The case for scrapping the highest rate of income tax


Professor Gianni De Fraja, University of Leicester

Gianni De Fraja, Professor of Economics, University of LeicesterRecently the FT published a letter signed by a motley crew of 20 economists: some well known “right wingers”, some regular pundits, others neither. The letter called for the government to scrap the highest rate of income tax. I was among the signatories, my first ever letter in the FT, and managed to surprise some of my friends, who are quite aware that my sympathies are to the left, that I typically vote Labour, and that I view the extent to which Gordon Brown has protected lower incomes in the face of a strong global tendency toward inequality as the main achievement of his tenure as Chancellor. And certainly my salary is way below the 50p tax threshold.

The reason I agreed to sign the letter is because I believe that tinkering with marginal income tax rates is counterproductive.

I do not think that the high ability ambitious people are deterred from working hard by the 50 pence tax: I agree with Simon Jenkins who argues in the Observer that high earners are not motivated by money, but by the desire to succeed. However, when they have succeeded, they also try to take measures to reduce their tax liability.

The benefit of any such measures will depend on the comparison between the marginal UK tax rate they face (today 51%), and the marginal tax rate their income would face if channelled differently. I can give three examples, but there are hundreds of instances of taxpayers’ inventiveness.

  1. Try to pay income tax where the marginal rates are lower. Lewis Hamilton pays tax in Switzerland, and Boris Becker used to pay tax in Monaco. Not all high earners have this choice, but many do (recently a loophole closed that allowed City financial sector workers to live in Switzerland, fly every Monday morning to London and back on Thursday night, thus remaining below the 180 nights per year tax residence requirement), and if a percentage of them finds that the benefit of those opportunities exceed their cost, revenues are reduced, the only effect is that socially wasteful tax avoiding effort is exerted.
  2. Try to pay corporate or business tax rates. A lot of high earning people set up as companies. Many more are paid in shares or options, or other differentially taxed fringe benefits. This distorts choices with no efficiency justification.
  3. Try to pay lower marginal tax rates. This can be done by employing and/or transferring assets to other members of the family.

Setting up these activities requires skill and intelligence, and because advising on how to do is both difficult and very valuable, many ambitious and bright people are employed as highly paid socially unproductive tax accountants, draining away scarce resources from the productive parts of the economy.

My own opinion is that a single marginal income tax rate, levied on the whole of person’s income (irrespective of source) would go a long way towards addressing problems 2 and 3 (and many others). Eliminating the 50% tax rate would be a move in this direction. It would not be progressive, but progressivity should be a feature of the tax system as a whole, not of each specific tax.

There are better (in the sense of raising the same amount of tax revenue while causing less costly and less harmful distortions in the economy) ways of making a tax system progressive.

Some examples:

(i)                Accompany a single income rate tax with a sufficiently large exemption: if additionally, this were administered as a negative income tax, it would be a benefit system without many of the problems associated with the current one (complexity, low take-up and stigma among them). In practice, everyone alive would receive a sum, say £15,000 per year (less for children and more for pensioners), and everyone pays 40% of the total of their income and this sum. This would also be the opportunity to confine to the dustbin the archaic and utterly senseless absurdities generated by National Insurance payments: created as insurance, NI is now a tax levied on income from work, precisely the activity society should provide incentives for.

(ii)             Tax wealth. At the moment wealth taxation is an obscenely regressive tax. The buyer of this property in Lambeth will pay £1,784.05 per year in council tax (a rate of 2% per year). The buyer of this property in the same borough will pay 38% more, viz £2,470.22:  a rate of, wait for it, 0.03%!. A proportional tax of say 0.5% per year on wealth in excess of £1m would cost this household around £38000 per annum; many would view this as fair. It is unlikely to create much costly avoidance, or to cause people to move abroad; it would generate revenues transparently with little distortion. The Spanish government has just introduced a wealth tax. Well done. And Mr Clegg has offered to swap it for the 50% income tax rate. I suspect this offer will ensure that the 50% rate will stay firmly in place for this parliament.

The tax system is necessary to raise revenue. The design of the tax system can be good or bad: indeed it can be very good or very bad. The current system is very bad: a higgledy-piggledy jumble of income, consumption, inheritance, capital, in- and disin-centivising taxes, incoherently assembled without a plan, at different times by different governments. An excellent overview of the potential flaws and pitfalls of the current system, with a very lucid exposition of the principles which should underlie tax reform, with potential applications to the UK is the Mirrlees review: there are worse things to be required as compulsory reading for journalists and MPs.

Gianni De Fraja is the William Tyler Professor of Economics in the Department of Economics at the University of Leicester.  Information about him and his research can be found on his personal webpage.

8 Comments

  1. Oliver
    Posted 14/11/2011 at 18:47 | Permalink

    The rich people should not only be taxed but taxed heavier

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  2. Tom Hilldon
    Posted 09/11/2011 at 21:03 | Permalink

    There is definitely a case for scrapping the highest rate of tax.

