Labour’s proposed tax grab will backfire even before it starts

Allister Heath

HERE is how Labour’s misguided, punitive and anti-growth 50p tax plan could backfire almost immediately. If the Tories go into the election promising to keep the top rate of tax as is, and Labour to increase it by 5p, and it continues to look like Ed Miliband will triumph in May 2015 (albeit on a small share of the vote), we can expect widespread behavioural change.

Billions of pounds of income will be reported in March and April 2015, at the very latest, with bonuses and dividends brought forward from future years; this could make the fiscal situation in the run-up to the election look better than it otherwise would. Income would then dip for the rest of the 2015-16 tax year, and perhaps also the next one, hitting Ed Balls and his plans to balance the current budget (excluding capex) by the end of the Parliament. It would be poetic justice.

The fact that taxpayers shifted income about in response to the pre-announced cut to the top rate of tax over the past couple of years is the one thing everybody can agree on. Other than that, the 50p experiment doesn’t tell us very much about anything; supporters or opponents of the tax need to look elsewhere. It didn’t last long, took place at a time of extreme economic dislocation and market volatility here and abroad; and it was seen as time-limited, which meant that some people put up with it in a way they wouldn’t have had they believed it to be permanent. In the end, regrettably, it was only partly abolished.

The IFS took another look at the data yesterday; its conclusion was that “at the moment, the best evidence we have still suggests that raising the top rate of tax would raise little revenue and make, at best, a marginal contribution to reducing the budget deficit an incoming government would face after the next election.” HMRC published a caveated analysis highlighting all of the uncertainty in 2012 and concluded as a central estimate that the tax might have raised £100m; the IFS believes that the evidence since then hasn’t really changed, contrary to what some have claimed.

Of course, one can reject these conclusions. The issue is that nobody agrees about how much people’s reported incomes respond to tax changes. HMRC’s central estimate is that this elasticity was 0.45, which happens to be in line with estimates by IFS researchers based on the last time the top rate of income tax changed – in the 1980s (a very long time ago, when the world was very different) – as well as with some international estimates.

But if people respond less and the true elasticity was 0.35, the tax cut would have reduced tax revenues by just £700m, while if they respond more and the true elasticity were 0.55, the tax cut will have actually raised an extra £600m (and the 50p tax rate would actually have reduced revenues).

I’m in the latter camp: to me, people are increasingly responsive, over time, to permanent changes to tax rates in a world of high labour and capital mobility. The response is not as large in the short term as it is in the long-term. In my view, there is a great deal of evidence for the deleterious and devastating impact of high marginal tax rates from a variety of international studies – but sadly this debate won’t conclude any time soon.

But the real question is not just what tax rate brings in the most income over one or even five years – it is what tax rate boosts economic growth by the most over many decades. This has a huge effect on people’s productivity and incomes. In my view, this is the key question, and once again the evidence that I find the most convincing is that which shows that high marginal and average tax rates reduces economic growth. Britain therefore needs to cut taxes at all levels, not hike them; Labour’s strategy is entirely wrong-headed and would damage the UK’s performance even further.
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