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Taxation: revenue maximisation vs. the politics of envy

Is there any reason to set top tax rates at anything but the rate which maximises government revenues? And what is that rate? Jeremy Fox has argued that the 50p rate does not constrain growth. Michael Bullen returned with the argument that 50p is too high for public revenue maximisation. Jeremy Fox countered that 50p was too little and that equality is a good in itself. Here, Michael Bullen questions Jeremy Fox's numbers and his levelling instincts

Michael Bullen
29 September 2011

In an article published on 15th September 2011 Jeremy Fox reflected on a recent letter by 20 university professors, consultants and "business gurus" concerning the 50p top rate of income tax that was published in the FT. He complained that the group provided no evidence for their assertion that the 50p rate is inflicting "lasting damage" on the UK economy and claimed "nor has any emerged during the heated but hardly illuminating debate that has followed".

The Mirrlees Review, released on 13th September 2011 and described as "the deepest and most far reaching analysis of the UK tax system in more than 30 years", suggested otherwise. The Review was published under the auspices of the Institute For Fiscal Studies, a leading and politically independent economic research institute based in London. The Review was chaired by Sir James Mirrlees, Nobel laureate, bringing together a high-profile group of international experts and younger researchers.

Jeremy wrote in glowing terms of the British economy of the 1970s, an era more normally associated with boom and bust, poor and inconsistent GDP growth, high inflation and when Britain was dubbed "the sick man of Europe": for Jeremy, these economic facts seem insignificant when compared to the greater prize that he aspires to and for which 1970s Britain was also notorious: namely, higher marginal rates of personal taxation.

Jeremy has had a second attempt at justifying his position, not just that the 50p rate should be retained, but that it should indeed be increased. Regrettably, his new article is littered with errors of fact, errors of omission, errors of analysis, misrepresentations and other flights of fancy.

He starts by "noting that nothing in Michael's piece addresses the main focus of my objection to the FT letter of September 7th from twenty economic gurus, namely that there is no evidence for their suggestion that the 50p rate will inflict "lasting damage" on the UK".

It is almost as if the Mirrlees Review never happened. Yet with respect to the 50p tax rate, the Review concludes: "It is not clear whether the 50% rate will raise any money at all....according to these estimates, the introduction of the 50% rate would actually reduce revenue". In these days of poor GDP prospects and high and increasing public debt, Jeremy does not address how reduced tax revenues would benefit the economy: yet, casting an eye across Europe, the implications of a lack of fiscal responsibility are being played out before us. In my first reply, I argued that the current public debt circumstances are such that the Chancellor must set policies to maximise taxation revenues without putting the economy at risk. The consequences of failing to address the debt over-hang while at the same time supporting the economy are simply too grave. It wouldn't just cause "lasting damage" to the economy, it would cause lasting damage to society.

Jeremy returns to the economic trajectory of Britain in the 1970s. He claims that I "stated that exogenous factors have exercised far more influence on the economy than marginal tax rates". What I actually wrote, in regard to the immediate post-1970s era and in view of all the numerous factors at play in the UK economy at the time, was that "isolating the impact of lower top end tax rates in this era is challenging." I also wrote that "growth is affected by so many factors.....that the impact of changes in any one factor can be very hard to assess." No mention of the word "exogenous", no mention of which factors may or may not have exercised "far more influence" and the examples that I gave included several that are entirely endogenous.

Jeremy moves on to what he calls the second platform of my view, "the threat that movers and shakers of the UK economy will desert the ship". Jeremy calls this "blackmail" and does not seem at all concerned at the likelihood that "movers and shakers" may exit the country or boardroom. (Others might characterise this as "whitemail", an opportunity to have some leverage over the irresponsibly profligate instincts of government). Jeremy also comments that "recent performance certainly suggests that the country would gain considerably if they abandoned the board-room" and refers to Fred Goodwin, whose name always seems come up in such discussions. He focuses on "senior executives of PLCs to whom Michael refers" and in particular on those for whom a salary of £150,000 is "loose change". Actually, I referred to all those in the 50p marginal rate tax bracket, not just to those for whom a salary of £150,000 is loose change.

