Laffer curves and the logic of the 50p rate
“What do you make of the idea of a 50p tax rate on top earners, then?”
“What do you mean, ‘the idea’? It’s here. It’s happening. Look around you! It’s the reality we have to deal with, not the idea.”
“Come on, Charlie. It’s not as if you have to deal with the “reality” of the 50p rate, is it? Not on your salary.”
“It’s not about salary, mate. It’s about entrepreneurialism. The 50p tax rate discourages entrepreneurial spirits.”
“Not if your entrepreneurial spirit doesn’t pull in 150 grand a year, it doesn’t. And there’s no chance of that.”
“Not any more, there isn’t. But that’s because my entrepreneurial spirit has been deflated by the 50p rate. I was planning to become a millionaire this year, but I decided it wasn’t worth my while. It’s exactly this kind of thing that those 20 economists were worried about when they wrote to the FT this week. The 50p rate should be scrapped. It’s damaging the country.”
“I suppose that’s possible. I don’t doubt your story for a second, but I wonder how many people are in the same boat. And the government needs money – if not from the richest, then from somebody less able to pay.”
“Does the 50p rate make money?”
“I’ve looked it up. The Treasury reckons the 50p rate will earn £2.7bn a year in revenue, which is something like £40-£50 a person per year.”
“That doesn’t sound a lot.”
“Fifty pounds is better than a poke in the eye. If the Treasury doesn’t raise it from the rich it will have to raise it from somebody else. But the estimate is very uncertain because of what the Treasury calls a ‘behavioural response’.”
“What’s that?”
“Could be pure fraud: tax evasion. Or people like you, deciding to remain lowly wage slaves because of the disincentive effect of the 50p rate. Or people using legitimate accounting dodges, delaying collection of dividends, relocating to Dubai, that kind of thing.”
“How big is the behavioural response?”
“We don’t know yet, some of it we’ll probably never know. But I saw some numbers suggesting that the behavioural response would wipe out two-thirds of revenue. The 50p rate would have raised £7.8bn if not for the behavioural response.”
“But people keep saying that the Institute for Fiscal Studies reckons the 50p rate could actually lose money.”
“The IFS said it might lose money, not that it would.”
“But what about the Laughter curve?”
“The Laffer curve?”
“Same thing.”
“Interesting you should ask. The idea behind the Laffer curve is that if the tax rate is zero then revenue is zero and if the tax rate is 100 per cent then revenue is also zero, and if the tax rate is somewhere in the middle then revenue is positive.”
“Doesn’t sound that profound.”
“It’s not that profound. Logically, there are tax rates so high that cutting them actually raises revenue.”
“Such as the 50p rate.”
“Well, maybe. In some circles the Laffer curve is now simply a claim that whatever the tax rate is, if you cut it then you’ll raise revenue. Which is daft.”
“Well, maybe – but 50 per cent is a pretty high tax rate in my book. And there’s national insurance and VAT on top. The real tax rate on the top earners is probably over 60 per cent.”
“Yes – which as far as anyone can tell is pretty close to the top of the Laffer curve. In other words, it’s close to being the optimum for raising revenue. Not that we really know for sure.”
“Optimum? What are you talking about?”
“Calm down – I just mean that the 50p rate, that is about a 60 per cent marginal tax rate on the top earners, is probably close to the rate that raises the maximum amount for the Treasury. It doesn’t mean it’s a good rate. It means that after you account for all the fraud, the discouraged entrepreneurs, the tax exiles and the money paid to accountants, the Treasury is still keeping a pound or so out of every three pounds it tried to collect with the 50p rate.”
“That doesn’t seem ideal.”
“It doesn’t. Now there are some people who don’t care if the Treasury raises nothing at all, as long as the rich are inconvenienced. And others will look at that and say it’s a lot of fuss for not a lot of revenue and so it’s probably not worth the risk of discouraging entrepreneurs. That’s true even though that risk is probably not very big, yourself excepted of course.”
“Are there really people who think that?”
“Right now? No, nobody. At the moment most of us are happy if the rich get it in the trousers. I’d wait a couple of years to become a millionaire, if I were you.”
Also published at ft.com.
9 Comments
aloa5 says:
50p over all – not only for the last Dollar.
The problem with Laffer is that it doesn´t take care of the economic circuit and it dies not reflect income inequality (in relation to the circuit). And (of course) the basis of his claim is the individual taxation – not including the vat wich you don´t “see”.
