Wake up and smell the money: the 50p tax rate doesn't work

Neither theoretically nor practically can the 50p tax rate be justified on the grounds of bringing in more revenue for the government. It doesn’t

What is the purpose of tax? To raise money or wind up the rich?
John Phelan
On 13 March 2012 09:37

Wake What is the point of taxation? Is it to raise money to pay for things the government does? Or is it to wind up those in society we resent or don’t like? The answer would seem to be obvious but the current debate over the 50p tax band suggests that it is not clear cut.

The top rate of income tax was raised from 40 percent to 50 percent in 2009. With the economy tanking following the credit crunch tax revenues were vanishing revealing the extent of Gordon Brown’s uncontrolled spending. The search was on for anything which might plug the deluge of red ink.

The thinking behind it is simple. If you raise the tax on income from 40 percent to 50 percent the revenue from that tax will increase by 25 percent. But it doesn’t work like that in real life.

That people respond to incentives is one of the most basic truths in economics. If people have an incentive to do X they will do it. If they have a greater incentive to do Y they will stop doing X and do Y instead.

It is precisely this thinking that causes politicians to use taxes to incentivise/disincentivise certain desired/non desired behaviours. Home owning is incentivised and smoking and drinking are disincentivised by tax.

But when applied to labour, on which income taxes are levied, politicians abandon this logic. While they assume that raising taxes on fags and booze will lead to less smoking and drinking they think that they can raise taxes on labour without reducing the amount labouring being done.

That, it appears, has been the utterly predictable effect of the 50p tax rate.

In January the Treasury received £10.35 billion worth of income tax revenue from self assessors, generally the top rate tax payers, £509 million lower than in January 2011. Revenue from most other taxes, by contrast, went up over the same period.

This behaviour was famously modelled back in the 1970s by the economist Arthur Laffer. The Laffer Curve, like that below, says that there is a rate of tax, t*, beyond which the disincentive effect of the tax will be so great that whatever it is being taxed, be it smoking or labour, will decrease and so will tax revenue. Put simply, why would you go to work if you knew that 80 percent of your income would be taxed from you?

There are caveats. First, there is no single t* for the economy, it will vary from individual to individual and from tax to tax.

Second, it doesn’t mean, in the case of income tax, that with tax rates above t* people will simply stop working. Instead they will find ways to receive their income in forms which are less heavily taxed, the now popular bogeyman of tax avoidance. It is more accurate to say, not that labour will diminish, but that taxable labour will diminish.

The Rolling Stones did not stop recording in the 1970s when faced with tax rates of 83 percent, they simply moved to the south of France and watched on TV as Britain had to go to the IMF for a bailout. Or, like Ken Livingstone, you can stay in Britain and incorporate yourself so that you pay the Corporation Tax rate of 20 percent instead of the nearly 60 percent combined income tax and National Insurance he would have paid otherwise.  

The obvious answer is a flat tax. But the same people who complain most bitterly about tax avoidanceare often most opposed to any levelling of the tax system. Those wedded to a ‘Progressive’ tax system must therefore reconcile themselves to the loopholes and avoidance that come with it.

The truth of the Laffer Curve has been seen across centuries and across cultures. The late fourteenth century Islamic polymath Ibn Khaldun wrote

“In the early stages of the state, taxes are light in their incidence, but fetch in a large revenue...As time passes and kings succeed each other, they lose their tribal habits in favour of more civilized ones. Their needs and exigencies grow...owing to the luxury in which they have been brought up. Hence they impose fresh taxes on their subjects...[and] sharply raise the rate of old taxes to increase their yield...But the effects on business of this rise in taxation make themselves felt. For business men are soon discouraged by the comparison of their profits with the burden of their taxes...Consequently production falls off, and with it the yield of taxation”

In 1933 John Maynard Keynes wrote

“Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more--and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss”

When Margaret Thatcher was elected in 1979 the top rate of tax was 83 percent and the richest 1 percent of Brits paid 11 percent of all income tax. Thatcher cut the top rate of tax to 60 percent and the total amount of income tax revenue the richest 1 percent paid rose to 14 percent. When the top rate was cut again to 40 percent the share the top 1 percent paid rose again to 21 percent.

Neither theoretically nor practically can the 50p tax rate be justified on the grounds of bringing in more revenue for the government. It doesn’t.

John Phelanis a Contributing Editor for The Commentator and a Fellow at the CobdenCentre. He has also written for City AM and Conservative Home and he blogs at Manchester Liberal. Follow him on Twitter at @TheBoyPhelan

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