While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.

The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth

The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.

An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.

The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.

The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.

In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.

But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!

Questions

Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?

What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?

Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?

But will this raise more tax revenue? The question here concerns incentive effects. Will the higher rate of income tax discourage work by those earning £150,000 or encourage tax avoidance or tax evasion, so that the total tax take is reduced? The Conservatives say the answer is yes. The Labour party says no, claiming that there will still be an increase in tax revenue.

These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.

As Labour is claiming that re-introducing the 50% top rate of income tax will increase tax revenue, the implication is that the economy is to the left of the top of the Laffer curve: that, at current level of income, the curve is still rising.

Work by HMRC, and published in the document The Exchequer effect of the 50 per cent additional rate of income tax, suggested that the previous cut in the top rate from 50% to 45% would cut revenue by around £3.5 billion if there were no incentive effect, but with the extra work that would be generated, the cut would be a mere £100 million. This implies, other things being equal, that a rise in the rate from 45% to 50% would raise only a tiny bit of extra taxes.

However, the HMRC analysis has been criticised and especially its assumptions about the incentive effects on work. Then there is the question of whether a rise in the rate from 45% to 50% would have exactly the reverse effect of a cut from 50% to 45%. And then there is the question of how much HMRC could reduce tax evasion and avoidance.

The following article from the Institute for Fiscal Studies examines the effects. However, the authors conclude 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.

But there is also the question of equity. Putting aside the question of how much revenue would be raised, is it fair to raise the top rate of tax for those on high incomes? Would it make an important contribution to reducing inequality? This normative question lies at the heart of the different views of the world between left and right and is not a question that can be answered by economic analysis.

On 21 March, the Chancellor of the Exchequer, George Osborne, delivered the 2012 Budget for the UK. The details of the tax and benefit changes can be found in the Budget Report, with the Treasury’s summary of the tax changes here.

One of the key elements in the Budget was the reduction in the top rate of income tax from 50% to 45% from April 2013. The Chancellor argued that the introduction of the 50% rate in 2010 had raised very little extra tax revenue. Partly this was the result of people managing their tax affairs so that they could bring forward income to the year before the 50% rate was introduced – a practice known as forestalling. People are likely to do the reverse with the latest tax change and delay receiving income until next year. For details of the effects of forestalling, see the Office for Budget Responsibility’s Economic and fiscal outlook charts and tables Box 4.2a.

But part of the reason for the 50% tax rate raising relatively little has been the effect on incentives. A rise in the top rate of income tax can encourage people to move from the country – or move their incomes; it may discourage top earners from working more; it may encourage people to engage in various tax avoidance schemes; it may encourage people to evade taxes by not declaring all their income.

The effect of a rise (or fall) in the marginal income tax rate (t) on taxable income is given by the taxable income elasticity (TIE). This is defined as the proportionate change in taxable income (Y) divided by the proportionate change in the net-of-income-tax rate (r) (where r = 100 – t: i.e. the percentage of an extra pound that is not paid in income tax, but is retained by the taxpayer for spending or saving). TEI is thus ΔY/Y ÷ Δr/r. The larger the disincentive effect of raising taxes, the more will taxable income fall and hence the higher will be the value of TIE.

The Office for Budget Responsibility (OBR) in 2010 based its calculations on a TIE of 0.35 for the rise in the top marginal rate of income tax from 40% to 50%. This means that for each 1% fall in the net-of-income-tax rate, taxable income would fall by 0.35%. With a TIE of 0.35, the OBR calculated that the new top rate would bring an extra £2.9bn per year by 2011-12 (after allowing for any temporary residual effects of forestalling). However, the OBR now believes that the TIE is significantly higher and that the 50% rate will bring only an extra £0.7bn in 2011/12.

In its analysis of the effects of a cut in the top rate from 50% to 45%, the OBR has assumed a TIE of 0.45.

Turning to the costing of the move to 45 per cent, measured against our baseline that reflects the new information on the 50 per cent yield, we have endorsed as reasonable and central the Government’s estimate that the underlying cost would be around £0.1 billion in 2013-14, based on an assumed TIE of 0.45. The figure is as low as this because a TIE of 0.45 implies that the revenue-maximising additional tax rate is around 48 per cent. Moving from just above to just below this rate would therefore have very little revenue impact. Moving the additional rate back to 40 per cent would take it further below the revenue maximising rate and would thus be more expensive at roughly an additional £600 million. But for the reasons set out above we would again emphasise the huge uncertainties here.

Economic and fiscal outlook – March 2012 (p110)

The government’s arguments for reducing the top tax rate, therefore, are that it will have little effect on tax revenue, but would have a significant effect in encouraging inward investment, discouraging emigration of high earners and encouraging high earners to work more.

Questions

What are the arguments for and against reducing the top rate of income tax from 50% to 45%? Do the same arguments apply to a further reduction to 40%?

According to the OBR, at what top tax rate is the top of the Laffer curve?

Why are the OBR’s calculations subject to considerable possible error?

Why might a fall in the top tax rate from 50% to 40% not exactly reverse all the effects of an earlier rise in the top tax rate from 40% to 50%? In other words, why may the effects not be symmetrical?

Distinguish between the income and substitution effects of a change in income tax rates. Which is assumed to be larger by the OBR in the case of reducing the top rate of income tax from 50% to 45%? Explain.