James A. Mirrlees
In 1996 James Mirrlees and william vickrey were awarded the Nobel Prize in economics “for their fundamental contributions to the economic theory of incentives under asymmetric information.” Mirrlees’s main contribution was some highly complex mathematics that allowed him to solve a problem in taxation that William Vickrey had posed but had not been able to answer. Many economists, including Mirrlees, want to use the tax system to achieve a higher degree of equality than would otherwise obtain. This means taking a substantial amount of the additional income of high-income people, which would imply high marginal tax rates on them. But when the government imposes such high marginal tax rates on the highest-income people, it reduces the incentive of the most productive people to be productive. There is, in short, a trade-off between equality and efficiency. Economists have long wanted to figure out the optimum, but until Mirrlees’s work no one had been able to solve it.
Mirrlees started with no presumption against high marginal tax rates. Indeed, he has been an adviser to Britain’s Labour Party, which for decades imposed marginal tax rates in excess of 80 percent. But Mirrlees found that the top marginal tax rate should be only about 20 percent; and moreover, it should be about the same 20 percent for everyone. In short, Mirrlees’s work justified what is now known as a “flat tax,” more appropriately called a “flat tax rate.”
Mirrlees wrote, “I must confess that I had expected the rigourous analysis of income taxation in the utilitarian manner to provide arguments for high tax rates. It has not done so.”1 Indeed.
Mirrlees also proved that the marginal tax rate on the highest-income person should be zero. This is the opposite of the way most noneconomists and most politicians think: marginal tax rates are typically the highest on the highest-income people. Mirrlees’s reasoning is as follows. Imagine that the top tax rate is, say, 40 percent and that the top-earning person makes $500 million in a year before tax. If the government reduced the marginal tax rate to zero for all income over $500 million, it would not lose any revenue because no one was earning more than $500 million. But the individual currently earning $500 million might, because of the increased incentive to earn, decide to work more. He would be better off because he voluntarily chose to do something he did not do before, and the government would be no worse off. The net result is that society, which includes this individual, would be better off.
Mirrlees’s work on consumption taxes produced another important finding. Working with American economist Peter Diamond, Mirrlees found that small economies should not impose tariffs on foreign trade and that taxation should be on consumption, not production.
Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.
Mirrlees has a refreshing, understated sense of humor. Of his early years in university Mirrlees wrote: “It was regarded as morally dangerous to take philosophy at the beginning of one’s university course.” Reminiscing in 1996 on the advice one of his Cambridge teachers gave him to read Keynes’s 1936 classic, The General Theory of Employment, Interest and Money, Mirrlees commented, “That may not have been the best advice, but it did no great harm, and one day I hope to finish it.”
Born in Scotland, Mirrlees earned his M.A. in mathematics and natural philosophy from Edinburgh University in 1957 and his Ph.D. in economics from Cambridge University in 1963. He spent his early career at Cambridge, was an economics professor at the University of Oxford from 1968 to 1995, and returned to Cambridge in 1995 as an economics professor.
Mirrlees 1971, p. 207.