The choice of tax base

1. The choice of tax base Stuart Adam

2. Outline • Criteria for evaluating a tax system • Choosing components of the tax base • The choice of principal tax base • Some specific areas

3. Criteria for evaluating a tax system • Distributional effects • Distortion of behaviour (neutrality) and effect on long-run growth • Horizontal equity (neutrality) and other conceptions of fairness, privacy etc • Transparency (simplicity) • Ease of administration and compliance (simplicity), level of evasion and avoidance • Flexibility • Stability and ease of transition

4. What could tax bills depend on? The main tax base: • Earnings, savings income, spending Also used: • Hours of work • Past earnings / taxes paid • Age, marital / partnership status, number and age of children, disability Almost never used: • Sex, race, height, birthweight, parents’ characteristics, education, IQ etc

5. What should tax bills depend on? The ‘optimal contracting’ perspective: • should use anycostlessly observable characteristic that provides additional information about earning ability, responsiveness to taxation or needs But… • Nothing is costlessly observable! • Must trade off precision against complexity • This takes no account of horizontal equity • On which characteristics is it legitimate to discriminate?

6. The principal tax base • Little argument that should be something like earnings, income or expenditure • The best feasible guide to ability to pay • Individual or family? Measured over what period? • But which? • This largely boils down to the question of how to tax saving

7. A baseline: zero tax on saving Two arguments for zero tax on saving: • Don’t discourage saving • Treat all capital the same • Simplest route to equal taxation is zero taxation

8. Don’t discourage saving Goes back to Atkinson & Stiglitz (1976)… • Saving just defers consumption • A tax on saving means taxing earnings spent tomorrow more than earnings spent today • Under certain conditions, this decision to delay consumption tells us nothing about ability to earn • So taxing saving is an inefficient way to redistribute • Tax those with high earnings/spending, not those who choose to spend their earnings later

9. On the other hand… Conditions for Atkinson-Stiglitz don’t hold: • If work decisions depend on the timing of consumption • If consumption substitutes for leisure then tax retirement saving to encourage work • If high-ability people have higher saving rates (eg more patient, longer life expectancy) • Then saving indicates high ability, not just consumption preferences • If we think about trying to tax earnings over time • Keep wealth low so you can tax earnings without people stopping work • With decisions taken under uncertainty (over various things) There are many other (complicated!) arguments • See Banks/Diamond/Mirrlees draft chapter

10. The upshot • Theoretical arguments for zero capital taxation don’t survive without unrealistic assumptions • But the basic intuition still seems sound • Arbitrarily high taxation of long-delayed consumption seems wrong • And the objections give little guidance on how much to tax saving • No reason to tax capital income at the same rate as earnings • Maybe focus more on practical considerations • How easy would it be to tax capital income ‘properly’? • How easy would it be to move to zero taxation of saving?

11. How might we not tax saving? • Present value of lifetime earnings and expenditure are the same if all saving earns the normal return r • Ignoring bequests: a tricky issue! So three mechanisms: • Just tax earnings: National Insurance contributions • Just tax expenditure: VAT • Tax expenditure, calculated as: earnings – net contributions into saving accounts • In all cases, no tax on the return that converts earning today into spending tomorrow

12. Earnings or expenditure? • Not all saving earns the normal return • Expenditure tax captures higher (or lower) returns • Equivalent to an earnings tax with the proceeds invested in the same way as the private savings • Does this matter? Depends why return varies… • Risky returns don’t change much • Scale up holding of risky assets • Not quite equivalent as tax isn’t proportional • ‘Rents’ do change things • Some exceptional returns due to market power, factors in fixed supply, entrepreneurship, etc • Often efficient to tax these • How much of these are at the corporate level?

13. Income tax treatment of saving Default is to tax returns to saving (interest, dividends, capital gains) as well as earnings • at lower rates: dividend tax credit, CGT allowance / taper But… • ISAs: returns tax-exempt (earnings tax treatment) • Housing & other durables: ditto • Pensions: expenditure tax treatment • contributions deducted from taxable income • returns within the fund untaxed • withdrawals (pension income) mostly taxed These account for most saving for most people

14. Other taxes on capital • Corporation tax • Stamp duties • Council tax • Business rates • Inheritance tax • Withdrawal of means-tested benefits

15. Treat all capital the same “the attraction of an expenditure tax is not so much that it would remove a disincentive to saving in general but that it offers a practicable way of eliminating the differential taxation of particular forms of saving and capital income” Kay & King (1990), p.96

16. There has been progress A general levelling of treatment since 1979 • Abolition of tax relief on mortgage interest and life assurance • had provided significant net subsidies • Introduction of personal pensions and ISAs • greatly extends access to tax-free saving • Alignment of income tax and CGT rates The decline of inflation has also helped

