Mirrlees Review Recommendations on Taxation - Essay Example

A brief review of the Mirrlees Review recommendation to provide a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers ‘The Mirrlees Review’ was a project conducted by the Institute for Fiscal Studies that aimed at “identify[ing] the characteristics that would make for a good tax system in an open economy in the 21st century” (Mirrlees, Adam, Besley, et al., 2012: v). The Review aimed at closing a crucial loophole within the UK tax system, by presenting a comprehensive analysis of the right direction for the UK tax policy, encompassing specific reforms proposals coupled with suggestions for broad strategic reforms. The current system followed in the UK for savings taxation is replete with various complexities and disparities, while saving is discouraged in many ways, wherein simple interest-bearing accounts are meted out the harshest treatment, while the same time other types of savings are granted large-scale benefits for tax savings (Mirrlees, Adam, Besley, et al., 2012). This disparity and intricacy in tax treatment have led to the emergence of an industry that thrives on simply advising people on the nature of their savings allocation that is not based on the best form of underlying investments, but is more dependent on the form of tax treatment. In this context, the essay provides a brief review of the Mirrlees Review’s recommendation to provide a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers. The Mirrlees Review aimed at addressing the challenge of designing a tax system that would enable the UK government to raise revenues necessary for achieving its distributional and spending objectives, while lowering its administrative and economic inefficiencies and avoiding disparity in tax treatment across citizens and different types of economic activities. It main principle behind all its proposals was the framing of a progressive, neutral tax system, wherein the three words ‘progressive,’ ‘neutral,’ and ‘system’ form to be the important keywords that are suggestive of the main findings of the Review. Therefore, it can be suggested that first, policy makers must aim at designing a tax system that functions effectively as a ‘system.’ The way in which different taxes can be assembled together is important, as is a clarity regarding the role played by each tax within the system. Second, distribution plays a major role within the system of tax and benefits, similarly the trade-off between efficiency and redistribution is at the core of tax policy related debates. The redistribution ambit is ascertained by society’s choices and the system effect is based on efficiency. Lastly, neutrality is a crucial factor and remains an important benchmark for analysing the tax system. The current system of taxation of household savings in the UK A look at the current system of household savings in the UK shows that for shares and cash held in Individual Savings Accounts (ISAs), and owner-occupied houses, saving comes from taxed income, while no tax is levied on returns and withdrawals (as for example, proceeds from a house sale, in the context of housing), which comes under TEE treatment (Dye and England, 2009). This treatment has restrictions in case of ISAs, where annually just around £10,000 can be deposited. From this, a maximum of 50% can be in deposited as cash in ISA; however, one can also opt to place the entire money in an equity ISA. Therefore, here it can be derived that TEE treatment is preferential towards equity investments, instead of cash savings. There is a different way for tax exemption, in regard pensions, where saving is derived from untaxed part of the income and the fund income remains untaxed, however all withdrawals are taxed, which comes under the EET treatment. While this system for pensions would create zero effective tax rate on the normal savings return, but the 25% total sum that is allowed to be withdrawn tax free from pension funds, means that pension saving is actually subsidized (Wakefield, 2009). Furthermore, contributions from the employers’ pension have tax benefits, as they are not subject to employee or employer National Insurance contributions (NICs), during the time of contribution or withdrawal. NICs are not chargeable on any savings return nor are NIC reliefs available for contributions except for employer contributions towards pensions, thus it can be derived that the NICs treatment in terms of other savings is TEE in form. It is for this reason, majority of the UK wealth is held in ISAs, housing and pensions, since saving in any other form is not encouraged by the current tax system. In ordinary interest-bearing accounts cash is generally saved from taxed income, then income tax is applied to the entire nominal return, and this is applicable in case of equities that fall outside ISAs, while CGT is also levied on capital gains. Effective tax rates (ETR) on an interest-bearing account for a basic-rate taxpayer is 33% and not the 20%, which is the official income tax rate, since tax is levied on the nominal return, and not