There’s been lots of excitement in the press over the last couple of days about Ed Ball’s announcement that he plans, if elected, to reintroduce the 50% tax rate for high earners in the UK. (That’s 50% income tax on everything over £150Kpa. As Fraser Nelson points out in The Spectator, when you factor in National Insurance, that’s an effective rate of 52%).

Twenty-four outraged business leaders (including Sir Stuart Rose from Ocado, and Alistair McGeorge of New Look) have done what you do in these situations, and written a letter to The Daily Telegraph:

We think that these higher taxes will have the effect of discouraging business investment in Britain. This is a backwards step which would put the economic recovery at risk and would very quickly lead to the loss of jobs in Britain. 

Well, most of us will feel: they would say that, wouldn’t they? It’s hard not to be suspicious of the motives of a group of people who will definitely lose out if a higher rate is introduced.

But a person having something at stake in a contentious issue doesn’t mean he can’t tell the truth about it. The truth being in someone’s interest doesn’t stop it being the truth.

Is it the truth, though? The big question here is about what taxation is for. Ed Balls doesn’t seem to be claiming that he expects much new revenue from the proposed increase: for him, the issue is about ‘fairness’. Why, goes this line of reasoning, should the wealthy be permitted to carry on accumulating lucre by the bucketful at a time where most people are struggling to pay the mortgage or the rent? Haven’t the rich got a responsibility to us all?

There is of course a different moral stance that can be taken on this. By what right, this view asks, does the state take so much of the earnings of individuals? Shouldn’t what you earn be, at least in principle, yours to do with as you see fit? How is it ‘fair’ for the state to take it off you?

Most people probably feel one thing and then the other about this at different times; it’s a hard matter to be consistent about. But a further question, raised by the writers to The Telegraph, is whether high taxes even work. What’s the point of increasing income tax if all it does is chase away the people who you need to generate the income in the first place?

Something like this may be happening in France (I have blogged about it here). The increase in the top level of tax to 75% seems to be fuelling the already marked migration of talented French professionals into the EU (particularly London). Income taxes have risen, but unemployment remains at 11%; France seems to be staying in recession even as the rest of the Eurozone begins to recover.

George Osborne nearly blew his political career over the reduction of the top rate to 45% in 2012; but, says Fraser Nelson:

After the cut, the tax haul from the richest 1 per cent surged to a record high – they earn 13 per cent of the income but now pay 30 per cent of income tax collected. That’s what I call a fair share.        

Both these examples appear to illustrate the paradox of the Laffer curve – that beyond a certain point, increasing tax rates has the effect of reducing overall tax revenues. A Laffer curve attempts to show the point at which taxation creates such a disincentive to economic activity that taxpayers either stop working in the jurisdiction in question, or start to avoid paying tax in it, legally or illegally. The assumption of the curve is that a 100% tax rate will generate no tax revenue, because people will either stop working, or cheat.

The question for policymakers is which rate actually maximizes revenue. Much time is spent in treasuries around the world trying to establish the exact point at which additional rates become counter-productive, and trying to stop a percentage point before!

Some academics have tried to work out the most efficient possible rate of tax, in all circumstances. But it seems that the Laffer curve is sensitive to culture and circumstance. In wartime, for example, people are much more willing to contribute higher proportions of their income for the common good.

What about in Europe, and what about Europe’s great contribution to taxation, VAT? The European Commission has long harboured the ambition to harmonize tax rates around the EU, in order to increase the efficiency of the single market. But, would harmonizing VAT rates actually lead to a reduction of the tax take in some countries? You only have to think about the different attitudes to paying tax in, say, Greece and Sweden to see the problem.

Two Portuguese academics, Francisca Guedes de Oliveira and Leonardo Costa, have looked at the data from 2000 to 2010, and attempted to work out the ideal harmonized rate for the EU. They note that Portugal’s own VAT rate of 23% is already just over the optimum percentage:

Using a panel data for the EU-27 countries in 2000-2010, assuming rational expectations and a real business cycle, one has estimated the VAT Laffer Curve for the EU-27 countries in the period 2000-2010 and found the maximum VAT rate as being 22,5%. Thus, countries such as Portugal are already operating in the prohibitive range of the curve.

So there you have it: 22.5% is the perfect rate for the EU. But with that one, enormous, caveat: ‘assuming rational expectations’…

By |January 27th, 2014|