Sunday, 14 February 2010

Why the 50p tax rate is bad politics and bad economics

The issue of tax has long been a thorny issue for the Labour Party, due in large part to the suspicion that it was the one single issue that cost it both the 1987 and 1992 elections. Hence Tony Blair's pledge before 1997 not to raise income tax in the first term of a Labour government. However, last year Alistair Darling did indeed announce an intention to raise income tax for those earning over £150k by introducing a new 50% tax band for those high earners. The intention of the tax seemed clear: to increase wealth redistribution and to make Britain a fairer and more equal society. There is just one problem with this proposal. Any objective analysis of it suggests that it will probably fail miserably to achieve any of its aims. In short, it is a rubbish policy.

This 50% tax targets a miniscule proportion of the population, it is too easy to avoid, and so it will raise virtually no extra money. In fact by encouraging tax avoidance, it may even reduce the overall tax receipts by also decreasing the number of 40% tax payers in the economy. In addition, the level and threshold at which it is set are so arbitrary that the signals it sends out are entirely negative. To put it simply, if the Government can tax at 50% today, then why not 66% or 90% tomorrow? With no logical reason to doubt that the tax rate could go even higher in the near future such a policy completely destroys any confidence in Labour's future tax plans. Instead it raises the spectre of the bad old days of the 1970's and Dennis Healey's pledge to "tax the rich until their pips squeak." It therefore destroys confidence in the Government without even having the positive compensating effect of raising significant amounts of extra money. So, instead of a win-win scenario, we have a lose-lose one. Brilliant!

If the Government was going to raise the tax rate for high earners, it should at least have done so based on some underlying guiding principle. That principle should be one of equality or fairness. The questions then become, how can we justify such a higher rate of income tax for higher earners, and what should it be?

Historically, government expenditure has tended to hover around 40% of GDP, at least in recent decades. In the light of this one could reasonably argue that anyone who is paying less than 40% of their income in tax is clearly not paying their fair share. At first sight that might appear to encompass the majority of the population who only pay income tax at 20%. However, that argument doesn't account for the additional 11% they pay in National Insurance (soon to increase further), Council Tax (which averages out at another 4%) and the VAT and other consumption taxes that they pay on most other basic costs including transport, food and clothing. So in practice a person on an average income (which is currently about £25k) pays significantly more than 40% of their total income in tax, almost all of which is unavoidable.

As the average Briton is clearly being taxed at a rate that is greater than the overall taxation ratio of 40%, it is therefore only fair that those on higher incomes should also be expected to be taxed at an overall tax rate that is commensurate with the ratio of Government expenditure to GDP as well. However, any additional income that the richest 10% of the population earn in excess of the average household income (currently about £45k) is predominantly disposable income. It is income that is above and beyond that which is required to cover most daily living expenses. Therefore, it seems only reasonable that this should be taxed at the same overall ratio as the national average. That seems to me to be the justifiable rationale behind imposing a higher tax rate for the top earners in society, and perhaps why it has been set at 40% for most of the last few decades. However, there is now a problem. The current recession means that the ratio of Government expenditure to GDP is increasing above 40%, while tax receipts are declining. With public sector net borrowing (PSNB) predicted to exceed £175bn this year, and the bond markets getting increasingly nervous about the scale of our national debt, politicians need to come up with credible policies to tackle this problem. However both the solutions advanced so far have a dark side.

On the one hand is the spectre of tax rises, as exemplified by the recent announcement by Alistair Darling to raise National Insurance contributions, for both individuals and employers. This, though is a tax on both jobs and consumption, both of which could slow any economic recovery. On the other hand the Tories are baying for spending cuts. Yet this also risks prolonging the recession by increasing government spending on benefits even more while reducing government procurement and economic consumption. What is needed is a 'third way' that reduces the deficit without taxing jobs and reducing revenues from consumption. That way is to tax surplus wealth, and one such source is the disposable income of higher earners. I would therefore argue that rather than introducing a new 50% tax rate that benefits no-one, the Government should have raised the existing 40% rate.

My reasoning is this. Given that the ratio of Government expenditure to GDP has now increased to nearly 44% for this financial year (2009-10), and is expected to remain at such a level for the foreseeable future, and tax receipts have plummeted to only 33% of GDP due to the recession, gradually raising the upper tax rate from 40% to 44% would have represented a far better policy than the introduction of a new 50% rate. Not only would it have been fairer, it would have been based on a clear and transparent principle that would have reassured the public that such rates were not arbitrary and vindictive. It would have also raised ten times as much in tax as the 50p rate (£10bn versus £1bn). As such it would have made a significant impact on our underlying budget deficit (currently estimated at about £50bn), while having little or no adverse effect on either levels of employment or consumption (due to it being targeted at the disposable income of the affluent that would normally be invested in assets and savings). It would also be far less prone to the problems of tax avoidance as it is highly unlikely to cause a mass exodus of higher rate tax-payers from the country.

So the essence of this tax policy is this. Rather than having a fixed 40% tax band, or introducing a new 50% band, the current 40% band should 'float' with its level set by the current ratio of government spending to GDP. Under the current financial circumstances we find ourselves in that would mean gradually increasing the rate from 40% to about 44%.

There would of course still be great howls of protest from those with salaries in the top decile of the earnings league who would be the most affected by the raising of this tax level. However, these are to a large extent the very people who enjoyed the largest percentage growth in their earnings during the boom years, earnings that we now know (or at least suspect) were, in a large measure, based on fictitious or inflated profits, particularly in the financial sector. In which case, these were, in large part, salary rises that were unearned.

These are also the people who, more than any other sector of society, invested those earnings in the property bubble that caused the boom and the resulting crash in the first place. So, given that many of them were the largest beneficiaries of the credit boom, and partially responsible for it, isn't it fair that they should also be the ones who should contribute most towards restoring the economic stability of the country? Given that they are also the only ones with the spare cash to do so shows that they also have the means to do so. And if they don't like this policy? Well, they can always vote for a party that will promise to slash public spending in order to keep it below 40% of GDP. But then don't most of them do that already?

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