With respect to Jeremy's mention of everyone's favourite villain, Fred Goodwin deserves all the opprobrium he gets for his failures at RBS. Other senior bankers caught up in the financial fiasco of 2008 deserve the same treatment. However, blame should be shared. I am not that impressed with the politicians who introduced policies that enabled these failures to take place either, and indeed who knighted "Sir Fred" not long before the crisis. Nonetheless, while it is occasionally gratifying to vent our national spleen at the failures of Sir Fred, economic policy must be made with respect to what is beneficial to the economy as a whole and not just to reflect public revulsion at certain key individuals. 

Specific policy failures are implicated in the failure of the UK banks, primarily the "light touch regulation" regime. It is remarkable that then-key government personnel closely involved with introducing the regime still retain senior positions. In 2006 Ed Balls proudly spoke of replacing the previous regime with "today's system of increasingly light-touch and risk-based regulation". He went on to say that  "we must take action.....to safeguard the light touch and proportionate regulatory regime that has made London a magnet for international business". 

Barely two years later, a Parliamentary Committee found in 2008 that the Financial Service Authority, established under the Financial Service and Markets Act of 2000 and which was responsible for "light touch regulation", was guilty of "systemic failure of duty". Public anger at the banking sector is entirely justified, but countries that retained tight regulatory regimes, for example Canada and Australia, continue to have strong banking sectors. Key to the UK's future financial stability and prosperity will be a return to a tight regulatory system of a similar nature to that which kept Britain's banking sector secure for generations. By way of comparison, in the Great Depression of the 1930s, when UK industrial production fell by 14% and one third of US banks failed or were taken over, no UK bank failed.

A tighter rule book for banks is high on the list of priorities for the government. Indeed, the Independent Commission on Banking chaired by Sir John Vickers recently published its final report and its conclusions will guide government policy. Additionally, the government will almost certainly impose sector-specific taxes on banks, as it already has, to expedite the long process of recovering public monies pumped into banks in 2008 to keep them and the economy afloat. It is likely that governments will continue to direct new measures, as required, towards the industry. However, it is important to recognise that banking had a long and blameless record up until the financial crisis as one of the UK's key industries, not just financing UK PLC but also as a major foreign currency earner, over many decades. Government must set in place policies directed towards returning to that status quo; if not, the UK's finance sector will slowly be absorbed by finance capitals abroad and a major policy objective of foreign governments will have been achieved, to the likely very considerable detriment of the UK economy.

Banking must return to a more simple 1950s style of operating as a basic utility with lower returns for shareholders and investors. Investment banking operations of major banks will be ring fenced such that these more highly leveraged/risk taking operations cannot contaminate traditional lending activities. One expects that the lower returns for shareholders and investors will be matched by lower returns for key operators within banks as well; however, as the FT's Martin Wolf has pointed out, targeted returns of 15% are ambitious, if not unsustainable, unless the banks are high risk, protected from competition, subsidised or a combination of all three. It seems that banks have yet fully to recognise the changed reality and that this must apply to banker pay packets as well.

In respect of potential returns for bankers, this will be an area of attention for politicians of all hues: Business Secretary Vince Cable continues to focus on transparency of executive remuneration such that top earners are paid by results and answerable to shareholders. Ed Miliband recently called for greater responsibility from those at the top end of society. In my view, Messrs Cable and Miliband are thinking along the same lines as the rest of the country, though I hope Mr Miliband, in making his comments, is reflecting on the world of politics as well as that of business. Banking will remain in the spotlight until its practices better reflect the standards and aspirations demanded by the public.

Notwithstanding the above, banking is only one aspect to the finance sector and Sir Fred only one face to it. The policies and prognostications of Messrs Cable and Miliband are not inconsistent with rewarding top earners for top efforts. It is also the case that a demonstrable concern for the public good does exist at the top end of society; it often goes unreported and we could always do with more, perhaps a lot more, but it is nonetheless alive and well. For example, Chris Hohn, an investment manager who founded The Children's Investment Foundation (CIF) in 2002, is Britain's biggest charity donor. The CIF receives its funding from profits of Chris Hohn's business activities. In 2006-2007 it had income of £324 millions, the following year £466m. Arki Busson, based in London but of French origin, is a finance professional who co-founded children's charity ARK (Absolute Return for Kids). ARK runs a network of 8 school academies in London and elsewhere and has raised more than £150m in charitable donations and significantly more in other funding. Michael di Giorgio, an ex-finance professional, launched Greenhouse Project, which provides sporting, arts and educational activities for young people who would not otherwise have access to those opportunities.

