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The Political Economy of Taxation: Issues and Implications for the UK
Jim Alt Ian Preston Luke Sibieta

The Political Economy of Taxation
• A good tax system has to be politically sustainable within the institutions of government • Part of specifying the constraint set but more than this
– – – – Distributional issues central so not just an issue of good advice Administration is part of this but not just an issue of collectability Considering elections and information is critical Tax policy should be credible -- especially in a dynamic setting

• Political economy makes us think more rigorously about constraints on policy
– what recommendations are feasible and sustainable

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How institutional reform might be an instrument of tax policy reform
• Hypothetically
– Decentralization – Transparency, accountability, information quality and availability – Contractual arrangements

• A real example
– The inflation tax since 1992

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How do we understand these issues without political economy?
Three tax policy puzzles:
• The poll tax • (No) VAT on children’s clothing • Coexistence of National Insurance and Personal Income Tax Not new to say “it’s political”, we’re just trying to be more systematic in order to draw lessons
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Determinants of Tax Structure
• How we think about tax structure …
• • • • • Scale Composition Centralization Administration or compliance Incidence or redistribution

• … as determined by
– Institutions – Political forces
• Public opinion • Lobbying • Elections and voting

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How the Conflict over Taxes Plays Out:

Three Stylized Intellectual Traditions
• (1) Tax policy an issue of “class” conflict
– Different income groups the main cleavage – Government a neutral or benevolent agent; everything could be Pareto-efficient – Electoral model central: government by referendum – Romer, Roberts, Meltzer-Richard are in this tradition

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Three Traditions (cont’d)
• (2) The public choice view
– Rent-seeking (Buchanan)
• Government misappropriates revenues • May not be Pareto-efficient • Peacock, Rowley, IEA, CPS are British examples

– Competing lobbies (Olson)
• Tax policy resolved by people with different interests trying to influence allocation • Elections irrelevant except as a source of contributions

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Three Traditions (cont’d)
• (3) Agency and accountability
– – – – Conflict of interest between politician and citizen Ex post control via institutional features Barro – elections and partial control of moral hazard PRT – rents, public goods, and redistribution – a big step forward, different view of tradeoffs – But not directly applied to issues of taxation

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Intellectual Developments in the Years Since Meade
• Theory dominated by the Meltzer-Richard model
– – – – – Exemplar of the “class conflict” tradition Referendum voting Right-skewed income distribution Labor-leisure tradeoff Proportional tax, lump-sum transfer

• Two famous implications
– Median voter prefers redistribution – More inequality means more redistribution
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Whatever Happened to the MeltzerRichard Model?
• Flurry of theory looking for equilibrium linear tax schedule
– Foley, Kramer, Snyder – Assumed tax structure not helpful for explaining instrument choice or mix, which was important in policy debate and reform

• Generally found little empirical support
– More inequality meant less redistribution – Not so clear that government was growing – Later: some effects through turnout
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Patching up Meltzer-Richard: Attempts to Explain Patterns
• Redistribution versus insurance in welfare states
– Moene-Wallerstein

• Proportional representation and legislative bargaining changes everything
– Austen-Smith, Iversen and Soskice

• Divided societies
– Religion (Scheve), Moral values (Roemer, Benabou) – Race (Alesina & Glaeser) … – … and jobs (Austen-Smith & Wallerstein)

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Further Explanations: Voters’ Information, Interest Groups
• Ignorance, self-interest, and estate tax repeal
• Homer gets a tax cut (Bartels) • Interest groups framed debate (Shapiro)

• Explicit role of interest groups
– Dixit & Londregan, Grossman & Helpman
• Rationalizes resistance by rich • Rationalizes non-income targeted redistribution • Relevance of veto player analysis

• Little of this an obvious frame for studying UK, especially in terms of dynamics
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(This Homer)

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Scattered Empirical Results
• Non-democracies
– No voluntary taxes in repressive regimes (Kenny-Winer)

