The impact of the 50p income tax rate
In April 2010, a new top rate of income tax of 50% on gross incomes above £150,000 per year was introduced in the UK, having been legislated for back in 2009. Are the right-wing bloggers who insist it has not increased revenues correct? What evidence is there and what does it show?
There has been considerable debate among economists and other commentators as to the revenue-raising potential of the 50p rate. HM Treasury’s analysis in the November 2008 Pre Budget Report (where the original plan for an additional rate on incomes above £150,000 per year was proposed, at a rate of 45%) and the March 2009 Budget (where the rate was raised to 50%) suggested that the 50p rate would raise a total of £2.4 billion extra revenue per year by the 2012-13 tax year.
By contrast, research carried out by Brewer et al (2009) for the Institute for Fiscal Studies (IFS)’s recent Mirrlees Review of the tax system suggested that the previous top tax rate of 40 percent was the revenue maximising rate, and that an increase to 50p was likely to reduce revenue rather than increasing it. The IFS argued that the 50p rate would reduce revenue because taxpayers on gross incomes of over £150,000 are relatively adept at taking action to reduce their tax burden – for example by:
- reclassifying income as capital gains (which are subject to a much lower tax rate);
- incorporating into a small company (a tempting option for ‘sole traders’ small businesses or partnerships, because corporate profits are taxed at a much lower rate than earned income, and company dividends are not subject to national insurance contributions);
- engaging in complex avoidance schemes (one of the reasons for the complexity of tax legislation in the UK is the need for the law to address the plethora of complex avoidance schemes marketed by tax advisers);
- (in the most extreme scenario) leaving the country altogether.
The IFS used UK data from the income tax cuts of 1988 (where the then Chancellor of the Exchequer, Nigel Lawson, reduced the top income tax rate from 60% to 40%) to estimate the response of taxable incomes to a change in tax rates. It is on this estimate that they base the contention that the 50p rate will lose money. However, they admit that it is difficult to estimate the gains or losses from the 50p rate with any precision based on this approach. The difference between HM Treasury and IFS’s estimate of the revenue from the 50p rate is driven by different estimates of the taxable income elasticity – the extent to which taxable income responds to a change in the marginal tax rate. However, there are a large number of factors which could affect this calculation – for example, a change in the underlying distribution of gross incomes, the rate of growth in the UK economy as a whole, changes to the taxation of corporate income, changes to capital gains taxation, and the finer detail of changes to allowances and reliefs in the income tax system. Nigel Lawson’s 1988 reduction in the top income tax rate took place when the economy was already booming as Britain emerged from the severe recession of the early 1980s. Therefore, it is quite possible that tax revenues would have risen even more in the post-1988 period if the top rate of tax had been kept at 60% rather than being lowered to 40%.
More generally, a recent summary of the literature on estimating taxable income elasticities by Saez et al (2010) is sceptical about the ability of research such as IFS’s actually to be able to isolate the underlying efficiency effects of changes to top tax rates:
“there is compelling evidence of substantial responses of upper income taxpayers to changes in tax rates, at least in the short run. However, in all cases, the response is either due to short-term retiming or income shifting. There is no compelling evidence to date of real responses [e.g. changes in work effort, etc.] of upper income taxpayers to changes in tax rates… estimates of the elasticity of taxable income in the long run (i.e. exceeding a few years) are plagued by extremely difficult issues of identification, so difficult that we believe that there are no convincing estimates of the long-run elasticity of reported taxable income to changes in the marginal tax rate.”
(Saez, Slemrod and Giertz, “The elasticity of taxable income with respect to marginal tax rates: a critical review”, NBER Working Paper 15012.)
Because there were no changes to the top rate of income tax between 1988 and 2010 there are no more recent estimates of the impact of top tax changes on revenue in the UK on which to draw. However, there is some evidence from the one-off payroll tax on bankers’ bonuses which was introduced in the 2009 Pre-Budget Report. This tax imposed a 50% tax on any bonus paid by a bank to an employee of more than £25,000. The original Treasury estimate from the 2009 Pre-Budget Report was that the bonus tax would raise £550 million. However, based on actual data on bonuses being paid in the 2009-10 tax year, the estimates of the yield from the bonus tax were revised upwards to £1.3 billion in the 2010 Budget – more than double the original estimate. In other words, the Treasury – presumably using a methodology similar to the one used for its estimate of the revenue impact of the 50p income tax rate – vastly underestimated the revenue yield from the bonus tax. It therefore seems reasonable to infer that yields from the 50% tax rate will also be larger than the Treasury estimates, if anything. Moreover, in many ways the one-off bonus tax is a lot easier to avoid than the 50% rate, assuming that the 50% rate stays in place for a number of years. Banks could have chosen to defer bonuses until the following year, for example. So the high yield from the bonus tax is strong (if indirect) evidence that yields from the 50% rate will exceed Treasury expectations.