17. A comprehensive income tax? We would like to tax the accrued real return. But… • Hard to measure real returns in some cases • Taxing nominal returns means an ‘inflation tax’ • Hard to measure accrued capital gains • Taxing realized gains distorts towards delaying realization • Hard to identify an individual’s income within certain pooled savings vehicles • Problematic if we want a progressive tax schedule • Hard to measure the return to ‘investment’ in durable goods • notably housing • Hard to separate capital from income in some cases • eg annuities

18. A ‘pure’ zero-tax regime? • Pure earnings tax difficult for some things • Defined-benefit pensions • Pure expenditure tax difficult for some things • Housing and other durable goods • The current mixed selection has problems…

19. Tax smoothing • Pensions are taxed as deferred earnings • But the tax rate faced in retirement may be different • 40% tax in work, 22% tax in retirement • 59% tax + tax credit taper in work, 22% tax in retirement • 22% tax in work, 40% (or higher) benefit withdrawal in retirement • This can make pensions extremely attractive or unattractive • and favour strategic timing of pension contributions • Lifetime tax depends on the timing, as well as the level, of earning and spending • This seems both unfair and distortionary

20. If you can’t beat it, join it • Tax smoothing is inevitable as long as both earnings-tax and expenditure-tax vehicles exist • But if they were unlimited, everyone could smooth their tax base completely • This gives us a lifetime tax! • Almost: uncertainty is again a tricky issue

21. A choice of regimes (1) • This was exactly Meade’s suggestion • ‘Registered’ and ‘unregistered’ assets • Can choose to register new savings • Contributions deductible; withdrawals taxed • Otherwise, savings are simply ignored and only earnings are taxed • Certain assets must be registered (DB pensions, unincorporated businesses) • Certain assets cannot be registered (durables) • Otherwise, free choice

22. A choice of regimes (2) What would this require? • Abolish income tax on saving and CGT • Create new pension-type vehicles • No perks (25% lump sum, NICs on employer) • No limits, illiquidity or compulsory annuitisation • Create symmetric borrowing vehicles • Amount borrowed added to taxable income • Repayments deducted from taxable income

23. Other appealing options • Just make more use of VAT and NICs • Hall-Rabushka-style ‘flat’ tax • VAT with wages deductible; separate wage tax • No reason wage tax must be flat! • Nordic-style Dual Income Tax • A rational and feasible way to tax capital income?

24. Transition issues (1) • Windfall gains or losses for existing asset-holders • Created by all reforms, to varying degrees • Windfall tax efficient IF credibly one-off • Such (in)efficiencies may be large relative to the inefficiency of putting the wrong tax rate on capital • But gains/losses seem undeserved in any case • ‘Transitional protection’ could last decades!

25. Transition issues (2) • Changes in prices • Depends what reform implemented and how • No impact in the (very) long run • But short-run impact could be big: nominally denominated contracts, indexation of benefits, etc • Problems with all transitions • One-off administrative cost of change-over • Unforeseen teething problems • Professional expertise is in current system • Losers angry, winners ungrateful

26. Saving among low earners • Discussion so far has been about life-cycle saving • Save (and borrow) so you consume when it’s most valuable to you, not when you happen to earn it • This assumes rational, forward-looking behaviour • Actually seems to fit behaviour quite well over most of the distribution • But not at the bottom of the distribution • Evidence of myopia, self-control problems, framing effects, etc • Possible role for subsidizing saving for these people • But are irrational people likely to respond to incentives? • Can also have some strange implications • More favourable incentives might reduce saving

27. Pensions • Broadly expenditure tax treatment • But more generous • 25% tax-free lump sum • Employer contributions escape NICs at both ends • Why? Pensions need special inducement… • Must lock in the money until retirement • Compulsory annuitisation • May well be good reasons for this • But is the inducement well designed? • Why a percentage of the fund? • Why favour lump-sum withdrawal? • Why related to rate of employer NICs? • Highlights bizarre taxation of non-pension annuities

28. National Insurance • UK NI has become much more like income tax • Either make it a proper social insurance system • There is a good case for this • Or merge it with income tax • Reduced admin and compliance costs • Transparency • Significant transition issues

29. Stamp duties • A tax on transactions • 0.5% on securities, 0-4% on property • An insane tax • Reduces effective returns • Hinders the efficient allocation of capital • Cheap collection not enough to justify it • Only defence is that it already exists! • Windfall gains from abolishing it undesirable • ‘Slab’ structure looks particularly absurd • £1 higher price incurs £5,000 more tax

30. Conclusions • Theoretical arguments for tax-free saving not robust • Practical arguments still seem strong • Distortions have been significantly reduced • Still some clear improvements available • Maybe not quite as central as it was for Meade? • Focus more on other elements of the tax base • What characteristics is it legitimate to use? • How much complexity is justified?

31. The choice of tax base Stuart Adam