Jeremy's focus on "Sir Fred" is simplistic and populist. It is not in the interests of UK PLC to alienate successful, high earning individuals, many of whom not only have the wherewithal to pay a great deal of tax, but also make large charitable donations and have the social conscience to go with it. For every Sir Fred there is a Chris Hohn, an Arki Busson or a Michael di Giorgio. Michael Spencer, whose ICAP group, started just over twenty years ago and now one of the largest and most successful international broker/dealer groups, annually donating £12m or so to charity, recently expressed the concern that ICAP may have to relocate abroad because of taxation issues. He should be taken seriously. Is it in the interests of UK PLC that ICAP, with its hundreds of highly paid brokers, none of whom were responsible for the Credit Crunch, should relocate to Switzerland or Singapore, with inevitable consequences for HMRC tax receipts, charitable gifts and related job losses elsewhere?

Jeremy doesn't seem at all concerned by that prospect but I think it should concern us all greatly.

Returning to the broader picture, in the UK we have a vast range of successful, creative and innovative companies that span every industrial sector. Many have continued to do well even in the difficult current conditions faced by the UK and elsewhere, and in particular those companies concentrating on high-tech export markets. It is ludicrous for Jeremy to suggest, in respect of the men and women who run them, that "the economy would gain considerably if they abandoned the board-room altogether". Jeremy also suggests that high earners do not take action to mitigate their tax bills. What nonsense. We all know of numerous British individuals from every walk of life who live abroad for tax reasons, including celebrities from the worlds of motor racing, music and film who live in Switzerland, Monaco, Jersey, the United States and elsewhere. Of course, it isn't just celebrities nor even high profile industrialists and retail operators who minimise exposure to UK tax by residing outside of the UK. 

Jeremy prefers to focus on "fat cats": my preferred focus is on those highly paid, highly qualified people further down the food chain whom the UK can sorely do without yet who are leaving the country in large numbers, many of them educated and trained at great expense. The last thing that is needed is for Britain to set tax policies providing further incentives for them to leave. Indeed, the reverse must surely be right.

The key factor is that people further down the income scale, but nonetheless still falling into top tax categories, also vote with their feet in response to higher taxes. This has always been the case; in 1970s Britain it was known as "the brain drain". In 2008 the OECD reported into current "brain drain" trends and revealed that 3.2m British-born people live abroad, 1.3m of whom are graduates. The report further stated that Britain is currently experiencing a "brain drain" that is the worst seen in any country in the biggest exodus for almost 50 years and that Britain has 700,000 more highly skilled expats living in OECD countries than highly skilled immigrants from other OECD countries living in the UK. For purposes of comparison, the United States had 809,000 of its citizens living abroad. Of those British graduates relocating, 27% had health or education qualifications, 38% humanities and social science degrees and 28% were scientists or engineers. Britain's universities currently rank among the best in the world but that situation will be at considerable risk if we cannot retain our top graduates.

Eventually, in his last response, Jeremy managed to get round to addressing the Mirrlees Review. However, he doesn't like the Review's assumptions, for example, the labour supply model that the Review incorporated into its analysis and which assumes that there is a trade off for workers between the financial rewards of working and the loss of leisure time. One suspects that Jeremy would take exception to the supply and demand model taught on Day One of an Economics GCSE. Yes, economists make assumptions: but the alternative is simply to put rates up and down and play it all by ear. There is no doubt that pragmatism goes into Treasury tax rate setting, but these types of models are used by finance ministries all over the world because it helps them raise revenue. It is the public purse's equivalent of the models of consumer behaviour that marketing departments of large firms have. My own view is that Sir James and his team are serious economists working for an independent, non-political research body and that their conclusions, which have taken a number of years to produce, are the result of best efforts and best academic research practice. As I wrote in my earlier piece, the Review is not likely to be the last word on this topic; nonetheless, it is the most significant research into the topic in the last 30 years. 

One of the facts that I report from the review - and this is straight measurement, not assumption - is that the top 1% of income tax payers currently pay a great deal more tax, as a proportion of the total, than they did in 1978-79 (the review obtained it from HMRC). Jeremy does not comment on this information, which must be some sort of embarrassment for his argument. Here are a few key statistics comparing the periods: in 1978-79, the last year of 83% marginal tax rates, 11% of tax revenues were paid by the top 1% of tax payers and 82% was paid by the top 50%. In 2008-2009, 23% was paid by the top 1% and 89% by the top 50%. Projections for the current year are that 27% of income tax will be paid by the top 1%.

