Means-testing and tax rates on earnings: a contribution to the Mirrlees Review Mike Brewer (IFS) Emmanuel Saez (UC, Berkeley) Andrew Shephard (IFS & UCL) © Institute for Fiscal Studies

“The Mirrlees review: Reforming the Tax System for the 21 st Century” Independent review, run by Mirrlees, with Besley, Blundell, Gammie and Poterba –Commissioned 13 studies, plus discussants. All available on-line. –Editorial volume will distil, and make own recommendations. Published late 2009 (?) Objectives –To bring together international experts in public economics, tax law, political science and tax practice –To identify the characteristics of a good tax system for any open developed economy in the 21st century –To assess how well UK tax system conforms to these ideals –To recommend how it might realistically be reformed in that direction Inspired by the 30 th anniversary of the ‘Meade Report’, The Structure and Reform of Direct Taxation (1978) © Institute for Fiscal Studies

Means-testing and tax rates on earnings Aim –to review developments in optimal income tax, and make recommendations for UK personal tax, tax credits and benefits Outline –Optimal tax theory Top rates of tax & all rates of tax Extensive and intensive responses –Other issues Family vs individual Administering transfers for low-income families –Lessons for the UK –Reform proposals for the UK

Reflections Optimal income tax still not that useful when designing income tax and cash transfers Saez (2002) was key advance by integrating extensive and intensive responses, and making problem tractable (see also Immervol et al (2007), Blundell et al (2009)) But we found ourselves unable to ignore –Dynamic issues (eg response of high-salaried workers to higher METRs) –Family formation (not just “how to tax couples” (Kleven et al, 2009) but also tax and welfare (dis)incentives to be (or to admit to being) in a couple (Anderberg, 2008; Hoynes, 2008) –Fertility responses to child-conditional transfers (Brewer et al, 2008; Laroque and Salanie, 2008; Milligan, 2005) –Administrative/operational issues So we learned lessons from optimal tax theory and positive economic analysis, then imposed our own value judgements to suggest reforms. We mostly ignored the UK political context. © Institute for Fiscal Studies

Optimal income tax: intensive responses Use Saez (2001, 2002) Intensive-only model: tax rate elasticity to net-of- tax rate density of earners fraction with higher earnings social value of consumption above z

Optimal income tax: intensive responses, simple simulation for UK © Institute for Fiscal Studies Earnings estimated from FRS and SPI; METRs estimated from TAXBEN

Optimal income tax : intensive responses Use Saez (2001, 2002) Intensive-only model: Revenue-maximising top rate of tax: –If z is Pareto distributed above zbar, then a is constant –BSS estimated a =1.6; Brewer and Browne (2009) estimated a=1.8

Estimating the Pareto parameter (a) for top incomes in UK © Institute for Fiscal Studies Source: Brewer and Browne, 2009 based on Survey of Personal Incomes

Optimal income tax : intensive responses Use Saez (2001, 2002) Intensive-only model: Revenue-maximising top rate of tax: –If z is Pareto distributed above zbar, then a is constant –BSS estimated a =1.6; Brewer and Browne (2009) estimated a=1.8 –What about e ? No evidence from UK, so did naïve analysis based on income shares, and changes in average METRs…

Income shares and top rates in UK, © Institute for Fiscal Studies Source: BSS (2008) based on income shares from Atkinson (2008). METRs estimated from TAXBEN

Optimal income tax : intensive responses Use Saez (2001, 2002) Intensive-only model: Revenue-maximising top rate of tax: –If z is Pareto distributed above zbar, then a is constant –BSS estimated a =1.6; Brewer and Browne (2009) estimated a=1.8 –What about e ? No evidence from UK, so did naïve analysis based on income shares, and changes in average METRs… giving e=0.46 (0.13)

