Designing Taxes for Raising Revenue Efficiently and

Equitably

ByBy

James A MirrleesJames A Mirrlees

Designing Taxes

Taxes are introduced to obtain government Taxes are introduced to obtain government revenue, but it matters who pays. People with revenue, but it matters who pays. People with higher income and wealth should pay more. higher income and wealth should pay more.

Taxes also affect what people do. They affect the Taxes also affect what people do. They affect the amount and quality of labour people supply, they amount and quality of labour people supply, they affect the supply of capital, and they affect affect the supply of capital, and they affect patterns of consumption. The impact of a tax patterns of consumption. The impact of a tax change on revenue is therefore not simple to change on revenue is therefore not simple to estimate.estimate.

The tax system should be designed to raise the The tax system should be designed to raise the desired revenue in such a way as to reduce the desired revenue in such a way as to reduce the welfare of consumers as little as possible. welfare of consumers as little as possible.

Therefore you need to assess the relative Therefore you need to assess the relative importance of welfare gains and losses of people importance of welfare gains and losses of people with different incomes and family circumstances. with different incomes and family circumstances.

But a surprising number of recommendations can But a surprising number of recommendations can be made without strong commitment to a be made without strong commitment to a particular way of assessing the welfare effects.particular way of assessing the welfare effects.

Equivalence of Tax Systems

Apparently different tax systems can be effectively Apparently different tax systems can be effectively the same. the same.

Ignore for the moment movement of people in and Ignore for the moment movement of people in and out of the economy. Then a tax at a uniform rate on out of the economy. Then a tax at a uniform rate on all goods and services sold to consumers has the all goods and services sold to consumers has the same effect as a tax on earnings at a uniform rate. same effect as a tax on earnings at a uniform rate. The only difference is the level of prices and wages. The only difference is the level of prices and wages.

Therefore, to a first approximation, any debate Therefore, to a first approximation, any debate between an (earned) income tax and a sales tax is between an (earned) income tax and a sales tax is empty.empty.

Minor Differences

There are some differences in the real world.There are some differences in the real world. Administrative costs are different. Probably Administrative costs are different. Probably

smaller for the income tax.smaller for the income tax. Visitors pay the sales tax, not the income tax. Visitors pay the sales tax, not the income tax.

Travellers abroad pay the income tax, not the sales Travellers abroad pay the income tax, not the sales tax on consumption while away.tax on consumption while away.

Evasion and avoidance are different.Evasion and avoidance are different.

Major Differences

The income tax need not be uniform: The income tax need not be uniform: different individuals generally pay a different individuals generally pay a different proportion of income in tax.different proportion of income in tax.

Commodity taxes can differentiate between Commodity taxes can differentiate between consumption of different goods and consumption of different goods and services.services.

Both of these ways of differentiating can be Both of these ways of differentiating can be valuable.valuable.

Income Tax Schedules

Two aspects of the tax schedule matter to the Two aspects of the tax schedule matter to the consumer: the total tax paid, and the marginal tax rate, consumer: the total tax paid, and the marginal tax rate, the proportion of extra income that would be paid in the proportion of extra income that would be paid in tax.tax.

Tax paid reduces welfare, and increases labour supply Tax paid reduces welfare, and increases labour supply (except that it encourages emigration).(except that it encourages emigration).

A higher marginal tax rate reduces labour supply; thus A higher marginal tax rate reduces labour supply; thus reducing tax revenue, and increases tax paid by people reducing tax revenue, and increases tax paid by people with yet higher incomes.with yet higher incomes.

An optimal tax schedule takes account of both these An optimal tax schedule takes account of both these effects.effects.

Optimal schedules have been calculated under Optimal schedules have been calculated under various assumptions. In almost all cases, marginal tax various assumptions. In almost all cases, marginal tax rates are found to be constant or falling for most rates are found to be constant or falling for most incomes. incomes.

For the highest incomes, marginal tax rates do not For the highest incomes, marginal tax rates do not depend much on the total revenue to be raised, or on depend much on the total revenue to be raised, or on judgments about the relative welfare of rich and poor. judgments about the relative welfare of rich and poor.

Optimal marginal tax rates vary from 40% to 60%. Optimal marginal tax rates vary from 40% to 60%. These are rates for These are rates for allall taxes that vary with income, taxes that vary with income, and should be compared with the total of taxes on and should be compared with the total of taxes on income and expenditures in real economies.income and expenditures in real economies.

Family Size It has proved difficult to work out how taxation It has proved difficult to work out how taxation

should depend on the family structure, such as the should depend on the family structure, such as the number of dependents, and long-term relationships number of dependents, and long-term relationships between earners. between earners.

