12 November 2018

The regressive consequences of targeting top earners


One of the more surprising aspects of Philip Hammond’s recent Budget was Labour’s decision not to oppose the big hike in the personal allowance, much to the chagrin of many of the party’s own MPs who saw it as a measure that would mostly benefit the already well-off.

We were left in an unusual situation where more moderate Labour MPs were condemning the budget with the usual left-wing rhetoric of “giveaways for the rich”, while the self-proclaimed Marxist Shadow Chancellor, John McDonnell, was left defending tax cuts for the wealthy.

McDonnell reiterated Labour’s 2017 manifesto promise that there would be no income tax increases for 95 per cent of earners, with revenue coming from higher corporation tax and those earning over £80,000 per year.

Today in the Guardian, Labour MP Clive Lewis backs McDonnell up, arguing that a “truly fair” tax system would target the top 5 per cent.

The Shadow Chancellor is right to not oppose increases to the personal allowance, which ensure that the lowest earners are taken out of income tax completely. Supporting the raising of the higher rate tax threshold was also the right step to take. It was an admission that those earning £46,350 a year cannot necessarily be considered wealthy. He rightly pointed out that there are many ordinary people, such as head teachers, who provide essential public services and are on incomes of this level (and often much higher).

He also rightly pointed out that it is not just the poorest people in the country who are struggling to get by. What’s more, tax is a key component of the UK’s well-documented cost of living crisis. Allowing people to keep more of their hard-earned money is a progressive step, one which all political parties, and especially Labour, should be supporting.

However, it does represent a departure from orthodoxy on the part of Labour, at least the Labour Party of the past 25 years. From 1997 New Labour pursued a progressive and broad-based tax policy. While it got many things wrong, Tony Blair’s government recognised the importance of the wealthiest people in supporting the economy and providing the tax revenue to fund essential public services. As Peter Mandelson once famously said, New Labour was “intensely relaxed about people getting filthy rich — as long as they pay their taxes”.

Those centrist Labour MPs attacking McDonnell also seem to have forgotten the economic benefits of reducing the tax burden on the poorest. Higher taxes reduce the time that households sell on labour markets. As a study from the IZA Institute of Labor Economics concluded: “households decrease their market hours and devote more time to leisure and home production”, adding that the effect is “especially large in the service sectors”. The study finds that “higher taxes are associated with lower market hours” and that the link is more than doubled for low-skilled women.

High levels of taxation on low earners have a negative impact on the economy as people spend less time undertaking productive activity as a result. Therefore, it makes sense from an economic perspective to take the poorest people in the country out of paying income tax altogether. Indeed, as the Centre for Policy Studies has suggested, the Government could go even further to making work pay by allowing every single worker to earn a “universal working income” of £1,000 every month free from national insurance and income tax.

However, the moderate Labour MPs are right to be concerned. This shift in focus on the part of Corbyn and McDonnell from a broader tax system to one which targets the highest earners, along with the accompanying rhetoric, should worry us all.

Going after wealthy individuals and big companies may sound sensible, but it will be economically damaging. As already discussed, people tend to respond to high taxes by working fewer hours. That is particularly damaging for an economy when it involves the most productive people in the country. Research by Piketty, Saez, and Stantcheva has found that high earners respond to lower taxes by doing more productive work and putting less effort into avoiding paying taxes.

What is more, the most productive people in an economy also have an impact on the productivity of others. For example, a study looking at OECD countries found that the evidence suggests that: “there is a negative relationship between top marginal personal income tax rates and the long-run level of [total factor productivity]”. If high taxes on high earners reduce productivity growth then that will, over time, result in lower wage growth across the economy.

Therefore, increasing income tax on the wealthiest will, ultimately, be regressive, as it will lead to lower wages and a fall in living standards.

It also increases the likelihood of tax revenues decreasing. There is a great deal of evidence from both the United Kingdom and the United States which demonstrates that when the top rate of income tax is cut, then revenues increase, whereas when the top rate is increased, tax receipts drop.

Increasing corporation tax would also be a mistake. The academic research shows that higher corporate tax rates have an adverse impact on firms’ investment levels. High corporation tax means lower investment which leads to low productivity, low wages, and stagnant living standards.

Corbyn and McDonnell could, of course, try to target the wealthiest through wealth taxes, which seem to be very much in vogue at the moment. However, this would not work either. Many countries have recognised the folly of wealth taxes and have abolished them. France, on the other hand, increased its wealth tax, a move which has helped turn London into the sixth largest French city.

For all the class war rhetoric of left-wing MPs and columnists, there is no pot of gold lying around for the Government to tap into. Attempting to tax the wealthiest even more would be at best counter-productive and at worst economically damaging.

All this talk of “the wealthy”, “the undeserving”, and “the top five per cent” is also deeply disturbing and divisive, setting one group of people against another. The “us versus them”, “workers against bosses” caricature also bears very little relation to reality, and is straight out of Old Labour’s playbook.

We need a tax system which is simple so that avoidance is difficult, with rates low enough to reward hard work and encourage investment. Only then can we get the kind of economic growth that can properly fund essential public services.

Ben Ramanauskas is a Researcher at the Taxpayers' Alliance.