Mirrlees Review - worthy, but incompatible with the real world?

THE LATEST installment of the Institute for Fiscal Studies’ Mirrlees Review makes a lot of sense. After a five-year process, the tome on radical reform of the tax system has been produced.

I confess, I have not read all 523 pages of Tax by Design, released yesterday, or the 1274 pages of its final review, but it will make for enjoyable holiday reading.

But the overall recommendations have a lot going for them. The complexity of the system costs the UK tens of billions of pounds a year, it says. Starting from scratch, a tax system by design would not separate income tax and National Insurance, or have such complexities in VAT, or tax savings in different ways, etc. It will be progressive, neutral and, above all, it will be a system, structured to meet overall spending needs. This means not all taxes need to be progressive, or green, so long as the system as a whole is.

Because of this final point, the headlines focusing on single elements of the proposals (including that on Accountancy Age…) might not be useful to the IFS. Its director, Paul Johnson, hammered home the fact that the reforms must be considered as a whole and as an aspiration to be achieved in a decade or two.

It is a fair criticism to ask whether this is the product of a think-tank that has no need to engage with the real world that politicians must engage with. Johnson did acknowledge that the political realities were such that the reforms could not be brought in piecemeal, but as an evolution. The last chancellor to try such a thing was Nigel Lawson, he said.

The main problem for politicians, of course, is that even the smallest of tax changes can create such winners and losers to the extent that a government could lose an election. Even evolution would, in Sir Humphrey’s words, be courageous.

But there is another element to the political problems that the IFS inadvertently stumbled upon. As part of its proposals to encourage employment in the over-50s, the review suggested bringing National Insurance exemption down to the age of 55, from the over-65s that currently benefit. This simply highlights the main political problem in merging income tax and National Insurance – that is, that elderly people are the main beneficiaries of such a distinction.

It would be unfair to criticise the IFS for this contradiction: the integration of NI and income tax is the IFS’s desired long-term goal and the reformed system as a whole will benefit pensioners in other ways, through taxation of pensions and savings, for example; while the lowering of the age for NI exemption is a short-term micro-policy designed to encourage elderly people to continue working.

But this highlights the fact that the tax system is used to change behaviour. Although this has been criticised in the past, few in the tax profession would criticise research & development tax credits, for example. The tax system can be an important tool in this way.

And the IFS accepts this. It says the hurdle for departing from neutrality – ie, introducing tax reliefs to shape behaviour – should be high and will only be passed through a handful of headline items, such an environmentally harmful activities, ‘sin taxes’, pensions , R&D, educational investments, and childcare.

But this not simply mean sensible government, rather than radical evolutionary reform? Namely, governments that fully review tax changes to see whether a tax change does pass the neutrality test – as the government is currently doing with the patent box, to take one example. The patent box is borderline, Johnson says – again highlighting real problems for politicians even within this ideal system and its hurdles.

Furthermore, many inconsistencies come, perversely, from striving for neutrality. Take the taxation of dividends, for example. In theory, money taken out of a company is subject to broadly the same rate of tax as if taken out as income, when you factor in the corporation tax it has already been subject to. But this leads to a system where some forms of savings – ie, dividends – have a completely separate rate to others.

This is not to criticise a very worthy review. But in the real world that politicians must operate in, inconsistencies are very often either a result of using the tax system to encourage certain types of behaviour or, perversely, striving for consistency. Therefore, even if we had the luxury of starting with a blank sheet – which we don’t – there is a real danger we will end up where we are now.