on real return. Fig 1 demonstrates the ETRs for higher and basic rate taxpayers taking into consideration that all assets before tax earn a real rate of 3% while the inflation is 2%. The ISA system is considered the base case, where the effective tax rate is zero, as here there are no chargeable taxes on the real return. Wealth/assets Effective tax rates for higher-rate taxpayer (%) Effective tax rates for basic- rate tax payer (%) Direct equity holdings - invested for 10 years - invested for 25 years 35 33 10 7 Rental housing – invested 10 years 50 30 Housing—only or main house 0 0 Pension (employee contribution) -10 years -53 -21 Pension (employer contribution) -10 years -102 -115 Interest-bearing account 67 33 Individual Savings Accounts 0 0 Fig 1: Effective tax rates on different assets in saving (Wakefield, 2009). Inflation has no impact on the ISAs, ETRs on pensions, and housing that are occupied by the owners, where the returns are exempted from paying tax. Since pension savings are given preferential treatment over a cash-flow expenditure tax, therefore it shows a negative ETR. This emerges because employer contributions do not have NICs charged on them and the lump sum is tax-free. Despite the differences between tax treatments of the different assets, over the last three decades observations revealed that there has been a lowering of ETS dispersion mainly due to less dispersed and low income tax rates and decreased rates of inflation (Wakefield, 2009). Furthermore, there have been certain specific reforms, such as introduction of ISAs and personal pensions that has increased the ambit of tax-free savings modes. In the context of taxation of capital gains, there is tax only on the realization of profit, while there is no tax liability adjustment to make it similar to accrual-based tax treatment. In 2011, CGT in the UK is charged only on actualised annual capital gains greater than £10,100. The additional high tax-free allowance for CGT tends to make capital gain returns as more attractive, since the allowance translates into the fact that for those with many asset holdings can divest the assets for long-term, where there will be no tax levied on the capital gains (Brewer and Browne, 2009). More lucrative are profits as personal business assets, where the first £5 million are exempted from CGT through ‘entrepreneur’s relief’ (Cullen and Gordon, 2007). This has led to various types of tax planning regimes in the UK that are mainly centred on realisation of capital gains. The capability of many of the private equity fund managers and the very rich to accept returns only as capital gains has led to a great deal of controversy and growing concern around the effectiveness and fairness of the current tax system in the UK (HM Treasury, 2007). Recommendation of the Mirrlees Review and the purpose for providing a tax system with a neutral treatment of life-cycle savings According to the Mirrlees Review, the current tax system UK fails to function as a system, with a lack of coordination between corporate taxes, personal taxes, and welfare benefits, which caused deviations in the revenue and unnecessary distortions (Gordon, 2011). Furthermore, the review contended that the system is not neutral and are clear distinctions in the treatment of various forms of assets and revenue. The system is not well framed in instances where it shifts from neutrality, and fails to achieve efficient progressivity, as for example, not including certain products (food) from the value-added taxes disturbs progressivity (Auerbach, 2012). Taking into consideration, the aforementioned issues the Mirrlees Review recommended the following reforms within the UK tax system: “lowering some marginal rates, with less aggressive means testing, tagging by age of youngest child, and at pre-retirement ages; integrating different benefits and tax credits, to improve transparency, administration, and up-take; limiting tax increases for top earners, but reforming the base to reduce tax avoidance and revenue shifting; and aligning personal and corporate tax rates, to equalize treatment of different income sources and reduce incentive to convert labor income into dividend income and capital gains” (Blundell, Tax Reform and Empirical Evidence: Lessons from the Mirrlees Review, 2013) The basic notion that underlies the recommendations in the Mirrlees Review is the creation of a neutral tax system that would treat similar activities in the same manner. As for example, a system that uniformly levies the same taxes on all consumption goods would produce neutrality over peoples’ preferences on what to consume. A neutral tax system where all types of income receive the same treatment, achieves neutrality over the preference of income form. A system that uniformly charges taxes on savings types, achieves neutrality over the manner in which the households aim at saving. In the same way, a system that applies same tax value on current and future consumptions will achieve neutrality as regard the decision to consume or save from the current income. Therefore, a neutral tax