The tax and welfare “mess”
Fri 21 Jan 2011 by Infometrics Ltd.

The tax and welfare "mess"

Last November the findings of a wide-ranging review of the UK tax system “the Mirrlees Review” were released. The review provided an up-to-date report card on the nightmare that is the UK tax and welfare system (providing a salutary lesson on what not to do) and sought input from academic economists renowned internationally for their theoretical and empirical work in the field of tax and welfare. The chair of the review was Sir James Mirrlees, winner of a Nobel Prize in economics.

An important point made in the Mirrlees Review was that tax and welfare benefits must be considered as one "policy” individual policies in each of these areas interact with each other. It is the combination that determines the degree of income redistribution and the consequent behaviour of people which may constrain the performance of the economy. This is a message our own government needs to take on board. Both the 2009 Tax Working Group and the Welfare Working Group due to report next month were asked to investigate individual parts of the tax and benefit system, but no one has been asked to review the tax and welfare system as a whole.

The argument that tax and welfare policies must be considered together was important for the Mirrlees recommendation that the UK’s VAT system (equivalent to our GST) cease to have exemptions for necessities. Mirrlees made the point that redistribution is better done through the income tax and benefit system because VAT exemptions are administratively costly and lead to distortions in spending (these costs are unnecessary if the sole point is to redistribute to those on low incomes). Those calling for exemptions to GST here would do well to take note their goal is achievable, but GST isn’t the way to do it.

Our Working for Families policy is a close cousin to the UK Working Tax Credit and, excepting   NZ Super, we follow a similar approach to the UK in our benefit system. So the Review’s findings in this area were particularly sobering:

"Despite improvements for some groups in recent years, the current system of income taxes and welfare benefits creates serious disincentives to work for many with relatively low potential earning power. The benefit system in particular is far too complex."

Elsewhere in the report the UK tax and benefit system is described as a "mess".

Just as in the UK, not only does our current tax and benefit system suffer from a lack of transparency and high administrative and compliance costs, it can create incredibly high barriers for those considering paid work.

Mirrlees outlined that an ideal system “the holy grail of integrated design” is one which fully integrates tax and welfare benefits. He pointed out that a flat income tax schedule combined with a universal transfer paid to every citizen a "negative income tax" or "social dividend" (sometimes called a "universal basic income”) is such as system.

"The defining feature of such proposals is that there is no distinction between income taxation and benefit withdrawal: instead there is just a single schedule for how payments vary with income, whether that means that support for low incomes is achieved through tax refunds (as in the negative income tax) or that benefits are paid to everyone regardless of income (as in the social dividend)."

Thus for example, if the universal transfer was $10,000 and the tax rate was 25 percent, the individual’s break-even point would be at earnings of $40,000 (here the tax they paid $10,000 would be the same as the universal benefit they received so their exchange with the government would be exactly zero). Any income earned would pay tax at the rate of 25 cents in the dollar, thus making part time earnings and low paid work financially rewarding even for those who, for whatever reason, largely relied on the universal transfer. It is easy to see how such a system improves the incentives to work relative to the system we currently have (and is a vast improvement on a "hit with a stick" approach to moving long term beneficiaries into work).

Mirrlees went short of recommending such a scheme, pointing to the practical difficulties that would be encountered in trying to move so far from current practice and the fiscal cost. However, flat income tax systems have been introduced into a number of Eastern European countries in recent decades, suggesting that the policy is feasible in a practical sense. What is needed, however, is the political will to reform. Political inertia, and little else, is what stands in the way of the holy grail.

The papers prepared as part of the Mirrlees Review, and the final report, can be found here.

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