Laffer curves and the logic of the 50p rate

10th September, 2011

“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.”

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