system tends to curtail the welfare loss linked with contortions in household management. In tax system that is non-neutral in form, people and corporates tend to make socially incontinent efforts to decrease the amount of tax paid, by altering the structure or nature of their activities. The tax system in the UK, like other economies in the developed nations, contains many types of non-neutrality that tend to create welfare debits without any justifications. It distorts preferences between equity and debt finances, carbon prices, between owner-occupied housing and other forms of wealth, between capital gains and other capital income types, between different types of work remuneration, and between different types of business firms (Advani, Levell, and Stoye, 2011; Committee on Climate Change, 2008). Such distortions lead to further complications, encourage tax evasion, while adding to the expenses for both the government and taxpayers. On the other hand, a neutral tax system that treats similar economic activities in the same manner in the context of tax savings will help to avoid all complexities and unjustifiable inequity between citizens and their economic activities, while helping to remove economic contortions. However, there are some disadvantages to the neutral tax system, wherein it does not always minimise distortion, and in some cases, there must be the additional support from efficient policies that would actually help to set apart different activities. As for example, there must be discriminating taxes charged on tobacco, alcohol and other activities that cause social and environmental damages. In such instances, majority of the people left to choose will tend to behave in a manner that cause would harm to themselves and to the others around. Furthermore, evidences revealed that tax policies also help in affecting individual behaviours in terms of activities that may harm social and environmental factors. Similarly, the neutral tax saving system must be exempted from being applied to the research and development units and pension saving, where there must be encouragement towards such activities that produce high social returns. Similarly products and services associated with social work (such as, environmental protection, childcare, child education, providing for the homeless and other similar activities that are often undertaken by corporates), is another case where there can be applied a lenient tax treatment so that it offsets the determent to economic activities generally created by the overall tax system (Heckman, 2006). While taking into consideration such exemptions that can be made within a neutral tax system, policy makers must check the advantages of shifting from neutrality against the disadvantages of adding further complications to the tax treatment, since defining and monitoring boundaries between different taxes has many difficulties that includes rise in compliance and administrative expenses. References Advani, A., Levell, P., and Stoye, G., 2011. “Inconsistent and Inefficient UK Carbon Prices.” IFS Observations: Reflection on Current Events. Institute for Fiscal Studies, accessed 10th February 2014 http://www.ifs.org.uk/publications/5927 Auerbach, A., 2012. “The Mirrlees Review: A U.S. Perspective.” National Tax Journal 65 (3), 685–708. Blundell, R., 2013. Tax Reform and Empirical Evidence: Lessons from the Mirrlees Review. Accessed 20th February 2014 https://bfi.uchicago.edu/events/program/tax-reform-and-empirical-evidence-lessons-mirrlees-review Brewer, M., and Browne, J., 2009. Can More Revenue Be Raised by Increasing Income Tax Rates for the Very Rich? Institute for Fiscal Studies note BN84, accessed 25th February 2014 http://discovery.ucl.ac.uk/18303/1/18303.pdf\ Committee on Climate Change, 2008. Building a Low Carbon Economy: The UK’s Contribution to Tackling Climate Change. London: TSO, accessed 24th February 2014, http://image.guardian.co.uk/sys-files/Environment/documents/2008/12/01/BuildingALowCarbonEconomy.pdf Cullen, J., and Gordon, R., 2007. ‘Taxes and Entrepreneurial Risk-Taking: Theory and Evidence for the U.S.’ Journal of Public Economics 91, 1479–505. Dye, R., and England, R. (eds), 2009. Land Value Taxation: Theory, Evidence and Practice. Cambridge: Lincoln Institute of Land Policy. Gordon, H., 2011. “Commentary on Tax by Design: The Mirrlees Review.” Fiscal Studies 32 (3), 395–414. Heckman, J., 2006. “Skill Formation and the Economics of Investing in Disadvantaged Children.” Science 312, 1900–02 HM Treasury, 2007. Income Tax and National Insurance Alignment: an evidence-based assessment. Accessed 23rd February 2014, http://news.bbc.co.uk/2/shared/bsp/hi/pdfs/09_10_07_pbr_income_tax.pdf Mirrlees, J., Adam, S., Besley, T., et al., 2012. Tax by Design: The Mirrlees Review. Institute for Fiscal Studies. Accessed 23rd February 2014 http://www.ifs.org.uk/mirrleesreview/design/taxbydesign.pdf Wakefield, M., 2009. How Much Do We Tax the Return to Saving? IFS (Institute for Fiscal Studies) Briefing Note 82, accessed 24th February 2014 http://www.ifs.org.uk/bns/bn82.pdf Read More