    There should be only one rate of tax and it should be levied on incomes above £40,000 . It would probably need to be 60 or 70 percent at present but could be reduced to 40 or 50 percent as government spending is reduced. The ceiling would keep wages from rising too high. It should be coupled with a ceiling on managerial salaries of 7.5 times the lowest employee’s or 10 times the minimum wage whichever is the lower. Sole owners would be exempt provided no employee, temporary staff or contracted labour (e.g. Cleaner) was paid less than three times the minimum wage. Dividends would be included as salary. This would discourage the payment of poverty wages by the class of person most likely to pay them. Everyone would pay a 5 percent local authority tax but could vote to pay more for additional services. No arguments about it being difficult to collect an apportion, that’s why we have computers.

    National insurance would become voluntary except for a mandatory NHS contribution. So if you think you are unlikely to ever claim unemployment benefit (many people never do) then you may choose not to contribute and not to receive. If you have never worked then you cannot claim unemployment benefit until you prove you are employable. If you are physically or mentally incapable of work then you should be supported by the community through a property tax proportionate to the value of the property.

    There should be two classes of VAT: Utility and Luxury. Utility charged at 5 percent and Luxury at 25 percent. Basic food, fuel, land line call and basic broadband charges within the UK, low cost clothing and furniture, etc would be charged at utility rate. Processed food, all electronics, mobile phone charges, expensive furniture and clothes woul be luxury rate. In order not to be thought poor most people most people would opt for luxury rated goods and services whist the genuinely poor would be protected.

    A final lesson fo any prospective Chancellor of the Exchequer, don’ t borrow money at 30 percent when you can borrow it at 3 percent. Chancellors who have done that have not had the sense to do as I suggest and never will.

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    Garreth Reply:

    You honestly think that there should be a highest rate of tax at 70% on wages over 40k? Let me ask you, where do you live? If you lived in London you would soon realise that £40,000 is actually not that much to live on, certainly if you have a family. Also to jump from 20% to 70% is ludicrous. It’s a massive socialist policy and harms those who are the hardest working in the society. It’s a disincentive for people to want to climb a corportate ladder and fulfil their potential.

    Your next point about benefits is rather good, until you mention a property tax. So now not only am I being charged 70% tax for working hard, but I am also being taxed for wanting to live in a nice property? So now middle-ground employees are encouraged to find a job that pays less and live in small apartment.

    I fear that if you ever got in power you would want to turn this country into one filled with socialist policies. That would be a dark day indeed.

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    Tom Hilldon Reply:

    You have not thought it through Gareth. I live in London and earn £50,000 p.a. so I would pay 70% on £10,000 = £7,000. I will volunteer not to pay national insurance so I will only pay my NHS contribution. I already pay £2,000 p.a. property tax so my contribution to the disabled has to be less. I will only buy utility goods and services (I’m a real skinflint) so I will only pay 8% VAT. in order to increase the tax take the goverment has to promote policies the will raise low wages.

    The people who earn the big bucks in banking and financial services will either have to take more realistic salaries or leave the UK. The market for real financial services won’t change so the institutions will have to promote those immediately below those who leave and recruit replacements on sensible salaries, immediately reducing unemployment. The industry as a whole owes us about £1trillion so it cannot leave without paying us back or we freeze their assets. If they come up with the dosh, fine, fare thee well and good riddance. We get our money back sooner so we can invest it in the real economy.

    The whole proposal relies on the willingness to be flexible. The rates might need to be tweaked rather more often that we do currently but that’s what computers are for. It is like the variable transaction tax proposal but for people. Good transactions attract a low tax and bad transactions attract a high tax. Non retail banking has not made the country any money for the last 10 years so it is now bad for our economy. We have a special tax for banker’s bonuses already and we might want to extend that until loans to industry rise to the required level before reducing the tax as a reward. When banking starts to make money for the country then the taxes will be reduced further. The test is value to the people which means we get the benefits of capitalism without greed cycle (boom and bust) that is so destructive of our economy and society as a whole.

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    Tom Hilldon Reply:

    Apologies for the poor punctuation missing definite articles. I haven’t got the hang of this keyboard yet.

    [Reply]

  3. Garreth
    Posted 19/10/2011 at 10:43 | Permalink

    The main issue here seems to be avoidance. If there are loopholes to avoid the current tax rate then there will be loopholes to avoid even if the 50% marginal rate is scrapped.
    The issue we need to focus on here is closing these loopholes. People whose primary work in the UK should have to pay UK tax, regardless of how long they spend here each year. Other sources of payments such as bonuses, pension schemes, shares etc should also be included as part of a persons wage and should also be taxed.

    Your idea of a wealth tax is ludicrous. Taxing people because they have not spent their money is a terrible idea. People are being taxed on their wages, taxed on their spending and you want to tax them on their savings as well? It’s not difficult to see which side of the politcal fence you sit on.

