Optimal Household Labor Income Tax and Transfer Programs: An Application to the UK∗

This paper proposes an overview of the lessons that have been learned over the last 30 years in the economics literature for the optimal design of household tax and transfer programs and offers an application to the case of the United Kingdom. We review the tax and transfer system in the United Kindgom as well as its effects on labor supply. In particular, we investigate the link between top incomes and top marginal income tax rates since the 1960s. We derive simple optimal tax rate formulas in the context of the Mirrlees optimal income tax model and propose simulations based on the actual UK earnings distribution and empirically estimated labor supply elasticities. We analyze the effects of introducing participation labor supply responses, migration effects, and discuss the optimal tax treatment of couples. In each case, we discuss the empirical evidence and derive the consequences for optimal tax and transfer design. Finally, we propose a simple plan for reforming the UK household tax and transfer system based on the lessons from the analysis. ∗This paper has been prepared for the Mirrlees Review Reforming the Tax System for the 21st Century, http://www.ifs.org.uk/mirrleesreview/. Mike Brewer, Institute for Fiscal Studies, mike [email protected], Emmanuel Saez, [email protected], University of California, Department of Economics, 549 Evans Hall #3880, Berkeley, CA 94720, Andrew Shephard, Institute for Fiscal Studies, andrew [email protected]. We thank Richard Blundell, James Mirrlees, James Poterba, and numerous conference participants for helpful comments and discussions. Financial support from the National Science Foundation grant SES-0134946 is gratefully acknowledged. The Survey of Personal Incomes, the Labour Force Survey, and Family Expenditure Survey, the Family Resources Survey and the General Household Survey datasets are crown copyright material, and are reproduced with the permission of the Controller of HMSO and the Queen’s Printer for Scotland. The SPI, LFS and GHS data-sets were obtained from the UK Data Archive, and FRS from the Department for Work and Pensions, and the FES from the Office for National Statistics. None of these government department nor the UK Data Archive bears any responsibility for their further analysis or interpretation.