Tax policy in the United Kingdom is a current and hotly debated topic in Parliament, with both major political parties holding distinctly opposite views about whether the tax rate for top earners (those earning above £150,000) should be increased or even decreased.
The argument for the implementation of a higher top tax rate is that Government revenues will be boosted, the deficit in our economy can be better tackled and that the ‘tax fairness’ means we are ‘all in this together’, but is it really as simple as that?
What Factors Affect Taxation Revenue?
To begin to understand the impact that an increase in the top tax rate would have on Government revenues, we need to understand two concepts: “Taxable Income Elasticity” (TIE), and the distortion effect of progressive taxation.
Taxable Income Elasticity is a measure of how a one unit change in the tax rate affects the taxable income available.
If we get a large behavioural response from a change, the elasticity will be large.
Behavioural responses include top earners moving to countries which have better tax rates, high earners concealing parts of their incomes, and we could even see businesses which would potentially drive future growth in an economy, deciding not to invest in infrastructure in the UK in order to reduce their overall cost.
The theory of taxable income elasticity is demonstrated by the “Laffer Curve” which shows the possible levels of tax revenue for any given rate of tax, postulating a non-zero maximum at an unknown point.
The reason we have a curve and not a straight line is that a change in the top tax rate has a behavioural response, and so the optimal tax level is dependent on this Taxable Income Elasticity.
What is the Optimal Rate of Income Tax?
The HMRC estimation of the Taxable Income Elasticity was 0.35 in 2010, and was used as justification for the increase in the top tax rate from 40% to 50%.
Later, the elasticity was revised to 0.45 which influenced the decision to reduce the tax rate to 45%.
The TIE is clearly an important measure for policy making; however it is very hard to predict.
How Does the Distortionary Effect Work?
The second concept refers to the distortionary effect of progressive taxation. The effect is the square of the change in the tax rate.
If we see the tax rate increase from 25% to 50%, the effect will not double, but quadruple.
This happens in two ways; when the tax rate is increased, the disposable income of a worker is reduced pressuring employers to increase salaries.
The increased salaries mean that employers can only afford to hire fewer workers and therefore reduces the demand.
The product of these two outcomes is the total economic loss.
What Does History Tell us About Taxation?
There is plentiful evidence in history to support the benefits of a reduction in the top tax rate.
President John F. Kennedy attempted to implement a tax cut in the United States in the 1960s which was rejected in congress.
After his assassination in 1963, the “Revenue Act of 1964” was implemented by Lyndon Johnson who put this plan into action.
Following a reduction in the top tax rate from 91% to 65% (in addition to tax cuts at all other levels), unemployment fell by 1.4% in two years, and total tax revenue increased in the two subsequent years.
In the 1980s, Chancellor of the Exchequer Nigel Lawson mimicked this and cut the top tax rate from 60% to 40% in the UK, which preceded a rise in tax income.
Recent evidence continues to support this as the HMRC (Her Majesty’s Revenue & Customs) report shows how the Government income in the UK when the 50% tax rate was active was £41bn in 2012-13, but the top tax rate reduction to 45% increased income to £50bn in 2013-14.
Why Do We Argue for an Increase?
‘Politics’
Advocates of higher rates of taxation on the top earners seem to appeal to the opinions of the mass public in order to improve their appeal in the hopes of being elected.
The popular opinion is that the highest earners have plenty of disposable income and should be bearing the greatest share of the burden.
Currently, the top 1% of earners pay 29.8% of all income tax in the UK at the 45% tax rate, so is this not proof enough that the top earners already are carrying a large amount of the burden?
Are they supposed to take even more of the responsibility than they already are?
Someone who earns £200,000 (falling into the 45% tax rate) pays roughly 38p for every pound they earn, whereas someone on the £26,500 average wage will pay roughly 13p for every pound.
If we are measuring someone’s contribution on how much is paid per pound earned, the top earner in this situation is paying three times more tax than the average earner.
Recent Publications on Taxation?
A recent paper by Karel Mertens titled “Marginal Tax Rates and Income” provides the most interesting analysis.
A hypothetical tax cut for the top 1% of earners showed a statistically significant increase in real GDP of up to 0.34% in the third year (a theoretical addition of £8.09bn to the real GDP of the UK after three years of the tax change).
Average earnings of the bottom 99% of earners were found to rise by 0.15% after one year, and 0.35% after three years from this GDP increase, representing an interesting spillover effect.
The only noticeable downside to this decrease in the tax rate was the sizeable increase in the top incomes (increasing income inequality).
So if the top tax rate was cut, the majority of people asking for it to rise would see their wages increase.
Surely sacrificing a rise in your own wage just to be against income inequality is counter intuitive, isn’t it?
The results from the study and also from historical evidence point to mutual benefits of a reduction in the top tax rate, so surely when we say that ‘we are all in this together’, it would be wise to adopt the mentality that tax increases at the top end are more destructive than constructive.
