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 21st 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 30th 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
fraction with higher earnings
social value of
tax rate
consumption above z
• Use Saez (2001, 2002)
T ' ( z)
1 1 H ( z)
• Intensive-only model:
 
 (1  G( z))
1 T ' ( z)
e
elasticity
to net-oftax rate
zh( z)
density of
earners
Optimal income tax: intensive responses, simple
simulation for UK
METR
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
V=log(u), e=0.50
V=log(u), e=0.25
£50
£500
£5,000
Annual income
£50,000
Earnings estimated from FRS and SPI; METRs estimated from TAXBEN
© Institute for Fiscal Studies
£500,000
Optimal income tax :
intensive responses
• Use Saez (2001, 2002)
T ' ( z)
1 1 H ( z)
• Intensive-only model:
 
 (1  G( z))
1 T ' ( z)
e
zh( z)
• Revenue-maximising top rate of tax:
T ' ( z | z  z) 
E( z | z  z)
1
;a 
1 a  e
E( z | z  z)  z
– 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
a=E(z|z>zbar)/(z-E(z|z>zbar))
2.20
a
2.10
E ( z | z  z)
E ( z | z  z)  z
2.00
1.90
1.80
1.70
1.60
1.50
£0
£100,000
£200,000 £300,000
zbar
£400,000
Source: Brewer and Browne, 2009 based on Survey of Personal Incomes 2005-6
© Institute for Fiscal Studies
£500,000
Optimal income tax :
intensive responses
• Use Saez (2001, 2002)
T ' ( z)
1 1 H ( z)
• Intensive-only model:
 
 (1  G( z))
1 T ' ( z)
e
zh( z)
• Revenue-maximising top rate of tax:
T ' ( z | z  z) 
E( z | z  z)
1
;a 
1 a  e
E( z | z  z)  z
– 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, 1962-2003
100%
16%
90%
14%
80%
Income share
12%
70%
10%
50%
8%
40%
6%
METR
60%
30%
20%
10%
0%
1962
METR, top 1%
METR, top 5-1%
4%
Share, top 1%
Share, top 5-1%
2%
0%
1972
1982
Source: BSS (2008) based on income shares from Atkinson (2008).
METRs estimated from TAXBEN
© Institute for Fiscal Studies
1992
2002
Optimal income tax :
intensive responses
• Use Saez (2001, 2002)
T ' ( z)
1 1 H ( z)
• Intensive-only model:
 
 (1  G( z))
1 T ' ( z)
e
zh( z)
• Revenue-maximising top rate of tax:
T ' ( z | z  z) 
E( z | z  z)
1
;a 
1 a  e
E( z | z  z)  z
– 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)
T ' ( z)
1 1 H ( z)
• Intensive-only model:
 
