Cleaning Up This Taxing Mess

The dust has settled (or rather been obscured by an announcement about a rise in the price of alcohol) and now it’s time to go behind the headlines, and see what Georgie boy has done. Reading The Sun yesterday it seems the paper that backed the conservatives in the election has turned on them after the latest budget. It claimed that Osborne was putting Britain in “the wrong trousers” citing a lack of action on fuel duty, the hidden ‘tax’ on pensioners within the budget and the rise in duty on cigarettes as the punishment levied upon its readers. Unsurprisingly it also slated the cut in top rate tax, a subject that will undoubtedly define debates in the commons over the next few weeks, but is it right in doing so?

The labour party will be demonising the same old self-interested Tories, looking after their friends in the millionaires club, and many left wing activists and supporters will join them in spreading this. I refuse to believe that different political ideologies are based upon self-interest or that one side is simply evil. This blog concentrates on the drop in top rate tax.

What’s the rationale behind a drop in top rate tax?

Do you fancy coming round and doing my washing up? All my flatmates have gone away and the dishes are stacking up. Will you come and wash them? Given the fact no one is knocking down my door I’ll assume no one wants to. Some of you may even have reacted with an offhand “Yeah, if you pay me.” This is the basic reasoning behind the policy. If you pay someone more (by taking less in tax) they work more, and this is good for the country and possibly even tax revenue.

George Osborne has actually been very clever here. As we observed with the 50p tax rate introduction in 2010/11 high earners have no problem in forestalling their income. In this case when the 50p tax rate was announced many executives had income diverted from the 2010/11 tax year in which they would have been taxed at 50% to the year 2009/10 at 40%. Osborne claims that this forestalling was to the tune of £16 billion and that cost the exchequer around £1.6 billion pounds. This is plainly a fallacy, the forestalling cost nothing. If the tax rate had not been introduced the £16 billion would have been taxed at 40% in the second year just the same. No revenue was lost as a result of the policy and the chancellor has done well to portray it in such a light.

Furthermore, the tax drop also makes sense in an economic sphere. Having observed this tendency George can exploit it for the good of the exchequer. The announcement that this change will only take effect in the tax year 2013/14 has created potential economic benefits. By delaying the implementation we can expect high earners to react in a similar manner as they did for the rise. By delaying income into the year with the lower tax rate individuals can save 5p in the pound of tax paid. A decision that many will rationalise is worth the wait, especially because this can add up to over £40,000 for earners of £1million. However the difference between this and the forestalling observed in 2009/10 is that this will leave many firms not paying as high bills in salary this year, leading to a higher profit. Profit is taxable by Corporation tax, which this budget cut to 24%, and firms will either chose to face this tax or to re-invest the profit into their businesses leading to abnormal expansion. Assuming some firms choose each option this will lead to the double effect of increasing corporation tax receipts this year and creating jobs and fostering growth. Firms will then pay out the wages next year at the lower rate of 45%. On the whole the public coffer will lose the 5% on these bonuses, but gain the 24% on the profit. Overall on a £1 million bonus delayed for a year the government gains £82,000, an increase of almost a fifth over the 50p rate.

This effect will also help the Tories to justify their decisions in the budget. Firms being forced to pay tax on profits this year will increase corporation tax revenue, creating the illusion of a justification for cutting corporation tax, rather than the clumsy reasoning that cutting the rate will encourage businesses to locate in the UK they will have figures to show the benefits to lowering the rate. The fact high earners delay income till next year will also create a loss of revenue under the 50p rate this year and an increase in revenue next year, again ‘Proving’ that the 50p rate was too high and that a decrease in tax was the right policy option for the economy. Osborne will be keen to stress these facts when the figures come out just in time for the next election.

If it’s good for the economy what’s the problem?

Returning now to the scenario we had earlier, there’s a madman in my house and he’s chopped of my hands and says unless my washing up gets done he’s going to kill me. In this case you might be more tempted to come round and do my dishes, because you can probably afford the cost of coming and I’m unable to do them myself. This is the left wings argument for keeping the top rate. Those that are more able to help should help more.

It wont do itself

These arguments of equity and fairness however are difficult to justify as they do not come with easily linked qualitative data, in the first example I used above it is impossible to deny that paying is an effective way to get people to do my dishes. Comparatively the evidence that those who are the most efficient at doing them, and hence get paid the most to do so, should compensate those who are less able to is weak.

Yet the tax rate does not face this problem, for keeping it also has justification in an economic sphere. Retuning to our million pound bonus in the previous section, looking at it across the period above it is clear that it is more efficient to drop the tax rate. However if we assume the bonus is paid continually over 10 years the story is different. Under the 50p rate the bonus gives £5million in tax, on the other hand if there is a drop in the tax rate after the first year (and corporation and forestalling are taken into account) it is just £4.6 million. Unfortunately this benefit is all hypothetical the structure of tax change that the conservatives have implemented means that it will never be measured as at both ends of the spectrum high earners have shifted their income across time periods into the lower bracket, leading to insignificant tax receipts of the 50p rate and hence no compelling evidence to maintain or reinstate it. 

Of course we cannot tell if this would have caused revenue to be higher or not, because the higher tax rate may mean that less people in the UK earn that kind of money as they take their expertise elsewhere. Personally I would argue that these higher earners have a low tendency to leave as the UK is highly specialised in jobs with this kind of salary and hence moving between nations may be low. But there is no conclusive analysis that can take place to prove this here. Another factor to take into account is that the economy is currently short of liquidity, implying that money now is preferable to money in 10 years’ time. So the value of Tory policy may be more appropriate in the current climate. The earnings in the first year can be used to pay off debt, reducing interest rate payments across future years and leading to a stronger economy.

The conclusion here is rather unclear, while in the future the numbers will in all likelihood indicate that the Chancellor was right in his budget tax decisions the figures will only represent a temporary, rather than sustained, increase in revenue. Convincing arguments can be seen on both sides but the unpredictable nature of individual’s reaction to different tax rates make it impossible to assess direct effect of policy. The success or failure of George Osborne’s budget will likely fall solely upon the macro level performance of the British economy of the next few years, if sustained growth can be reached again debates of top rate tax will probably take a back seat in political discussions.  

Here's a song called clean:

Someone please come and do the washing up...