In January 2011, the first indications of the yield from the 50% rate arrived, with the publication of HMRC data on income tax yields including PAYE (pay-as-you-earn) receipts from the first few months of the 2010-11 tax year. Initial analysis by the economist Duncan Weldon suggests that the 50p rate could be responsible for a large growth in income tax revenues. Income tax revenues in January 2011 were £23.8 billion compared with £20.2 billion in January 2010 – an increase of around 18 percent. This compares with revenue from National Insurance Contributions of £9.2 bn compared with £8.8 billion in January 2010 – an increase of around 4.5 percent. This analysis should be treated with caution for two reasons. First, the data are for one month only, and PAYE revenue estimates can be volatile from month to month. Second, the data do not include self-assessment returns, where payments for the 2010-11 tax year will not be due until 31 January 2012. While most employees who are higher-rate taxpayers will be covered by PAYE (although they may well have to supplement this with a self-assessment return for unearned income), all self-employed income taxpayers are on self-assessment and so the data from January 2011 are a very incomplete picture. Nonetheless, the increase in income tax yields so far is an encouraging sign for advocates of the 50% rate as a revenue-raiser.
However, this has not stopped right-of-centre commentators from trying to debunk the 50p rate. In March, right-wing think-tank the Adam Smith Institute (ASI) issued a report on “The Revenue and Growth Effects of Britain’s High Personal Taxes.” The £350 billion figure (actually £35 billion averaged per year over ten years) is extrapolated from a survey of tax advisers undertaken by ASI and the Association of Certified Chartered Accountants, where the tax advisers asked their clients whether they were considering becoming non-resident in the UK. Appendix 2 of the ASI report sets out the main assumptions of the analysis, which unfortunately does not mention how many advisers were surveyed, whether the sample was representative, and how serious the clients surveyed might be about moving. Clients who had already moved were also included in the total of individuals ‘contemplating non-residency’ – which assumes it is possible to move twice!
Based on this evidence, ASI assumes that between 12% and 23% of UK taxpayers paying income tax at marginal rates of 40% or higher will leave the UK over the next 10 years – this would mean between 400,000 and 770,000 people leave, based on current HMRC estimates of the number of taxpayers in the UK. However, it must be said that there is simply no evidence at all from the economics literature that employees are this mobile across national borders in response to changes in marginal tax rates. Moreover, for almost 90% of the group which ASI are looking at, the marginal rate of tax is unchanged at 40%, because they earn less than £150,000. In short, the analysis vastly exaggerates the labour mobility implications of the income tax top rate increase.
ASI’s misinterpretation of the evidence also extends to their cross-country work on tax rates. Using data provided by the accountants KPMG they argue that ranked against the 86 largest economies in the world, the UK has the 83rd highest marginal tax rate. In fact, analysis by the OECD of the highest total effective tax rates in OECD economies – including employee social security contributions as well as income tax – suggests that the UK has the 6th highest combined top rate in the OECD (out of 30 countries) but is only about 3 percentage points above the median OECD top rate – hardly a huge outlier, and most unlikely to be enough to cause significant ‘brain drain’ from the UK. Furthermore, our standard VAT rate (which is also a big part of the tax burden on labour) was also below the OECD median of 19 percent – until George Osborne increased it to 20 percent in January. Overall, the ASI report looks more like right-wing scaremongering than serious economic analysis.
In summary, it is as yet unclear what the yield from the 50% top income tax may be, but initial signs are encouraging, while attempts by the right to debunk the policy are unconvincing. In the 2011 Budget George Osborne announced that the Treasury is to conduct a review of the 50p rate with a view to recommending whether it should be retained or not. While Mr Osborne’s instincts will probably be to abolish the rate, if it does turn out to be a revenue raiser he will have to either cut spending or raise other, less progressive, taxes to do so – both of which options are likely to be unpopular in the run-up to the next general election.