Don't tax the rich any more: it will cost us more than it raises

Should the marginal rate of income tax be reduced for very high earners? Jeremy Fox argues that there is no obvious link to growth. But the link to government revenue is much better understood, argues Michael Bullen, and the numbers suggest that 50% is too high
Michael Bullen
19 September 2011

Taxation will always be a contentious issue, though the knee jerk instinct that the only problem is that taxes are not high enough is always worth examining closely: is it based on sound analysis and prudent budgetary management, or only on a desire to level? Jeremy Fox's criticism of those seeking to reduce the top rate of income tax (as published in an FT letter in early September) deserves scrutiny - although he is right that we cannot say much about the impact of taxation on growth, we can say a lot about its impact on government revenues, which today are - quite rightly - our national priority. 

The top rate of income tax in the UK is 50%, but this is not the top marginal tax rate for high earners, who also pay secondary national insurance contributions of 2% on all weekly earnings over £817. Thus, the top marginal rate is 52%. Post-income tax and national insurance contribution earnings are also subjected to VAT, council tax, road tax, airport tax and the myriad other taxes that successive UK governments have over the years creatively devised as means of providing revenues to fund public expenditure. 

Jeremy mentions the record UK gdp growth rate in 1973, when the top rate of income tax was 75%. He says that economic growth later slowed but that, by the time Margaret Thatcher came to power in 1979, the economy had only been recessionary in one year.

Reading his article one might almost yearn for those heady days of economic largesse and plenty. Those of us who actually lived through those years may instead recall it as a time of war in the Middle East, oil embargoes, eye-wateringly high oil prices, record inflation levels, the miners' strike, the 3 day week and a time when rubbish piled up in the streets and coffins went unburied because grave diggers, dustbin men and just about everyone else seemed to be on strike during the Winter of Discontent.

It is certainly the case that the UK enjoyed a burst of economic growth early in 1973. While Jeremy seems to regard this growth spurt as a high water mark for the British economy, a more common response these days is to refer to this brief period as the Barber Boom, the unfortunate result of one the most blatant and notorious attempts by a British government to manipulate the economic cycle for electoral purposes in post-War history. Closer analysis of the data reveals that, by mid 1973, economic malaise was already setting in, ushering in a period of stagflation that beset Britain for the rest of the decade. During the 1973-1979 period, a total of 28 quarters, GDP growth was negative for 10 of them. The malaise continued into early 1981, when the UK suffered 5 consecutive quarters of negative growth. Following that recession, during the 108 quarters that took us from Q2 1981 to Q1 2008 - an era that saw the top rate of income tax fall to 40% and independence for the Bank of England, among other financial reforms - the UK enjoyed 100 quarters of GDP growth and 8 of negative growth.

What does this teach us with respect to the relationship between marginal tax levels and GDP growth, if anything? Perhaps not very much, and statistics can be spun one way or another, but I'd quite like to see the statistics behind Jeremy's contention that "the correlation between marginal rates of income tax and UK GDP is so small as to be statistically insignificant": and, of course, although high end income tax rates were certainly lower during the latter period than between 1973-79, there were numerous other factors at play, not least of which were the various wars, oil shocks, Asian Crisis, terrorist attacks, Argentine default, recession in Japan, tech wreck, Long Term Credit debacle and so on. Isolating the impact of lower top end tax rates in this era is challenging: nonetheless, there will be many who harbour suspicions that a more competitive tax regime contributed to the relative prosperity and stability that the UK enjoyed during those 27 years.

Jeremy says that information on the relationship between personal income tax rates and economic growth is hard to come by. He is right, for reasons given above: growth is affected by so many factors - others include culture, institutions, legal and regulatory infrastructure, technology, education, resources, work practices, even luck - that the impact of changes in any one factor can be very hard to assess. Moreover, changes that have one effect in one country may have an entirely different outcome in another. 

Having agreed with Jeremy that information on the relationship between personal income taxes and economic growth can be problematic, this is not to say that important information on related issues is not available: and although data on some questions is hard to find - eg how many high earners are planning to leave the country or have already done so, how many young people, educated by the state at vast cost, are planning to to leave or have already gone for much the same reason, how many high earners have chosen early retirement or to "wind down" their careers because of tax disincentives, and so on - there are nonetheless certain key statistics that we do have which the Chancellor can incorporate into his policy making decisions.

Of course, it could be argued that a state does not exist to extract every last drop of revenue from its citizens and that citizens do not exist to satisfy the needs of a state that seemingly has a bottomless requirement for cash. However, in the current public debt circumstances we may view such philosophical niceties as luxuries to be put to one side to debate on another occasion and that the Chancellor's objective must be to set taxation policies that will maximise revenue without putting the economy at risk. Risks include rising tax avoidance, tax evasion and driving increasing numbers of UK citizens to seek more amenable tax regimes abroad. 

Jeremy has suggested that, instead of abandoning the 50p rate, the Chancellor should raise it to 60p. However, if he is not persuaded that the relative stability and prosperity of the UK economy between 1981 and 2008 was at least partly the result of lower marginal tax rates than during the 1973-79 period, he may wish to consider the following: this year, the top 1% of earners are officially projected to pay 26.6% of all income tax in the UK (Vanessa Houlder, FT February 11th 2011). In 1978, during Jeremy's "good old days" and when top tax rates were 83%, the richest 1% paid only 11% of total income tax (Vanessa Houlder).

