Tony Wickenden writes in Money Marketing about the basic principles of taxation and behaviour – prompted by Prime Minister Theresa May’s decision to fund a £20bn NHS boost with a range of tax rises, including lifting the eight-year freeze on fuel duties.
There’s a strong argument that raising taxes is not necessarily the best way to bring down public sector debt and boost Treasury income. Nigel Lawson cut the top rate of tax from 60 to 40 per cent in 1988 and, within a decade, the amount of total tax paid by the UK’s top 1 per cent of earners had risen from 14 to 21 per cent.
So, what impact does taxation have on financial decision making? At a consumer level, governments have long used tax incentives to influence behaviour.
In the UK, we currently have pension tax relief, a large range of ISAs, Enterprise Investment Schemes, Venture Capital Trusts, and Business Property Relief, to name just a few, all aimed at incentivising particular types of investment and spending decisions.
Does it cause more people to invest than would without the incentive? Most likely. The big question is whether the benefit to the economy of this additional investment is worth the cost to the Exchequer.
This consideration will continue to exercise the minds of the Treasury in relation to pension tax relief, costing over £30bn a year.
Optimal tax rates
Back to the tax rates themselves. To what extent do they influence behaviour? If we assume the goal would be to set rates that result in the optimum amount collected for the government to implement its economic and social plans, then what is that level for, say, income tax?
There are many theories on optimal tax rates but, as we get closer to the Autumn Budget let’s hope the Treasury is familiar with the work of former chief economist at the US Office of Management and Budget, Arthur Laffer.
Granted, the theory avoids being specific on the actual tax rate break points but the principle on which it is founded is definitely worth a look.
As the chart below shows, at 0 per cent the government collects zero tax revenue. Revenue increases to a point at C but falls with further rate rises.
The decrease in tax revenue arises because higher tax rates create disincentives for people to work harder and invest. At a 100 per cent tax rate, people will have no incentive to work at all.
What is clear is that economists do not agree on where the all-important point C lies. But many politicians use the concept behind the Laffer Curve to justify cuts nonetheless. The idea is that cuts would increase revenue because the current rates lie beyond point C.
Laffer himself said his theory does not guarantee whether a tax cut will raise or lower revenues. Those who believe any cut at all will raise revenue are wrong. If tax rates are actually at the optimum level then further cuts will not help. Just as merely raising rates will not raise revenue where the rate is at the optimum level.
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