Defending the 100 Percent
Although it may be an uncomfortable topic of conversation around many liberal dinner tables there is a significant body of academic work that suggests lowering the tax burden can improve growth. One of the latest additions to it is Karel Mertens’ work on Marginal Tax Rates and Incomes published last month in which he finds a “statistically significant increase in real GDP” from cutting the top rate of tax.
Writing in City AM Ryan Bourne, head of economic research at the Centre for Policy Studies, accuses left-wing economists and commentators of ignoring the paper. Bourne speculates that this is because, despite vocal appeals for “evidence-based policy”, people cannot (indeed, he says, should not) avoid their underlying value judgements when debating subjects such as inequality and growth.
Undoubtedly there is a reluctance to address research that grates against ones Bayesian priors but few advocates for progressive taxation couch their arguments in the language of economic efficiency. Instead it is usually discussed from an ethical perspective, stressing a utilitarian case that redistribution is better for society as a whole even if it comes at the expense of economic growth. Indeed it was this utilitarian tendency among economists that Greg Mankiw attacked in his recent article “Defending the One Percent”.
It could both be true that lowering the top income tax rates could increase growth and that it could have negative social impacts. Equally, it may be the case that lowering the top rate of tax could increase growth and have a positive social impact. Mertens, for example, suggests it is possible that “real wages may…rise when income taxes are cut, for instance because increased investment shifts labor demand, or when there are nominal rigidities and aggregate demand effects”. (It is also perfectly possible that lowering tax rates might not increase growth, Mertens' paper is by no means definitive proof).
Yet what Mertens and other proponents of this view are missing from their analyses are the problems posed by the erosion of the middle class since the 1970s. This trend has been well documented and is common to the majority of advanced economies, although it has particularly affected the US and the UK.
One consequence of this is that the reliance on higher rate taxpayers is growing. Although for the 2012-2013 tax year income tax in the UK accounted for only around 26% of government revenues, 36.5% of it will be paid by the 13% of taxpayers who are subject to the top rate. Indeed according to IFS calculations 307,000 people, or around 1% of the UK’s total tax base, will contribute 24.6% of total revenues. On current trends this is likely to grow over time as improvements of executive pay significantly outstrip average earnings growth.
Indeed in the UK this process has been actively sped up by government policy with the increase in personal tax allowance from 2014 set to pull as many as 3 million Britons out of the income tax pool.
Removing those at the bottom end of the earnings spectrum is in itself something to be applauded. It can be seen as a statement that citizens, included those in tough circumstances, should be trusted to know better what to do with the money they earn than the state.
However, it might also be seen as a reflection of the fact that a rising proportion of the population are struggling to earn much above this rate. Stagnant wage growth and a sharp rise in the number of people in temporary- or self-employment over the crisis in Britain provides some evidence in support of this thesis.
Is a trade-off between equality and efficiency inevitable?
A 2002 paper by Knut Røed and Steiner Strøm looked directly at the problem of whether trade-offs between equality and efficiency are inevitable in relation to labour markets. In one particularly interesting section they discuss the apparent differences between European and US labour market conditions (emphasis mine):
“One of the most popular explanations for the current European unemployment problems runs as follows: There is a global trend towards increased productivity dispersion that brings about a skill-biased change in labour demand. This is the reason why we have observed a spectacular increase in wage inequality in the United States. European countries (with the exception of the UK) have typically avoided the increase in wage inequality, due to a more centralised and egalitarian wage system (e.g. in the form of minimum wages). But they have paid the price in terms of high long-term unemployment among low-skilled workers. Although this hypothesis is striking in its ability to explain simultaneously the most conspicuous labour market developments both in the United States (more inequality) and in Europe (more unemployment), it is controversial. But if it does convey something of importance, it suggests a potential role for tax reform in reducing unemployment. What the hypothesis implies, is that wages for some low-skilled workers are too high (including taxes) for the firms to employ them, while they are too low (net of taxes) for the workers to really want employment. A shift in the tax burden from those with low wages to those with high wages (i.e. a more progressive tax schedule) may in principle eliminate (or reduce) both these employment barriers. It may make it more attractive for low-skilled workers to work, while at the same time give the firms stronger incentives to hire them.”