The results show that, with lower top rates of tax, significantly more revenues are now raised from top tax payers than under earlier more highly taxed regimes and that the burden is reduced for those at the other end of the scale. The reason for higher tax revenues from the top 1% of earners is simply that they are now earning much more money on which to pay tax. Of course they are, that was the purpose of lowering taxes in the first place, a "supply side" measure designed to increase incentive and productivity within the economy; it worked and we should be grateful for it.

Jeremy pointed to conclusions from Professor John Veit-Wilson. We are not sure what the Professor's assumptions were because he didn't provide any. Professor Veit-Wilson wrote that "empirical evidence....has not yet confirmed the belief" that high marginal rates act as a disincentive for increased output by high earners and that "psychological studies of work motivation have tended to refute it". He does not say what he means by "confirmed": perhaps he just means "confirmed" in his own mind, because no further detail is provided. Interestingly, the Professor is quiet on the "foreign travel" aspect that is key to this whole topic, ie the propensity of high earners to seek work abroad in the event of high taxation at home. It is also not even clear what Professor Veit-Wilson means by "high earners". Is he talking about the top 0.5% of earners, the top 1%, the top 10%, the top 25%? We don't know because he doesn't say.

However, we are interested, for the purposes of the 50p tax rate, only with the very, very top earners. It takes an income of £100,000 to get into the top 1% and the average is £150,000. The average tax payer in the top 1% does not even pay the 50p rate. Only the very, very big hitters get to that level and we have no idea if the Professor was talking about them when he made his "contribution". 

Jeremy says that he "searched in vain" on an IFS document for evidence that would contradict Professor Veit-Wilson. He should have looked elsewhere, because there is plenty of it. For example, Messrs Davis and Henrekson concluded in 2004, after examining data from 16 industrialised countries, that a tax rate increase of 12.8% led to 122 fewer hours worked per adult per year, leading to a decline of 4.9% in the employment/population ratio and an increase in the underground economy of roughly 3.8%.

There is also the evidence of Nobel Prize winner Edward Prescott, who found that "low labour supplies in Germany, France and Italy are due to high (marginal) tax rates" and that of Ohanian, Raffo and Rogerson ("Long Term Changes in Labour Supply and Taxes. Evidence from OECD Countries, 1956-2004") who in 2006 concluded that average hours worked by the working age population across 21 OECD countries had fallen by nearly 20% and that income and consumption taxes better explained the decrease than other factors.

Jeremy moves on to the evidence of Mike Kimel, a US economist and statistician who estimates that, for the US, the optimal top tax rate should be 65%. Jeremy considers that this is relevant for UK purposes and says that he can find nothing wrong with Kimel's methodology: he invites others with more expertise to locate the flaws. I refer Jeremy's attention to my earlier piece, where I cautioned that changes which have one effect in one country may have an entirely different outcome in another. In that piece I also pointed out that the US has a very different tax structure to that of the UK because US citizens are subjected to US tax wherever they live in the world: thus if US taxes rise, US airports will not be thronging with US citizens on their way to Cayman, Monaco, Switzerland or Jersey because, for tax purposes, it doesn't matter where they live (though those same  airports may well be full of expats from the UK and elsewhere on their way back home). With respect to UK tax, British citizens are in a very different position: they have the ability to seek more amenable tax circumstances and, as OECD figures show, a propensity to vote with their feet. In short, Kamel's data is irrelevant for the purposes of this discussion.

Jeremy focuses on the benefits of "equality" and I think here we get closer to understanding his high tax instincts. He writes that  inequality has increased over the years, which it has: one factor is that the UK has had high gross immigration for a number of years, partly offset by high - but not quite so high - gross emigration. The OECD picture is one of relatively highly skilled, well-educated people leaving the UK being more than offset in numbers by relatively unskilled, less well educated people entering. Parliamentary data shows that in 2008 alone gross immigration totalled 538,000, of whom 52% were from outside of the European Economic Area. 

