Tax, inequality and the problem of the 50p rate
It is not often that I disagree with my colleague Frances Coppola’s policy analysis, but in the case of Ed Balls’ decision to bring the idea of raising the top tax rate in the UK to 50p back to the table I find myself in just such a position.
I think it is useful to sketch out here the reasons why I am more comfortable with the policy than Frances appears to be.
In her most recent blog post on the subject at Coppola Comment Frances writes:
“The simple fact is that we do not know, and can never know, what the 50p rate would have raised. HMRC did their best to create counterfactuals, and tested them with an impressive amount of Monte Carlo simulation. Although the Monte Carlo results suggest the counterfactuals are far from robust, HMRC's conclusion is that the 50p rate wouldn't have raised much if anything, and could even have lost them money.”
The April 2010-April 2013 period during which the UK had a 50p top rate of tax has certainly managed to confuse a lot of commentators. On the right there are plenty of people claiming that a fall in tax revenues while the 50p rate was in place and the rebound afterwards is a vindication of the Conservative decision to cut it back to 45p (incidentally the figures are £41.3 billion in 2011/12, £41.6 billion 2012/13 and £49.3 billion 2013/14).
Meanwhile on the left the siren cry is that these figures ignore the fact of forestalling and reverse forestalling. HMRC estimate that between £16 billion and £18 billion of income was brought forward to 2009-10 to avoid the additional rate of tax. This, many on the left suggest, mean the actual impact of the 50p rate cannot be accurately measured as the figures were skewed by income shifting.
The most important point to note here is the degree to which we just don’t know what the actual impact of a 50p top rate of tax would be. The Institute for Fiscal Studies summed up the extent of the uncertainty in a its recent note on Balls’ announcement:
“HMRC’s central estimate is that this elasticity was 0.45, which is broadly in line with estimates by IFS researchers based on the last time the top rate of income tax changed – in the 1980s – and with estimates from a number of other countries. If instead the true elasticity was 0.35 (which is well within the range of uncertainty), reducing the top rate of tax from 50p to 45p will have cost the exchequer about £700 million, whilst if the true elasticity was 0.55 (again, within the range of uncertainty), it will have actually raised about £600 million.”
So depending upon your assumptions either we’re a small step closer to reducing the fiscal deficit because the Coalition were savvy enough to cut Labour’s excessively high top rate of tax, or the reckless Coalition cost themselves around £700 million in its haste to slash taxes. At this point there is simply not enough good quality data to score the argument either way.
That said, the IFS’ central estimate is that the Coalition’s cut of the top rate of tax cost the Exchequer some £100 million, and that its reintroduction might therefore be expected to raise an equivalent amount. That is an extremely modest amount, especially considering the margin of error here.
However, I think attempting to analyse tax policy by trying to quantify its short run impact of government revenues is an inadequate way in which to frame the discussion. Instead I think this should be a debate about how aggregate income gains in an economy should be distributed.
In the UK the share of income going to the top 1% of income earners has grown dramatically over the past half century. The chart below from Piketty and Saez (2012) illustrates this trend:
As the authors note “it is striking to see that the countries where top income shares have increased the most - typically the US and the UK - are also those where top marginal income tax rates were cut the most”. Thus as the highest earners captured a larger chunk of aggregate income gains they were also seeing their tax liabilities reduced.
I tend to agree with the point made by Ken Rogoff during a debate in Davos last week that “it’s hard to believe that we would see these very low tax rates on the ultra-wealthy without some feedback through the political system”. That is, the power that the wealthy have is reflected in policy outcomes, which in turn reinforce their power and further skew policy.
Pikkety and Saez suggest the optimal top rate of income tax could be high as 82%. If France is anything to go by states unilaterally enacting such a large tax hike can have a significant distortionary effect driving capital (and people) out. Yet are we really suggesting that a five percentage-point difference in the tax rate would drive UK business people to emigrate?
The evidence we have from 2010-2013 shows that people are willing to opportunistically shift income around to decrease their tax liability but it tells us very little about their willingness to move to Hong Kong or Singapore. Furthermore, as Coppola notes, “there will always be a little island somewhere in the world that will seize the opportunity to build its GDP by cutting tax rates for the very rich” so it is clearly not in the best interests of the UK to try and win a race to the bottom on tax rates.
Ultimately the short-term cost/benefit of the 50p rate is impossible to gauge ex ante unless we can more accurately estimate the behavioural response. For the longer term, however, I contend that the risks – both political and economic – of allowing aggregate income gains to accrue so disproportionately to the few are likely to far outweigh a possible modest hit to revenues.
Where I strongly agree with Coppola is that if a 5% increase in the top rate of income tax is the extent of Labour’s vision for the future, however, it is a hopelessly conservative one.