But here’s the problem. If governments reduce the tax burden on lower income households at the same time as asking more from top rate taxpayers in order to supply a de facto employment subsidy then those at the receiving end of the subsidy begin to lose their voice. The “no taxation without representation” slogan could cut both ways – if the size of the employment subsidy is decided through a negotiation between government and the wealthy then we may very well be in a situation of “no representation without taxation”.
Furthermore as the Thatcher administration learned with the Poll Tax riots, raising direct taxes is a difficult and politically costly undertaking. Indeed the political temptation is almost always to do the reverse – lower direct taxes while surreptitiously raising indirect taxes such as VAT and fuel duty to compensate for some of the shortfall. Another short-term fix is to increase the number of people captured by the top tax rate.
Unfortunately, both strategies suffer from diminishing returns – either through raising the cost of living too high for many to support themselves or else distorting incentives. Moreover, as the tax pool shrinks the narrative that the majority are voting themselves incomes taken from a hard-working minority is strengthened.
Just as importantly, as I alluded to above, if it doesn’t improve their prospects being pulled out of tax may be a disempowering experience for those on lower incomes. While I disagree with much of what Mankiw wrote in his article I think the following is an important challenge that the political left still needs to answer:
“If the growing incomes of the rich are to be a focus of public policy, it must be because income inequality is a problem in and of itself.”
If a bifurcated labour market becomes seen as the "new normal" then growing reliance on top rate taxpayers provides a strong disincentive for government to address the underlying causes of inequality.
Are we looking at it the wrong way?
If inequality is a symptom and not a cause of underlying economic trends then addressing it through redistribution alone without reform is a blunt tool that could well backfire. For the UK to remain a prosperous, dynamic economy it would be a mistake to bring in draconian caps on earnings to maintain a welfare system if it does little to improve the prospects of recipients.
Perhaps then we are simply looking at inequality the wrong way. When the OECD looked into the issue of inequality and economic growth last year it found the following (emphasis mine):
“OECD countries can be divided into five groups according to their patterns of inequality. For example, in five English-speaking countries (Australia, Canada, Ireland, New Zealand and the United Kingdom) and the Netherlands wages are rather dispersed and the share of part-time employment is high, driving inequality in labour earnings above the OECD average. Means-tested public cash transfers and progressive household taxes reduce overall income inequality, but it remains above the OECD average. At the other end of the scale, four Nordic countries and Switzerland all have comparatively low labour income inequality because wage dispersion is narrow and employment rates are high. Cash transfers tend to be universal and are thus less redistributive. Income inequality for this group is considerably below the OECD average.”
That may sound strange but it is an idea worth considering. The British model of redistribution has been based on a managerialist approach that entails significant administrative costs. Despite the costly public sector infrastructure designed to funnel money to those in greatest need, it has not succeeded in reducing inequality even compared to countries where transfers are “less redistributive”.
So what is going on?
If inequality is a symptom of a dysfunctional labour market then the Beveridge welfare model designed “to make and keep men fit for service” may simply no longer be fit for purpose. This is not because benefits are set too high to dissuade people from seeking employment, but because the available low-skilled (and increasingly mid-skilled) employment has become so insecure and so poorly paid that work really doesn’t pay.
As such the problem is not that there are a growing number of wealthy people in society, but that a rising share of the job market is failing to provide the financial security that people require. Seen in this way instead of focusing on redistributive policies the state should be looking at ways to ensure a basic standard of living for all of its citizenry while maintaining incentives for people to work.
One way to achieve this would be through a universal basic income model (as both Chris Dillow and Frances Coppola have suggested). This could in part be paid for by, as the OECD suggests, shifting taxes from income to wealth or inheritance – and thereby reducing marginal tax rates. It could also involve dismantling much of the costly apparatus of the current welfare system and allow for a highly flexible labour market to be maintained without undermining the financial security of households.
This may appear too great a stretch for our political establishment. But if we allow the current status quo to sustain, it will likely be to the cost of both the wealthy and the poor alike.