45p Tax - Economic Sense or a Tax Cut for the Rich

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Last year the Chancellor reduced the top rate of income tax trim 50 pence in the pound to 45p pence. He was immediately accused by his detractors of giving a tax cut to the wealthy. Recent figures from the
HMRC (Her Majesty's Revenue and Customs) suggest that in actual fact it may have raised more revenue for the exchequer.

The basic rate of income tax is 20% and is paid on earnings over about £10,000. This rises to 40% of earnings above about £42,000 and finally to 45% on earnings over £150,000. This was the rate that George
Osborne reduced from 50%  in April 2013. At the time it was claimed that this move would cost the government about £100m but it now appears that the government received £9bn more in tax revenue from top
earners after the 45% tax rate came in.

How could reducing income tax rates raise more in tax revenue. The answer is an economic theory called the Laffer Curve. Laffer suggested that at high levels of marginal taxation (the tax you pay on the next pound you earn) there would be such a strong incentive to avoid tax legally or illegally, or simply not to earn the money in the first place, that tax revenue might actually fall. This disincentive to work is not only bad for government tax revenue, it also has an impact on the economy's economic output. The diagram below shows how as tax rates rise this initially raises more tax revenue but each increase raises less and less extra as people hire accountants to avoid tax, reduce work or under report their income. Eventually marginal tax rates are so high this actually reduces the amount paid. 

So is this what has happened? Is 50% too high. While tax in the UK has been higher (83% in the 1970s) 50% is seen as quite high at is roughly the level at which Laffer predicted this turning point would occur.

The figures would seem to suggest he is right but there are other explanations.

The earnings if the wealthiest have risen more than expected, meaning they would have paid more tax under either tax rate. The demise of the 50% tax rate was also announced well ahead of time. This means that those who could delay taking bonuses and pay did. That reduced the tax they paid under the old rate and increased the tax they paid under the new rate.

So what is the verdict? It is notoriously hard to tell but it seems likely that we are at least close to peak tax rate in the UK with the increase to 50p raising little and the reduction to 45p costing/raising little. This is certainly consistent with Laffer who originally suggested that around 50% would be the peak and the Mirrlees Report, which suggests around 40%. The diagram below was is taken from the Mirrlees report, published just after the 50p tax rate came in. It shows the top. bottom and central estimates of revenue raised at different tax rates. The report's authors stress, however the difficulty of estimating the impact.

Read 2634 times Last modified on Friday, 04 April 2014 22:41
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