USA about 40% public expenditure quota. How is it possible (Laffer in mind) to get an effective taxation of 40% over all with given income inequality? The difference between low income and high income taxation (over all) is very, very low in relation to the difference of the incomes.
A last picture. A king gets 99% of all income, the others 1%. How would the demand look like – if the others (including the state!) don´t take the neccessary debt to support the GDP.
And the very last – did Laffer (and you) take care of public/Government debt?
Regards
10th of September, 2011ALOA
Tim Leunig says:
Poor people often lose 80p if they earn £1 more, especially if they receive housing benefit. If we believe that incentives matter then we should be addressing this issue first.
10th of September, 2011Ralph Corderoy says:
“Allister Heath yesterday added his voice to the economists who think the government does need to cut the top rate of Income Tax from 50% to 40%. Politicians are wary of this, as taxing the rich is always popular with many voters. The problem the government faces, as Allister points out, is the best way to tax the rich is to set a competitive rate. In 1981-2 when the top rate of tax was 83% the top one percent of earners only paid 11% of the total Income Tax. By the end of the last century with a settled top rate of 40%, this figure had shot up to 21.3% of the total Income tax raised. The rich were paying lots more, and a much bigger proportion. This rose further in the last decade.” — The Rt Hon John Redwood MP, http://www.johnredwoodsdiary.com/2011/09/09/all-we-need-is-growth/
10th of September, 2011Ann Kittenplan says:
As with almost all economics arguments I come across this seems to me hopelessly one-eyed, reductionist, simplistic, short-sighted, and deterministic, for a start. (Sorry this stuff annoys me.)
F’rinstance lets say the 50p tax rate actually decreases revenue (on the narrow definition used in the article), Is that any reason to abandon it? You could argue No because it sends out a signal that, wait for it, We’re all in this together.
As a consequence society becomes a fairy tale of peace, harmony and co-operation. The feral underclass stops looting, the feral elite stops evading tax, the feral bankers run sustainable banks, and revenue *as a whole* goes up.
OK this is perhaps an overstatement but almost always there are consequences way beyond the narrow short-sighted focus of standard economic arguments.
10th of September, 2011Nick says:
The letter to the FT seemed to suggest that the top rate was too high because, “…just 1% of tax payers..already pay 24% of all income taxes..”
While this could be because taxes on the rich are too high, it could also be because the income gap between rich and poor is massive. When there are a small number of people earning massively above the average wage then we shouldn’t really be surprised that they pay a disproportionately high amount of the income tax.
When you look at it like that it doesn’t sound quite as compelling an argument to be giving those lucky few a handout.
I’m surprised the people who signed the letter didn’t think of this.
11th of September, 2011will says:
My marginal tax rate at one time was nearly 100%. If I had earned an extra £1,000 I would have paid tax and NI, a child lost £400 on EMA, we lost child tax credits and my eldest lost some of her student grant.
I could have raised the income we got from a rented home but it wasn’t worth it for us.
14th of September, 2011matt says:
I’m very impressed with any blog that attracts comments from the resurgently prominent Redwood – even if they are 2nd hand. That argument about increased revenue correlating with a drop in the top rate of tax really does need to take account of the increase in the number of those paying it, and the increase in the amount of income involved. I suspect that’s not entirely simple since any increases could be just that there are more rich folk around compared to average folk, or because of some folk getting richer whilst others get poorer (their tax take thus decreasing), or they could all have been tempted back into the clutches of HMRC from their self-imposed exiles in Monaco and the Carribean – I know I would get fed up of all that sand after a bit.
14th of September, 2011matt says:
Another thought (as I contemplate a two year pay freeze with inflation up around 5%). All those folk with a pay rate of 1PM (sorry – not paying enough attention to More or Less but I think that was the unit for a salary equal to the prime minister) or >1PM (and there was a list of them on the programme, which included public sector bosses, business execs, and footballers) must be looking forward to the tax cut / pay rise with a real “we’re all in it together” spirit. Presumably this will awaken their entrepreneurial spirit and they will go out to supplement their salaries with a few business start-ups on the side thus boosting not only tax revenue from their additional earnings, but also employment, GDP, and the general happiness of the rest of us.
14th of September, 2011Mo says:
@Ralph, in 1981-2 the top 1% earned about 7% of the total income, whereas in 2000 they earned about 14%. So to be contributing 11% and 21% of the income tax respectively suggests a (perhaps surprising) consistency of contribution across the changed marginal tax rates.
15th of September, 2011