Ahead of the curve?

It’s the Budget next month and there’s been quite a lot of speculation that the Chancellor may reduce the top rate of income tax.  The 50% rate was introduced by the last Labour Chancellor from 6 April 2010 for those with incomes of over £150,000 a year.  HMRC have now been commissioned to produce a report on the amount of tax collected from the 50% rate in its first year. This report will provide a first indication as to whether the increase in the top rate has, in fact, been a tax raiser.

It was while reading about the pros and cons of a reduction in the tax rate that I came across references to the Laffer Curve.  This is an attempt to model the link between tax rates and tax revenue and is named after Professor Art Laffer who was an economic advisor to President Reagan in the early 1980s (no need to hold that against him).

Professor Laffer suggested that, as taxes increased from fairly low levels, tax revenue would also increase, however, if tax rates continued to rise, there would come a point where people would not regard it as worth putting in the effort to generate more taxable income.  This lack of incentive would lead to a falling –off in taxable income and therefore a fall in tax revenue.

Professor Laffer was of the view that his model showed that there was an optimum tax rate where the maximum amount of tax revenue would be collected but once the tax rate was increased beyond that the tax take would reduce.  Conversely, where tax rates were higher than the optimum rate, cutting them could actually raise revenue.  In other words, although tax rates of 0% and 100% both raise nothing there is a point in between which maximises tax revenue.

Now I’m no economist but this makes sense to me (and to some others too, including the IMF).

In November 2011 the Centre for Economics and Business Research (CEBR) published ‘The 50p tax – good intentions, bad outcomes’, a report which said that, when combined with National Insurance and VAT, the 50% rate pushed those who might pay it beyond ‘a psychological threshold’, making it more likely they would take steps to minimise their exposure to it (a ‘behavioural response’ in economics speak), resulting in a loss of revenue. The CEBR estimated that a 36% top rate would maximise the take from income tax.

Earlier reports by the Institute for Fiscal Studies (summarised here) had similarly concluded that the 50% rate might not raise any extra revenue for the Treasury and could actually reduce the tax take.  The IFS felt that the optimal rate was 40%.

However what would be obvious even to a student at St. Custards is news to the boffins at the Treasury it seems.  According to page six of the CEBR report, in 2009 the Treasury predicted that the increase to a 50% rate would raise an additional £2.52 billion in the 2011/12 tax year (later revised upwards to £3.05 billion).

When HMRC publishes their report we’ll see who’s the daddy. My money is on Professor Laffer and his Curve.

By the way, last Friday I went to a conference on ‘A General Anti-Avoidance Rule (GAAR) for the UK?’ organised by the Oxford University Centre for Business Taxation.  The introduction of a GAAR is another hot pick for the 2012 Budget.  HMRC’s top civil servant, Dave Hartnett CB was in the row behind me looking pretty rough.  Dave disappeared at lunchtime and didn’t come back.  A sandwich lunch was presumably not his style or perhaps he had other things on his plate.

 

*** UPDATE – August 2013***

HMRC published their 60 page report, The Exchequer effect of the 50 per cent additional rate of income tax, in late March 2012.

HMRC’s conclusion (which was treated with a certain amount of scepticism in the tax trade press) was that ‘the underlying yield from the additional rate is much lower than originally forecast (yielding around £1 billion or less), and that it is quite possible that it could be negative.’

In August 2013 the Telegraph published an article with the headline ‘Companies and banks defer £1.7 billion of bonuses to avoid tax.’  Speaks for itself.

Tax lawyer specialising in business tax, SDLT and VAT