Optimal income tax : intensive responses Use Saez (2001, 2002) Intensive-only model: Revenue-maximising top rate of tax: –If z is Pareto distributed above zbar, then a is constant –BSS estimated a =1.6; Brewer and Browne (2009) estimated a=1.8 –What about e ? No evidence from UK, so did naïve analysis based on income shares, and changes in average METRs… giving e=0.46 (0.13) –Overall, BSS suggested revenue-maximising rate of 56.6%, and BB suggested 54.7% –At time of writing BSS, top income tax rate was 40% (47.7% on earned), but UK government has just proposed new top rate of 50% and rise in payroll tax! –All depends on e; Government argues has closed large loophole

© Institute for Fiscal Studies Revenue raised by different income tax rates above £150,000 (includes effect on NI and indirect taxes) Source: Brewer and Browne, 2009

Optimal income tax: extensive responses But we can’t ignore extensive responses, especially for lone parents and mothers in couples Evidence –Reviewed in Meghir and Phillips, (2008) –Saez (2002): The more important are extensive elasticities, the lower should marginal rates be for low earners –Adam (2005): METRs for low-earning lone parents in UK above Laffer bound –IKKS (2008): earned income tax credits (negative marginal rates for low earners) more likely to be optimal for countries with dispersed wage distribution, like UK Participation responses can include migration, participation in (in)formal economy

The family and the tax system Individual or joint? –Efficiency: individual-level tax (or, even, lower METRs for second earners/women) –Equity: family-level tax if partners share resources –Couple penalties? (Anderberg, 2008) –Hard to say much in optimal income tax model Kleven et al (2008): optimal to have higher tax rates on second earners with poor partners than those with rich partners, like UK. Leads to “Couple penalties” But assumes everyone lives in a couple forever Many transfers conditional on children (“tagging”) –Equity: higher transfers for families with children –Efficiency: lower MTRs for (some?) parents –Fertility response ??

How many lone parents in the UK? © Institute for Fiscal Studies Source: Brewer et al (2009) based on official estimates and admin data

Administering transfers for low-income households BSS argued that –Transfers should be predictable, impose low compliance costs on recipients and have high take-up –Little point designing transfer system for poor that does not reflect current circumstances UK system fails here (tax credits, Housing Benefit), but recent UK experience and international examples suggest no easy solutions

The tax and transfer system and work incentives in the UK Rest of the paper assesses the UK tax and transfer system and its impact on incentives Will show some pictures, then outline our proposals Will not discuss “conditionality” (ie what people have to do in order to receive welfare benefits) © Institute for Fiscal Studies

Budget constraint, lone parent, © Institute for Fiscal Studies Source: BSS 2008 based on TAXBEN tax system. Welfare benefits have 100% METR Rent subsidy makes huge difference… At 16 hours/wk, lose entitlement to welfare but gain entitlement to tax credits End of tax credit withdrawal

METRs, lone parents, © Institute for Fiscal Studies Source: BSS 2008 based on TAXBEN tax system. Welfare benefits have 100% METR Rent subsidy makes huge difference… End of tax credit withdrawal At 16 hours/wk, lose entitlement to welfare but gain entitlement to tax credits

Participation tax rates, lone parents, © Institute for Fiscal Studies Source: BSS 2008 based on TAXBEN tax system. Welfare benefits have 100% METR Rent subsidy makes huge difference… At 16 hours/wk, lose entitlement to welfare but gain entitlement to tax credits End of tax credit withdrawal

METRs, couples, © Institute for Fiscal Studies Source: BSS 2008 based on TAXBEN tax system. METRs higher for 1 st earners if have children METRs higher for 2 nd earners if have children From tax credit taper

PTRs, couples, © Institute for Fiscal Studies Source: BSS 2008 based on TAXBEN tax system. PTRs higher for 1 st earners if have children P TRs higher for 2 nd earners if have children