Any errors of judgement that the Chancellor makes with regard to top earners are thus likely to have non-trivial outcomes. A very modest movement abroad of some of those top earners, or others electing to spend more time on the golf course than in the board room, would likely have a significantly detrimental impact on UK PLC's ability to repay its debts.

An option that seems to receive relatively little attention is for the UK to adopt a taxation rule that the United States has and to subject UK citizens to UK taxation wherever they may live in the world, while having regard to double taxation concerns. This may be an approach worth investigating, though is unlikely to win popularity prizes from elderly ex-pats keen to spend a few of their declining years in the sun and among younger workers wishing to spend some of their prime earning years in a lower tax regime than exists for them back home. 

However, when those persons return home they will expect to benefit from state provision of essential services, including the National Health Service, and those tax payers who remained in the UK and paid their taxes like good citizens should are perhaps justified in asking why they are now expected to pay for the health needs of those who spent their prime tax-paying years abroad, returning only when they find their health service needs are beginning to be greater than their ability to pay for private health plans. Of course, even in the event that such a tax rule were to be introduced, the likelihood remains that excessively high marginal tax levels would merely lead to a bigger, more thriving black market, perhaps leading to reduced taxation receipts, as one suspects may be happening in certain parts of Europe where fiscal austerity programmes have recently been introduced. 

An alternative approach more frequently cited is the possibility of introducing a so-called "mansion tax". Leaving aside the absurd notion that a three bedroomed semi in Chelsea or Notting Hill may be described as a "mansion", such a tax would inevitably fall mainly on the same persons currently in the "top income" bracket (almost exclusively living within a few boroughs of London) and it is not clear to me that they would hold any particular distinction between an "income tax" that reduces their income and a "mansion tax" that also reduces their income. If the Chancellor wishes to target wealthy individuals who park their often extremely large wealth in the UK but pay relatively little (or perhaps even no) tax, my feeling is that it cannot be beyond the realms of human endeavour to identify a tax that is far better targeted. In particular, rich foreigners bringing their wealth into the UK in order to benefit from our economic, political and social stability (notwithstanding recent unrest on the streets) should perhaps pay for that privilege. Moreover, a "mansion tax" would likely have unintended consequences: an elderly couple, asset rich but cash poor and required to sell the house they have lived in for 50 years to satisfy the fiscal demands of the Chancellor would make for uncomfortable reading in the tabloid newspapers. Ultimately a wealth tax of this nature - for we should call it what it is - may be a cultural Rubicon that UK politicians will balk at crossing. 

At this point it is perhaps worth identifying what level of income it takes to find oneself in the top 1% of earners in the UK. HMRC data indicates that, in 2007-2008, the top 1% had average pre-tax earnings of £149,000. The starting level to enter that group was £100,000. In respect of wealth, a report by the Government Equalities Office and London School of Economics ("An Anatomy of Economic Inequality in the UK") published in 2010, using data for the years 2006 to 2008, revealed that wealth of the top 1% of households exceeded £2.6m.  

Returning to the 50% tax rate, the key consideration is how effective it will be in raising tax revenues over the long term. Jeremy refers to a letter in the Financial Times published last week and claims that the 20 strong coterie who signed it offered "no evidence" for their assertion that the 50p tax rate is inflicting "lasting damage" on the economy. However, the letter in the FT did not occur in isolation: the Institute of Fiscal Studies (IFS) last week published a report into the characteristics of a good tax system for any developed economy in the 21st century, the extent to which the UK tax system conforms to these ideals and recommending how it might be reformed to that end. The report is known as the Mirrlees Review, named after the chairman of the investigating body. 

In view of Jeremy's claim, and also in consideration of opinion polls indicating that the public supports a 50% top income tax rate on the basis that it raises money but are happy to scrap it if it does not, this is an opportune moment to consider the findings of the Review, which provided a critique of numerous aspects of the taxation system in the UK and has sparked debate on several of its conclusions. The most controversial concerns the 50p top rate of income tax, about which Mirrlees (a Nobel laureate) concludes:  

‘It is not clear whether the 50% rate will raise any revenue at all. There are numerous ways in which people might reduce their taxable incomes in response to higher tax rates; at some point, increasing tax rates starts to cost money instead of raising it. The question is, where is that point? Brewer, Saez, and Shephard (2010) addressed precisely this question for the highest-income 1%. Their central estimate is that the taxable income elasticity for this group is 0.46, which implies a revenue-maximizing tax rate on earned income of 56%. This in turn (accounting for NICs and indirect taxes) corresponds to an income tax rate of 40%. So, according to these estimates, the introduction of the 50% rate would actually reduce revenue'.

The 50p rate of tax is clearly an emotive issue for politicians and the Mirrlees Review is unlikely to be the last word on the topic. Nonetheless, if the 50p rate really does reduce tax revenue, politicians and others will have to balance the convenience of targeting a relatively small group of the electorate, frequently reviled and at the very least envied, and best of all perhaps irrelevant for electoral purposes, against the very real possibility that in so doing they will reduce the availability of funding for projects aimed at improving the lot of those at the other end of the income scale.

Perhaps most inconveniently for politicians, they may find themselves looking for alternate sources of tax revenue. The soft white underbelly for these purposes is not "the rich" but "the quite rich", about whom research indicates they are less likely to show tax rate-sensitive behaviour than "the rich". However, "the quite rich" is a significantly more important group from an electoral perspective and persuading them that they need to pay more in taxation is likely to be a challenge for which politicians may not be rewarded at the ballot box.

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