Tory leadership candidates may disagree on the best way to deliver Brexit, but there does at least appear to be a consensus on the need to reduce the burden of taxation. This week, for instance, we have had Boris Johnson outlining a plan to give 3 million people a tax cut by raising the threshold for the higher rate of income tax from £50,000 to £80,000.
Whatever the specific merits of Johnson’s plan, the fact this is on the agenda is welcome, because making the case for cutting and simplifying taxes has rarely been more urgent – or challenging.
The opposing view was well put recently by Labour in a slick video, ‘5 people versus a billionaire’. It imagines a straight choice between a £20,000 tax cut for one of the filthy rich, or sharing the same money between five more needy people – in the form of a pay rise, a pension increase, disability support, a small business loan and a student grant.
In Labour’s tale, the callous billionaire simply pockets the cheque and forgets about it. When prompted, he announces that he’ll be sending the money to the Caymans ‘with all the rest’. In contrast, the five would spend the money in the local economy, driving a virtuous circle of rising expenditure, higher incomes, more jobs, and more tax revenues to fund public services.
This is cracking stuff. It even rings true. Five low-income earners would almost certainly spend more of any windfall than one billionaire. This spending is likely to be multiplied as it ripples through the economy. And the larger this multiplier effect, the more money the government will get back in the form of higher tax revenues and savings on income-related benefits.
In reality, though, the crude choice in Labour’s tale is a false one. For a start, there simply aren’t enough rich people to squeeze. To find £20,000 to share among five poor people, you’d have to tap many more taxpayers than just the few at the very top.
According to the latest Sunday Times Rich List, there are 151 UK billionaires. If each paid an additional £20,000 in tax, the total raised would only be £3 million, or roughly 5p per head to redistribute to the rest of the population.
Of course, the Labour video only singled out the evil billionaire to make a cheap point. But suppose we extend the target group to include all those taxpayers who are fortunate (or wicked) enough to pay the 45 per cent additional rate on incomes over £150,000. That’s around 400,000 people. If they each pay an additional £20,000, that would raise a handy £8 billion per year.
However, that still wouldn’t go very far. If we assume this £8 billion is redistributed among the poorest 20% of the population, say 5 million households, that’s just £1,600 each. It’s also only a drop in the ocean compared to Labour’s likely spending plans.
What’s more, all this assumes that it’s easy and costless to squeeze more tax out of those paying the higher rates. Money taken from them is money that they will not spend in the local economy too. But there is also overwhelming evidence that higher-income taxpayers are more likely to behave differently in other ways in response to changes in marginal tax rates.
In the words of the Office for Budget Responsibility (OBR), these individuals are “likely to be more willing and able to alter their working lives and financial arrangements in response to tax changes”, whether through “labour supply responses (e.g. working less, taking a lower paid job, retiring early, or leaving the country) or greater recourse to tax planning, avoidance and evasion”.
This is consistent with the idea – popularised by the US economist Arthur Laffer – that reductions in high tax rates could actually increase government revenues, without the need for more borrowing or cuts in public spending to finance them.
Admittedly, there is huge uncertainty about the magnitude of behavioural responses. Looking simply at what happens to tax revenues immediately before and after changes in tax rates can be misleading, especially when changes are pre-announced. The share of total tax revenues paid by those on higher incomes can also depend on many other factors, notably trends in income inequality.
Rather unhelpfully, economists can’t agree on the point at which an increase in the tax rate will actually lower government revenues (or vice versa). Some international studies have suggested that the tipping point for personal income taxes might be as high as 70 per cent, others that it is nearer 30 per cent.
Some cheerleaders for tax cuts may therefore be going too far in claiming that their proposals would definitely pay for themselves. But it is surely right that the favourable effects on incentives will significantly reduce the costs. For example, HMRC estimated that the cut in the additional rate of income tax from 50 per cent to 45 per cent in 2013-14 would reduce revenues by only £100 million a year, rather than the £3 billion, or more, if behaviour did not change.
We can also say with certainty that the overall tax burden in the UK, expressed as a share of national income, is already at post-war highs. What’s more, many people are already facing marginal tax rates of well above 50 per cent, once all taxes and benefit changes are taken into account.
So how do the Tory candidates tax plans stack up? Each proposal has its pros and cons.
Dominic Raab’s ambition to cut the basic rate of income tax from 20 per cent to 15 per cent would do most to help middle to low income households and make work pay for those nearer the bottom. It may therefore have more appeal to a wider audience than the further cuts in corporation tax favoured by Michael Gove and Jeremy Hunt, Boris Johnson’s plan to raise the higher rate threshold, or Sajid Javid’s suggestion of lowering the 45 per cent top rate, but these proposals all have strong economic merits too.
There are also some promising proposals on tax reform and simplification from both Raab and Sam Gyimah, with stamp duty an obvious target. In my view, the only obvious miss so far has been Gove’s plan to restructure VAT and replace it with a sales tax, which is something that few economists would support.
In summary, it’s great to see tax cuts back on the agenda. Let’s hope this lasts well beyond the campaign itself.
CapX depends on the generosity of its readers. If you value what we do, please consider making a donation.