Yet more proof that high tax rates are bad for the economy

Allister Heath

FOR some reason, many people simply cannot accept that high rates of tax discourage work and effort, damage the economy, reduce jobs and make all of us poorer. This reluctance to acknowledge the problem is strange: everybody accepts that the best way to discourage an activity is to tax it. Duties on alcohol and tobacco reduce their consumption; high rates of income tax discourage work. It’s that simple.

The disincentive effects of high marginal tax rates apply across the board, regardless of income level. A combination of tax and the withdrawal of benefits has meant that it hardly pays for many people on low incomes to get a pay rise or change job, a disastrous problem that the universal credit sadly won’t fully tackle.

High tax rates mean that many middle income families are forcibly turned into single-earner households once they have children: it makes no sense, after tax and childcare costs, for some parents to go back to work. High income families are also being hammered: marginal tax rates are extraordinarily high between £100-118,880 a year, when the personal allowance is withdrawn, and above £150,000 a year, when the top rate kicks in.

Like everything else in economics, the statistical evidence confirming that high taxes reduce the supply of labour and GDP is controversial. But the latest in a long list of studies in this area – a brilliant paper by Karel Mertens of Cornell University, published by the National Bureau of Economic Research – provides further, overwhelming confirmation that high tax rates are a disaster. The paper is the most sophisticated analysis of the subject that I have yet seen.

It studies the history and dynamic effect of tax cuts in the US between 1950-2010 and finds that they trigger significant improvements to behaviour across the income distribution. Lower tax rates lead to increased reported income, with the effect growing over time; crucially, this is not just about reduced avoidance but presumably also from extra effort and labour supply. Remarkably, a top marginal rate cut raises real GDP by up to 0.3 per cent after two years.

The paper also finds that cutting tax for high earners (defined as the top 1 per cent) boosts the income of everybody else: the average incomes of the bottom 99 per cent rise by 0.15 per cent when the policy kicks in and by up to 0.35 per cent in the third year.

Mertens’ findings are utterly devastating for those who believe that the best way to plug the gap in the government’s finances is to hike taxes: as he puts it, “the results imply that raising marginal tax rates to resolve budget deļ¬cits comes at a high price and that a proportional across-the-board tax cut provides successful stimulus that does not necessarily lead to greater income concentration at the top.” George Osborne, Ed Balls and every politician and economist should read this study. Tax rates are too high, and unless they start to fall significantly the economy will never fulfil its true potential.

Assuming that his main aim was to show the City who was boss, Mark Carney, the Bank of England’s new Governor, succeeded spectacularly yesterday. A few dovish sentences in a statement following the MPC’s no change decision was all it took to send sterling tumbling against virtually every currency, and bond yields lower.

But Carney has made his first mistake. The economy is strengthening, albeit only slightly, so why push yields back down again? And cutting sterling’s value no longer boosts exports, as we have seen in recent years, but merely fuels upwards pressure on the price of imported goods.

It was right not to boost QE, but talking down the cost of money is no different. We need to start moving towards a more normal monetary policy – clearly, however, that is not Carney’s view. Pity.
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