Main defects in the UK tax-transfer system… Participation tax rates at the bottom very high: –If on welfare, METR is 100% below 16 hours METR over 80% for low-income working families because of phasing- out of WTC, IT, NI, employer NI, VAT (70% if ignore employer taxes and VAT) –High METRs/PTRs focused on those with high responsiveness! Housing benefit has very steep withdrawal, and big administrative problems Tax credit administration less efficient than PAYE –Tax credits adjust slowly and unpredictably to changes –Absurd that transfer system for poor leads to over-payments (=debt) even if families comply fully Also concluded that –Participation responses important, hours responses almost irrelevant, but sizable response of taxable income amongst very rich. But not clear what is taxable income elasticity of middle- to high-income individuals –Income tax should stay individual

…lead to fairly obvious short-run proposals Higher disregards in all welfare benefits New disregard in tax credits for second earners Higher working tax credit Lower taper in tax credits All would cost money, and extend the number on tax credit withdrawal. None directly benefit those on lowest incomes who are not working © Institute for Fiscal Studies

Longer-term, more dramatic changes Propose a new Integrated Family Support programme –Hint: look at the initials… Key features –Unifies welfare benefits and tax credits for low-income families –IFS disregard aligned with income tax personal allowance –Maximum IFS entitlement paid direct to families, and IFS withdrawal operated by employers (ensures IFS is responsive) Problems –Hugely more generous to low-income families, hugely extends number on some sort of taper (on top of income tax) –HB still problematic: probably requires a change in housing policy –No elegant system for couples –Considerable amount of “churn” Attempt simple behavioural analysis by assuming families respond to changes in METRs and PTRs: a revenue-neutral reform is strongly redistributive, but slightly reduces total earnings (see BSS for details) © Institute for Fiscal Studies

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References Adam, S., (2005), “Measuring the marginal efficiency cost of redistribution in the UK", IFS WP 05/14 Anderberg, D. (forthcoming), “Tax Credits, Income Support and Partnership Decisions”, International Tax and Public Finance Blundell, R., Brewer, M., Haan, P. & Shephard, A., (2009), "Optimal Income Taxation of Lone Mothers: An Empirical Comparison of the UK and Germany", Economic Journal, 119, pp F101-F121. Brewer, M., Saez, E. & Shephard, A. (2008), “Means-testing and tax rates on earnings”, forthcoming in Dimensions of Tax Design, OUP. Draft available at Brewer, M. & Browne, J. (2009), “Can more revenue be raised by increasing income tax rates for the very rich?”, IFS Briefing Notes 84, Brewer, M., Muriel, Al. Phillips, D. & Sibieta, L. (2009), Poverty and Inequality in the UK: 2009, IFS Commentary 109, Brewer, M., Ratcliffe, A. & Smith, S., (2008), “Does welfare reform affect fertility? Evidence from the UK”, IFS WP 08/09 Hoynes, H. (2008), “Means-testing and tax rates on earnings: a commentary”, forthcoming in Dimensions of Tax Design, OUP. Draft available at Immervoll, H., Kleven, H., Kreiner, C. & Saez, E., (2007), “Welfare Reform in European Countries: Microsimulation Analysis”, Economic Journal, 117, pp 1-44 Laroque, G. & Salanie, B., (2008), “Does Fertility Respond to Financial Incentives?” CESifo WP 2339 Kleven, H., Kreiner, C. & Saez, E., (2009), "The Optimal Income Taxation of Couples”, Econometrica 77, 2009, pp Meghir, C. and Phillips, D. (2008), “Labour supply and taxes”, forthcoming in Dimensions of Tax Design, OUP. Draft available at Milligan, K., (2005). “Subsidizing the Stork: New Evidence on Tax Incentives and Fertility.” Review of Economics and Statistics, 87(3), pp Saez, E., (2001), “Using Elasticities to Derive Optimal Income Tax Rates." Review of Economic Studies, 68, pp Saez, E., (2002), “Optimal Income Transfer programmes: Intensive Versus Extensive Labour Supply Responses." Quarterly Journal of Economics, 117(3), pp Saez, E., Slemrod, J. and Giertz, S. (2009), "The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review“ NBER WP and forthcoming Journal of Economic Literature © Institute for Fiscal Studies