21 September 2017

Inequality, Tax Reform and the Labour Market

Speaker: Professor Sir Richard Blundell, Institute for Fiscal Studies

Venue: Ashurst, Broadwalk House, 5 Appold Street, LONDON, EC2! 2DA

Summary of SBE masterclass on inequality, tax reform and the labour market by Sir Richard Blundell on 21 September 2017

Inequality began increasing in the US and the UK in the first half of the 1980s, long before it became a headline topic in the mid-2000s.

This observation opened the September 2017 SBE Master Class by Sir Richard Blundell titled “Inequality, tax reform and the labour market”.

Sir Richard’s presentation can be summarised under three heading:

  1. Some key features associated with increasing inequality
  2. Advances in applied microeconomic research into the tax and benefits system with particular reference to the Mirrlees Review and
  3. Some key findings
Main features associated with increasing inequality

Three factors have been key to changing income distribution and increasing inequality in the US and the UK. One is slow or negative real income growth for lower educated men. A second is increasing income of women. A third is faster income growth for the top one per cent of earners.

For men, income differentials started increasing in the US in the early 1980s when the income of those who did not complete college began to fall in real terms. Only those who completed college saw real incomes rise.

The experience of the US and the UK differed. Between 1979 and 2015 the real wages of UK males earning below the median income did not fall but rose more slowly than for those above the median.

Lower educated white US males were significantly affected. By the mid-1990s, the income of white, male, high school drop-outs had fallen to a level no different from that of similarly educated blacks and Hispanics. This challenged and continues to challenge what some may consider preconceived positions in society.

For women, the pattern of income growth differed. The median income of US women increased between 1979 and 2015 regardless of education. However, as with men, those completing college saw their incomes grow more quickly.

The change in income levels between men and women could also question preconceived notions of status of males in society. Assortative partnering between men and women could then also be contributing to income inequality between families.

Increasing income growth by the highest one percent of earners also played a significant role increasing inequality. In the US, the income share of the top one percent has increased from a low of around 8-9% in the early 1980s to around 20-24% (depending on whether capital gains are included) in 2012. This is the highest level since the mid-1920s. In the UK, the situation is not as dramatic. The income share of the top 1% has risen from around 5% in 1961 to around 8% in 2014.

Advances in applied microeconomic research and the Mirrlees Review

If a country wishes to reduce income inequality, tax and benefit systems can play an important role.

The UK shows how effective this can be. In the twenty years between 1994-95 and 2014-15 the average growth in pay before tax of a household at the 15th percentile was about 0.2%. After tax and benefits this increased to around 1.2%. – a rate of growth similar to all incomes up to the 95th percentile.

The extent of tax adjustments and benefit payments in any country places a large burden on public finances. This supports the case for periodic review of the tax and benefit system. Further, the increase in inequality since the 1980s suggests a comprehensive review of tax reform is required. Suggestions for a redesign were detailed in the Mirrlees Review of 2011. Sir Richard was member of the review team.

The Mirrlees Review was partly modelled on the report of the Meade Committee which, more than thirty years earlier in 1978, argued that many aspects of the tax system had been developed in an ad-hoc fashion. Although various aspects of the Meade Commission had been incorporated into the UK tax system, strategic design was not followed. Piecemeal reforms were put in place. The Mirrlees Review aimed to detail how strategic designs could be incorporated into the tax and benefits system of any open developed country. It argued that advances in theoretical and empirical understanding of the way in which tax and benefit systems influence people’s behaviour should be incorporated into tax design.

An important aspect of the Mirrlees review was that it advocated making use of both advances in the data revolution of the past two decades and in applied microeconomic research techniques.

For example, tax and welfare records and administrative panel data are now available. This allows researchers to measure incentives correctly and model benefit take-up accurately. Further, linking surveys and field experiments allows a powerful and persuasive tool for practical policy reform.

The aim of research into taxes and benefits should be to build an empirically based agenda for tax reform to address inequality and enhance earnings. Sir Richard proposed five steps for effective research based on the insights gained from the Mirrlees Review.

  1. Identify the key margins of adjustment to reform. For example, workforce participation by men of working age does not change across countries despite different levels of taxation. Consequently, arguments about the disincentive effect of higher taxation may not be accurate.
  2. Measure the effectiveness of incentives. For example, understanding precisely how tax and benefit polices interact helps provide a better understanding of the incentives people face.
  3. Recognise the importance of information and complexity. For example, thresholds in incomes where taxes are increased and benefits decrease can produce bunching at particular income levels.
  4. Get evidence on the size of responses by people to tax reforms. For example, randomised control trials can be used to test the effectiveness of some policies.
  5. Figure out the implications for policy design.
Implications for policy design

Among others comments, Sir Richard made the following observations for tax and benefit reform.

Getting people into employment or returning to employment is important but not enough. The wages of the low skilled are already low and have not grown over the past few decades. There is no evidence this will change. As a result, Sir Richard argues the minimum wage is probably a good thing. However, it is also important that the complexity of the tax and benefit system at lower incomes is reduced. Sir Richard also questioned whether universal basic income would be effective as its costs would be much higher than a strategically designed tax and benefits system.

Sir Richard argued the minimum wage is probably a good thing and should go hand in hand with increasing generosity of the working tax credit. He also noted those with low skills find it difficult to get employment. Several times Sir Richard noted the increasing income growth of those with higher levels of education. As a result, investment in skills and education, especially in early years, is crucial.

For upper income earners, it is important that different types of income are taxed in the same way. There is evidence that a significant part of tax responses upper earners has come largely from avoidance. Marginal taxes on dividends, capital gains and income should be aligned to make the tax system more effective.

Ian Bright
04 October 2017