The real reason squeezing the rich makes us all poorer

Graeme Leach

RADICAL reform of income tax is not only desirable, but completely possible. To achieve it, however, proponents of change need to provide a strong evidence base for a much flatter tax system, with a much lower top rate in the UK in particular. We need to show that the optimal revenue-raising top rate of tax isn’t 50, 45 or even 40 per cent. It’s much lower.

Just when the political rhetoric in the UK is all about tax fairness (a vague and ill-defined concept) and paying your fair share, there could be a shift in society towards a more pragmatic approach to top rate taxation. In other words, what should matter is what works, and if a lower top rate yields more revenue, fairness arguments go out the window.

We need to move from fairness to facts. If an excessive top rate reduces revenues below the optimal level, everyone is worse off. And if the debate moves onto this territory, we will genuinely all be in this together. In fact, “all in this together” should be used to describe a flatter, not more progressive tax system.

But if that shift is ever going to happen, advocates of a much flatter tax system will have to bring to life – with vivid and powerful real world examples – two crucial concepts. The first is taxable income elasticity. The second is the distortionary effect of progressive taxation. Obscure? Yes. Unimportant? Absolutely not.

Taxable income elasticity measures how the income available to be taxed alters in response to a tax change. This elasticity can easily be high enough to reduce the government’s total tax take in response to a rate rise. Similarly, a reduction in rates can increase the tax take. This is a crucial measure. The bigger the behavioural response, the bigger the elasticity. And whether it’s the Kennedy or Reagan tax cuts in the US, or when Nigel Lawson slashed the UK top rate from 60 to 40 per cent in the UK, we’ve seen the behavioural response increase revenues.

More recently, even allowing for economic growth, HMRC is yielding significantly more from the 45 per cent top rate (around £50bn this year) than it was at 50 per cent (around £41bn in 2012-13). Reversing this would be a disaster. The top 1 per cent of taxpayers in Britain already pay around 30 per cent of all income tax, so the potential for diminishing returns from an even higher top rate is also obvious – their taxable income elasticity will be high.

So what is the optimal top rate of tax? The answer also depends on how income is distributed across those taxpayers impacted by the tax change. But the core issue is the taxable income elasticity. When modelling the impact of the reduction in the top rate to 45 per cent, HMRC employed a figure of 0.45 as its central taxable income elasticity. Only a few years before, however, HMRC had used 0.35 to justify the hike in the top rate to 50 per cent. Different elasticities produce different revenue-maximising top rates of tax.

But it’s now clear that, based on its own evidence, HMRC can only justify the current 45 per cent top rate with an implausibly low taxable income elasticity. My own calculations suggest that the revenue-maximising top rate is well below 35 per cent and quite probably below 30 per cent. Indeed, if the taxable income elasticity was around 0.55 – not much higher than HMRC thinks it is – the revenue-maximising top rate would be 30 per cent. There is also strong reason to believe that sensitivity to tax rates is increasing over time because of the growth in double income households.

This is far from the end of the story. Any taxable income elasticity will understate the revenue gains from a lower tax rate because it won’t capture the revenue that might have been raised but never will be – because people don’t come to the UK in the first place. This counterfactual is impossible to quantify, but strongly suggests that we could accrue even more revenue by lowering the top rate of income tax further.

The second key piece in the jigsaw is the distortionary effect of progressive taxation. This rises as the square of the tax rate. Thus an increase in a tax rate from say 20 to 40 per cent will not double the distortionary effect but quadruple it. This arises for two reasons. First, changing tax rates changes the effective price of whatever is being taxed. If income tax rises, this increases the pressure on employers to raise salaries to maintain the disposable income of employees. Secondly, when the price of something changes, this will impact on the demand for it. The total economic loss is the product of both distortions.

We have a top rate of income tax based on politics not economics, and a progressive tax system built on distortion not economic efficiency. The potential economic returns from addressing this are enormous, but the political challenges are even greater.

Graeme Leach is director of economics and prosperity studies at the Legatum Institute in London.