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50p Income Tax? Bad Politics, Worse Economics!

The Shadow Chancellor’s recent proposal to restore a 50p top rate of income tax has led to objections by business people but, so far, only a subdued counterblast from the Coalition. This is disappointing because Mr Ball’s proposal raises important economic issues. It also raises the question of what political gain Labour hopes from the 50p rate…

Politics, voters and the markets
One obvious point is that the Labour government when in power could have introduced a 50p higher rate band at any time between May 1997 and its losing office thirteen years later. The fact that it chose not to do so until near the end of its period in office, and then seemed to do so primarily as a ‘political spoiler’, suggests that Mr Blair and Mr Brown did not believe that a 50p rate had much merit. So if the decision is now made on economic grounds, then the ‘two Eds’ (the Shadow Chancellor, Mr Balls and Labour Leader, Mr Milliband) – both of whom were heavily involved in economic policy before 2010 – should explain why a 50p rate is justified now, when they refrained from such a step for a dozen years. If the decision to abjure a 50p rate was taken on political grounds by Tony Blair and Gordon Brown as Chancellor, then the question that now arises is why the current Labour leadership has changed its view. One answer is that the present Labour leadership attaches more weight to income re-distribution – and less to wealth creation, through intellectual conviction, or because of political expediency. Mr Blair always aimed for the largest possible majority in Parliament and, therefore, made every effort to appeal to the political centre ground and not to frighten significant parts of the electorate.

Mr Miliband, in contrast, has apparently concluded that he only needs to concentrate on the most left-wing 38% or so of the electorate in order to take office. Given the bias against the Conservatives in the current distribution of Parliamentary boundaries, the probable loss of Conservative voters to UKIP, and the possibility of forming a coalition with the Liberal Democrats’ ‘big spenders’, this may well be a viable strategy for gaining office. However, it is also a strategy that means that neither the foreign exchange markets nor international bond investors would welcome the prospect of a Labour government or an improvident Lib-Lab Coalition. Given the UK is likely to face twin deficits on its balance of payments and public sector net borrowing of around 4% to 5% of Gross Domestic Product next year, both of which will need to be plugged by borrowing, the historic parallel for any incoming Labour administration would appear to be closer to the 1974 to 1976 period, ahead of the December 1976 International Monetary Fund (IMF) loan, than to the arrival of the ostensibly moderate ‘New Labour’ in 1997. It is conceivable that the Labour leadership are so eager to acquire power that they have not considered the consequences of their Hugo Chavez style rhetoric on their policy credibility or how they will run a successful economic policy if they gained office.

The 50p Rate – good or bad economics?
First, most economists would accept that the disincentive effects of taxes reflect the marginal loss of income imposed by the total tax system, since this is what determines the trade-off between post-tax income and leisure. This means that National Insurance Contributions (NICs) which are no more than a surreptitious, parallel income tax system these days – need to be taken into account. This is a point that Coalition politicians seem reluctant to make. As far as higher rate taxpayers are concerned, there is an additional uncapped NIC surcharge of 2% as well as employers paying an uncapped employers’ NICs of 13.8%.* This means that a 45% income taxpayer is already facing a marginal loss of income of 53.4%, (45 +2 +13.8)/(1.138), while a 50% income taxpayer would face a marginal loss of 57.8%. If allowance is made also for the indirect tax content of household consumption – which is the most relevant concept when considering the output to untaxed leisure trade off – a 50% tax rate would imply that some 65.4% of any marginal income was directly or indirectly taken by the state.

Second, the interaction between NICs, income tax, and the withdrawal of means-tested benefits means that the effective marginal rates facing people contemplating undertaking extra hours, extra responsibility or the acquisition of useful qualifications are now a complete dog’s breakfast, with high marginal rates hitting the low paid, as well as the wealthy, and marginal rates rising and falling along the earnings curve like a lunatic roller-coaster. There is a crying need for tax simplification and reform and potentially high political, as well as economic, returns for any party bold enough to grasp the nettle.

Third, the jury is still out as to what the revenue maximising rate of higher rate income tax is and at what point increasing the rate leads to lower revenues because the tax rate is on the wrong side of the Laffer curve. However, there is widespread agreement that the extra revenue raised by a 50p top rate of tax would be trivial when compared to either the £740bn the government is likely to spend in fiscal 2014-15, or prospective public sector net borrowing that could approach £100bn. The Institute for Fiscal Studies, for example, has calculated that the 50 pence rate would raise no more than £100m (http://www.ifs.org.uk/publications/7066). There is also agreement that pre-announced changes in the higher rates of income tax lead to the shunting of large amounts of declared income from one tax year to another. This temporal displacement makes it hard to estimate the long-term behavioural responses. However, the range of potential outcomes clearly includes the possibility that a 50% marginal rate of income tax would reduce government receipts, even in a static analytical framework

Fourth, once allowance is made for the dynamic second-round effects of higher taxes on the wider economy, any significant increase in tax rates is likely to so undermine the private-sector tax base – and boost government spending on welfare etc. – that the Budget deficit widens, not narrows. Mr Osborne’s misguided decisions to raise VAT to 20% and add 1% to Employers’ NICs in his original 2010 Budget weakened the recovery from the Great Recession and was one cause of the ‘cost-of-living’ crisis that Labour is now exploiting. (Another important cause was the cheap pound policy pursued by Lord King, as Governor of the Bank of England, where the inflationary consequences were clearly underestimated by officials.) Mr Osborne’s own record as tax-hiker makes it difficult for him to occupy the moral high ground when confronted with Labour’s proposals.

Fifth, the reason Ed Balls has been talking about only a ‘temporary’ top 50% rate of income tax is that in pure theory one off unanticipated windfall levies do not change behaviour. In practice, of course, people realise that governments that engage in arbitrary impositions such as windfall taxes or other allegedly temporary expropriations will do so repeatedly. As a result, activity falls and human, financial and physical capital flight commence because of the uncertainty attached to future tax liabilities as well as because of the rate of tax itself.

Finally, globalisation has increased the international mobility of all the factors of production, including that of highly skilled individuals. The potential loss of tax revenues caused by high marginal rates has increased over recent decades and will grow in future. People with uncertain income streams, including entrepreneurs, suffer disproportionately from progressive tax rates, compared with people whose income streams are steady – e.g., public officials. This is another reason why Labour’s 50p tax proposal is likely to do especial damage to the stock of entrepreneurship on which Britain has to depend if it is to pay its way in the world and offer reasonable and rising living standards to all its people.

*The 2% surcharge on income over 41.45K is in addition to paying the standard rate of employee NIC (12% of earnings between 7.7K and 41.45K). Because higher earner employees’ NICs over the relevant income range are capped, the marginal rate is not affected.

*Professor David B Smith is Visiting Professor, Derby Business School, and Chairman of the IEA’s Shadow Monetary Policy Committee. He is author of Financial Regulation and the Wider Economy: Unintended Consequences in Politeia’s The Financial Services and the UK Economy: The Danger of Over-Regulation.

David B. Smith

David B. Smith is a City economist who worked as a macroeconomic modeller and economic forecaster, predominantly in banks (including the Bank of England) and security houses (1968-2006). He maintains his own macroeconomic forecasting model at Beacon Economic Forecasting. His Politeia publications include Britain's Taxable Capacity: Has it Reached the Upper Limit? (2020), The Brexit Settlement and UK Taxes (2018) and Banking on Recovery: Towards an accountable, stable financial sector (as co-author, 2016).

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