    We need to find the right balance between taxing people, and incentives to ensure the worlds greatest businessmen want to work in England. We want to attract companies and businessmen, not scare them away by taxing them every time we get the opportunity.

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    Alison Moody Reply:

    Not unexpectedly, the world’s greatest businessmen prefer to remain in their own counties rather than come to Britain. Joseph Bamford chose to retire to Switzerland but his heirs continue to pay their tax in the UK. Most British businesses have British managers and those that don’t are not sensitive to the tax they pay. This will not change if the highest tax rate is 50 or even 60%. Americans have to pay US taxes wherever they live. We could do the same. If we also made hedge fund managers pay the same rate of tax as their cleaners and this made them leave our shores, then that could only be good for our economy and save us all a fortune in subsidies. It is enough that Norman Lamont gave George Sorus and his pals £7billion of our money. Gordon Brown gave the bank shareholders billions more. I want my money back and I’ll vote for any one who will get it for me. Looks like I won’t be voting for anyone any time soon. But as 70% of the votes cast in the average election have no effect whatsoever no government is going to be over concerned about that.

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  4. Ron Jones
    Posted 09/10/2011 at 12:14 | Permalink

    Is the tax source the biggest issue or the tax spend? Blue Streak, TSR2, Polaris, Trident, MRCA, tanks, communications systems, jamming rifles, a fortune spent and either scrapped or never used. Wars without end or purpose. We could have given every sheep on the Falklands a £1million pounds in compensation for becoming Argentinean and still paid less that we have paid to date. Iraq, Afghanistan more money down the drain. Subsidies for wind farms that can never repay their energy inputs let alone their costs. The list is endless.

    Focus on the real problem. Insane spending by naves and fools and you won’t have to concern yourself about how revenue is raised. Hypothecate taxes to keep politicians and civil servants clean. All fuel taxes must be spent on roads. Public transport income spent on public transport. Health tax for the NHS. Elders tax for the care of the elderly, disabled care tax, children’s care tax, unemployment tax, an army tax, an airforce tax and a navy tax. All individually authorised in a referendum every 4- 5 years and perhaps more often by public demand.

    It is always less expensive to live in a democracy. Ask the Swiss if you don’t believe me. So the first step is to turn the nation into a democracy. We have seen how even limited democracy has benefited the Scots, Welsh, and Northern Irish. Now we must embrace it for the United Kingdom.

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  5. Richard Hagan
    Posted 09/10/2011 at 11:33 | Permalink

    There can be no case, practical or moral, for not taxing the rich more than the poor. If you tax the rich so much they move off shore then you go for their assets. There is a case for not taxing people as much who are growing their businesses and employing people in the UK rather than people in the far east. Not easy if you are in manufacturing but all efforts should be rewarded. Alison’s suggestion of a transaction tax is a good example of a progressive tax. Fifty percent of you income over £100,000 is very reasonable and so is sixty percent over £250,000. I would be both proud and pleased to be paying these taxes.

    There is a false assumption that rich people will move away and take their businesses with them. The laws of economics make this impossible. A competitor would just take its place. Britain used to be place where car manufacturers could charge excessive prices. When there was a public backlash, the manufacturers did not leave the UK. All this nonsense is tiring to hear repeated by people who should know better.

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  6. Alison Moody
    Posted 09/10/2011 at 11:13 | Permalink

    Chris, you are wrong. People would be taxed 3 times. Everyone is already taxed twice – once when they earn and once when they spend. To be taxed for holding assets for your old age is the most ludicrous suggestion I have ever read. When you consider what a variable transaction tax on non retail banking would bring in and what benefits it would have for ordinary people and compare it with this suggestion then one can be forgiven for wondering what planet academics live on.

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  7. Chris Williams
    Posted 08/10/2011 at 10:19 | Permalink

    Two people in middle class professions will accumulate £1m by the time they retire. This will have to house them and support them for the next 30 years if they are lucky. If they have a slightly larger pot, you propse to tax it twice. Once when it is earned and a second time because they have not frittered it away. Brilliant idea. A work of genius.

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  8. Peter S
    Posted 06/10/2011 at 12:17 | Permalink

    Whilst I agree with much of the intellectual analysis here there is something that sticks in my throat about this argument: That we should reduce tax because those who should pay it will avoid it (legally or illegally) if we don’t do so. I think that’s a terrible message to send out.

    Not all that is legal is moral and higher tax rate payers have a moral duty to pay their contribution.

    There is an argument that smoking declined when it became viewed as anti-social rather than through legal restriction. Tax avoidance should equally be viewed as anti-social and those that do it villified and shamed.

    I can just about live with a lower marginal rate for high earners. But we absolutely should not do it just beacause the rich will seek to avoid paying their share otherwise.

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