are taxed
  • Align tax treatment of employment, self-employment, and corporate-source income
  • Replace business rates and stamp duty land tax on business property with a land value tax for business and agricultural land, subject to confirming practical feasibility

Source: Tax by Design (Mirrlees review) chapter 20