Professor Gianni De Fraja, University of Leicester
Recently 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.
- 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.
- 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.
- 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.
(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.