Broadly, one would expect a good economic Broadly, one would expect a good economic system to subsidize people whose productivity is system to subsidize people whose productivity is small – and children are the leading example.small – and children are the leading example.

Therefore it may be appropriate to include children Therefore it may be appropriate to include children in a formula for adjusted family size, and base tax in a formula for adjusted family size, and base tax on income divided by adjusted family size. on income divided by adjusted family size.

Surely it is also appropriate to allow income-Surely it is also appropriate to allow income-sharing among adults, and base tax on income sharing among adults, and base tax on income after sharing. This generalizes allowing deduction after sharing. This generalizes allowing deduction of payments to charity; and implies a consistent of payments to charity; and implies a consistent treatment of gifts and inheritance.treatment of gifts and inheritance.

Commodity Taxes

How much of the taxation should be done by How much of the taxation should be done by taxing commodities? That depends on whether taxing commodities? That depends on whether some commodities should be taxed more than some commodities should be taxed more than others.others.

Some consumption is, or is believed to be, Some consumption is, or is believed to be, undesirably large, either because consumers do undesirably large, either because consumers do not appreciate the harm they do to themselves, or not appreciate the harm they do to themselves, or because it harms others. Taxation of these because it harms others. Taxation of these commodities does good, and also raises revenue.commodities does good, and also raises revenue.

Tobacco, and, more doubtfully, alcohol and Tobacco, and, more doubtfully, alcohol and gambling are examples of the first. Taxes to gambling are examples of the first. Taxes to reduce road use (by making petrol expensive), and reduce road use (by making petrol expensive), and taxes on the use of fossil fuels, to reduce global taxes on the use of fossil fuels, to reduce global warming, are examples of the second. In total warming, are examples of the second. In total these can provide a substantial part of a these can provide a substantial part of a government’s revenues. government’s revenues.

Apart from these considerations, producer goods Apart from these considerations, producer goods should not be taxed. Taxing goods sold by one should not be taxed. Taxing goods sold by one producer (or importer) to another creates producer (or importer) to another creates inefficiency. inefficiency.

There are reasons for taxing some consumer goods There are reasons for taxing some consumer goods more than others. The main one is that goods that more than others. The main one is that goods that use more time in consumption should, ideally, be use more time in consumption should, ideally, be taxed more heavily; or equivalently, time-saving taxed more heavily; or equivalently, time-saving consumption could be subsidized. It encourages consumption could be subsidized. It encourages labour supply, and increases general tax revenue.labour supply, and increases general tax revenue.

Housing

Many countries have substantial taxation of Many countries have substantial taxation of housing. Many also provide some subsidised housing. Many also provide some subsidised housing. Is this justified?housing. Is this justified?

It is hard to believe that housing provides many It is hard to believe that housing provides many externalities, or involves consumption more externalities, or involves consumption more meritorious than people realize. No doubt meritorious than people realize. No doubt consumption of housing requires time, not all of it in consumption of housing requires time, not all of it in competition with labour. But time-use per dollar is competition with labour. But time-use per dollar is not particularly high. It is difficult to see a rationale not particularly high. It is difficult to see a rationale for the relatively high taxation of housing that is a for the relatively high taxation of housing that is a normal feature of tax systems.normal feature of tax systems.

Saving and Taxes

These principles can be used to see whether These principles can be used to see whether income from savings should be taxed. If you save income from savings should be taxed. If you save now in order to consume more in future, and pay now in order to consume more in future, and pay tax on the savings, that is an extra tax on future tax on the savings, that is an extra tax on future consumption. If that future consumption is in consumption. If that future consumption is in retirement, it does not use time that might have retirement, it does not use time that might have been used to supply labour. So it would be better been used to supply labour. So it would be better to subsidize it.to subsidize it.

This is a rationale for not taxing savings that are to This is a rationale for not taxing savings that are to be used for retirement.be used for retirement.

But for the rich, much of the return to capital, though it But for the rich, much of the return to capital, though it appears as income from capital, is in fact a return to labour, appears as income from capital, is in fact a return to labour, and should be taxed as such; or it is the result of good luck, and should be taxed as such; or it is the result of good luck, and might as well be taxed without any adverse incentive and might as well be taxed without any adverse incentive effects. effects.

Perhaps a good form of taxation would be one on excess Perhaps a good form of taxation would be one on excess returns, that is on capital income (including capital gains) returns, that is on capital income (including capital gains) less an ordinary return, measured by some suitable base less an ordinary return, measured by some suitable base rate of interest. rate of interest.

Mobility of capital should be considered, but some loss of Mobility of capital should be considered, but some loss of capital can be accepted for the sake of the tax revenue capital can be accepted for the sake of the tax revenue raised.raised.