 (1  G( z))
1 T ' ( z)
e
zh( z)
• Revenue-maximising top rate of tax:
T ' ( z | z  z) 
E( z | z  z)
1
;a 
1 a  e
E( z | z  z)  z
– 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
Revenue raised by different income tax rates above
£150,000 (includes effect on NI and indirect taxes)
Change in tax revenues, £ million
£4,000
BSS behavioural response
£3,000
No behavioural response
£2,000
HMT behavioural response
£1,000
£0
35%
40%
45%
50%
-£1,000
-£2,000
-£3,000
-£4,000
Source: Brewer and Browne, 2009
© Institute for Fiscal Studies
Income tax rate above £150,000
55%
60%
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?
Number (millions)
2.5
2.0
1.5
1.0
Lone parents receiving income-related
child support
0.5
All lone parent families
0.0
10/1995
07/1998
04/2001
01/2004
Source: Brewer et al (2009) based on official estimates and admin data
© Institute for Fiscal Studies
10/2006
07/2009
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
Annual net income
Budget constraint, lone parent, 2008-9
£50,000
£45,000
£40,000
£35,000
£30,000
£25,000
£20,000
£15,000
£10,000
£5,000
£0
Welfare
benefits have
100% METR
Rent subsidy
makes huge
difference…
At 16 hours/wk, lose
entitlement to welfare but gain
entitlement to tax credits
£0
£10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000
Annual earnings including employer cost
Source: BSS 2008 based on TAXBEN. 2008-9 tax system.
© Institute for Fiscal Studies
End of tax
credit
withdrawal
METRs, lone parents, 2008-9
Welfare
benefits have
100% METR
Rent subsidy
makes huge
difference…
£50,000
£45,000
End of tax
credit
withdrawal
Annual net income
£40,000
£35,000
120%
100%
80%
£30,000
£25,000
60%
£20,000
40%
£15,000
METR, HB
£10,000
At 16 hours/wk, lose
entitlement to welfare but gain
entitlement to tax credits
£5,000
£0
£0
20%
0%
£10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000
Annual earnings including employer cost
Source: BSS 2008 based on TAXBEN. 2008-9 tax system.
© Institute for Fiscal Studies
METR, no HB
Participation tax rates, lone parents, 2008-9
Welfare
benefits have
100% METR
Rent subsidy
makes huge
difference…
£50,000
£45,000
End of tax
credit
withdrawal
Annual net income
£40,000
100%
80%
£35,000
60%
£30,000
40%
£25,000
20%
£20,000
£15,000
PTR, no HB
£10,000
PTR, HB
£5,000
£0
£0
At 16 hours/wk, lose
entitlement to welfare but gain
£20,000
£30,000 £40,000
entitlement to tax credits
-20%
-40%
£10,000
£50,000 £60,000 £70,000
Annual earnings including employer cost
Source: BSS 2008 based on TAXBEN. 2008-9 tax system.
© Institute for Fiscal Studies
0%
METRs, couples, 2008-9
100%
100%
90%
80%
With kids, partner not working
With kids, partner working
Without kids, partner not working
Without kids, partner working
70%
METRs higher for 1st
earners if have children
60%
90%
80%
70%
60%
50%
50%
40%
40%
30%
30%
20%
10%
From tax credit
taper
0%
£0
20%
10%
0%
£10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000
Annual earnings including employer cost
Source: BSS 2008 based on TAXBEN. 2008-9 tax system.
© Institute for Fiscal Studies
METRs higher
for 2nd earners if
have children
PTRs, couples, 2008-9
100%
100%
90%
80%
With kids, partner not working
With kids, partner working
Without kids, partner not working
Without kids, partner working
PTRs higher for 1st earners
if have children
70%
60%
90%
80%
70%
60%
50%
50%
40%
40%
30%
30%
20%
PTRs higher for
2nd earners if
10%
have children
0%
£0
10%
0%
£10,000 £20,000 £30,000 £40,000 £50,000 £60,000 £70,000
Annual earnings including employer cost
Source: BSS 2008 based on TAXBEN. 2008-9 tax system.
© Institute for Fiscal Studies
20%
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 phasingout 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
End
References
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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 http://www.ifs.org.uk/mirrleesreview/press_docs/rates.pdf
Brewer, M. & Browne, J. (2009), “Can more revenue be raised by increasing income tax rates for the very rich?”, IFS Briefing Notes 84,
http://www.ifs.org.uk/bns/bn84.pdf
Brewer, M., Muriel, Al. Phillips, D. & Sibieta, L. (2009), Poverty and Inequality in the UK: 2009, IFS Commentary 109,
http://www.ifs.org.uk/comms/c109.pdf
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
http://www.ifs.org.uk/mirrleesreview/press_docs/hoynes.pdf
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. 537-560
Meghir, C. and Phillips, D. (2008), “Labour supply and taxes”, forthcoming in Dimensions of Tax Design, OUP. Draft available at
http://www.ifs.org.uk/mirrleesreview/reports/labour_supply.pdf
Milligan, K., (2005). “Subsidizing the Stork: New Evidence on Tax Incentives and Fertility.” Review of Economics and Statistics, 87(3), pp 539-555
Saez, E., (2001), “Using Elasticities to Derive Optimal Income Tax Rates." Review of Economic Studies, 68, pp 205-229
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117(3), pp1039-1073
Saez, E., Slemrod, J. and Giertz, S. (2009), "The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review“ NBER WP 15012
and forthcoming Journal of Economic Literature
© Institute for Fiscal Studies