Immigration data must be interpreted very carefully; for example, there are large numbers of wealthy immigrants living in Knightsbridge and South Kensington. A visit to other areas of London will reveal a very different picture. According to Child Poverty Action Group (CPAG) data, in 2007 79% of native born Britons were in employment, earning an average of £11.30 per hour. Among migrants to the UK, those born in Pakistan had only 48% employment levels with an average wage of £9.20 per hour: 46% of migrants born in Bangladesh were in employment, earning £8.80 per hour and 29% of Somalians were in employment, earning £9 per hour. These groups together totalled 660,000 people. Poverty.org reports that "more than half of people living in low-income households in London are from ethnic minorities".

Other large demographic groups of migrants often had higher levels of employment but earned even lower wages. Poles, Slovakians and Lithuanians, for example, 560,000 in number, earned less than £7 on average per hour. 

Fullfact.org (an independent fact-checking organisation "promoting accuracy in public debate") has concluded: "it seems fair to suggest that a link between immigration and lower income (exists) among the lowest earners".

Jeremy says that inequality has increased since the Thatcher reductions in the top marginal income tax rate. Coincidentally, that is when immigration to the UK started to pick up. Perhaps Jeremy might wish to investigate whether it was the more competitive tax structure that attracted them or perhaps the stronger labour market.

Good luck to the immigrants. My experience is that they come here to work hard, to make a life for themselves, to do work that people already in the UK often don't want to do and generally to make a positive contribution to the UK, to its economy, public services and so on. However, in an economy that is growing wealthier overall, with large numbers of immigrants entering the country every year, many of them very poor, it is virtually certain that increasing economic inequality will result.

This is not to imply that it is an issue that is not of concern to us. There exists an element of the population that is poor and vulnerable and who need the support that society can and must provide. There is absolutely no alternative to state provision (supported by but not reliant upon the inestimable work undertaken by charities and charity workers up and down the country, as mentioned earlier) in order to help build better lives for them and to provide the opportunities that most of us take for granted.

Providing help and opportunities does not come cheap. Glancing across the economic panorama at some nations now counting the cost of long years of fiscal laxity and tax evasion, and the inevitable hard times that many Europeans now face, it is entirely clear to me that the Chancellor and future Chancellors must focus on maximising taxation revenues from top tax payers. The economy must be supported and bills paid in order to ensure the best possible provision of public services and support for those most in need over the long term.

There is a hint of "levelling down" in Jeremy's focus on equality. He writes, in respect of high earners, that the IFS (I assume he is referring to the Mirrlees Review) look no further than "expected government revenues from these individuals as if that is the only item worthy of estimation." He considers "the idea that human beings have only one kind of rationality - the economic - has now been so widely debunked that it is surprising to see it rehearsed here."

However, while different people may have different rationalities, we are talking about the rationality of a very small part of the population, namely those paying higher tax rates. I suggest to Jeremy that, while some of those tax payers may have a "non-economic rationality", the strong likelihood is that most of them do not: that they have an "economic rationality" that benefits us all because, without them, we would all be required to pay more tax ourselves or to accept lower standards of living. 

Jeremy leans heavily on Spirit Level, but the analysis of Spirit Level is heavily contested. For example, in 2009 Professor Andre Leigh (now a Labour Party politician) of the Australian National University showed that life expectancy and infant mortality improved in 13 rich countries during periods when inequalities were on the increase between 1980 and 2000. He concluded: "Countries that experienced big increases in inequality saw bigger improvements in health than those where inequality stayed stable or fell...the data certainly don't support the hypothesis that rising inequality harms population health." Swedish economist Andreas Bergh has pointed out that, even in Sweden, a Spirit Level paragon, increases in economic inequality have coincided with better health and better gender equality.

Singapore has high inequality and low taxes, yet few social problems: for example, levels of suicide and alcoholism are much higher in Sweden than Singapore, which has experienced enormous economic success in the last few decades, lifting tens of thousands from poverty. So why not favour the Singapore model?

The most recent academic research, including that of Nobel prize winners and Federal Reserve economists, indicates that employment levels and hours worked fall as marginal taxes rise and that a marginal tax rate in the UK of 50% is higher than the optimal level for maximum tax revenue generation. Jeremy is willing to risk this in the interests of "equality"; yet reduced tax revenues would place greater pressures on the economy and in particular on the most vulnerable, as we are seeing across Europe, with rising unemployment, lower salaries, lower pensions and cuts to essential public services. It is difficult to draw any conclusion other than that anyone willing to take that risk is driven less by concern for the weakest in society and more by the desire to level - and that this comes close to being the politics of envy rather than good sense.

 

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