• Democracies
– Agenda setters and veto players
• committees and floor (Stewart) • stickiness of reform (Hallerberg & Basinger)

– Spatial voting – turnout effects (Franzese) – Probabilistic voting – supports complexity (Hettich & Winer) – Partisan voting – factions and tax levels (Roemer)

• Two cross-section models of top rates in democracies …

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Domestic conditions on Internationalization
• International diffusion (yardstick competition) conditioned by domestic factors
• • • • Rate changes follow finance, trade links Conditional on domestic stress (unemployment, debt) Veto players important in pace of change See: Swank, Swank & Steinmo, Hallerberg & Basinger

• Welfare state demand and top rates
• • • • Corporate tax rates (internationalization factor) Total revenues (Wilensky’s welfare state argument) GDP/capita (Still Meltzer-Richard) See: Ganghof

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Our Approach
• Agency theory
– Gets the conflict of interest right
• Conflict between government and citizen • Approach is broader than Meltzer-Richard • Positive features of government as well as rent-seeking

– Increasing empirical support in other policy contexts

• We think: The median voter turned “right”
– Loss of trust in government more than change in attitudes to redistribution, which do not “do all the work” – Linked to sustained cuts in top rates of income tax

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Trust in Government, Redistribution

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Ubiquitous Top Rate Cuts
1975 Australia France Germany Italy New Zealand Norway Spain Sweden United Kingdom United States Average
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2005 48% 56% 47% 46% 39% 47% 45% 57% 40% 42% 47%

Change 1975-2005 17% 4% 9% 26% 21% 26% 17% 30% 43% 28% 22%

65% 60% 56% 72% 60% 73% 62% 87% 83% 70% 69%

The Paper in six sections
– Intellectual context – – – – The British Experience compared Public Opinion Special Interests The General Interest

– Recommendations

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The British Experience Compared
• Income tax rate cuts sustainable in electoral politics
• Copied throughout EU, OECD • No reversal under Labour

• Large increases in VAT
• Indirect tax relatively high as share of revenue • Now within EU constraints • Structure more controversial than rates in UK elections, unlike elsewhere

• Corporation tax falls, but rarely an electoral issue • Internationally, tax reform within connected groups of countries
• Temporal waves 1986-9, 2000-5 • Yardstick competition

• These tax reform patterns are independent of party
• Left in New Zealand, Australia • Social Democrats in Sweden

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Public Opinion
• British Social Attitudes Survey 1986-2004 surveys attitudes to taxation and redistribution • Allows attitudes to be related to both real and perceived position in income distribution • In-depth microanalysis of redistributive preferences
• How have they changed?

– How do they respond to tax policy innovation?
• Does tax policy respond to them?
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Perceived and Real Incomes

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Redistribution, Age, and Period

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Special Interests
• Outside U.K. much evidence firms important in lobbying.
– – – Process of contacting in UK How big is the distortion? Restrictions to insiders (implications of EU policy) Do firms get tax breaks? Model follows Coate and Morris “Policy Persistence”. Volume versus incremental credit for R and D; for small firms first. Growth, distribution of credits. Possible firm response. Definition of SMEs. State aids. List of notifiable state aids. EU tax policy – rules on state aids in the EU Film (the luvvy lobby) industry as a special interest Unsustainable policies like depressed areas aid


Possible case studies:

– – –

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The General Interest
• Explaining declining trust and limited accountability
– People voting strongly on non-economic issues
• Other loyalties • Bundling • Divided societies

– Poor availability of information to voters
• Poor processing • Poor availability

– Limits on political competition
• Incumbency advantage • Electoral system aspects, districting

– Within-party dynamics
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Recommendations and Conclusions
• Need to study systematically the politics as well as economics of tax policy decisions • Need to see how individuals and firms respond to institutional as well as economic change • Need to see how institutions respond to political, social, and economic forces

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© Institute for Fiscal Studies, 2006

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