Thursday, 24 September 2015

What's The Optimum Income Tax Rate? It Probably Will Surprise You To Know That It Is Zero

In a period of time in which Corbynomics has gained much electoral sway, and the man behind it, Richard Murphy, is talking about raising top rates of tax to the disastrously high levels we saw in the 1970s, it would be good to bring things back to reality by reminding everyone that the idea of taxing ourselves to prosperity is a ridiculous one that's been discredited at every turn in history. To give you an idea, this is a chart that shows some differing tax incomes in the UK based on differing top rates of tax.

This is often brought up because of Chancellor Nigel Lawson's great reforming tax budget in 1988 where he famously cut top rates of tax from 60% down to 40% and saw increased economic growth and generated more tax revenue in the process. As you can see, in 1986-87 when the top rate was 60p, the richest 1% contributed just 14% of all income tax, whereas once the top rate was reduced from 60p to 40p, the proportion paid by the richest 1% soared to 21% where it stayed.

This is all about what's known as the Laffer curve, which shows the relationship between tax rates and the amount of tax the government collects. Obviously with the current system of fairly large government, 0% and 100% would bring in no income at all, with the optimum amount being somewhere in between. So if you start to increase it from 0% upwards you see an increase in tax revenue, but after a certain point the line will flatten and it will reach a point of declension when too high a tax rate discourages work and innovation, and encourages avoidance and evasion, makes some people leave the country, stops others from investing, and increases black market transactions too.

In this blog post I explained why the government tends to behave a bit like the mafia running a protection racket - they try to extract out of their victims as much as they can without extracting so much that they ruin their business and can no longer collect any money. Incidentally, the last time I checked, the Centre for Economics and Business Research (CEBR) calculated an optimal top tax rate of 36% - even lower than Lawson's great reforming tax.

No one knows, under the present system, exactly what the optimum top tax rate is, but all the evidence shows that high rates in the region of 60%-80% are ridiculously off the mark. We know that fairly recently when the top tax rate was reduced from 50p to 45p the Treasury received an extra £1.3 billion in income tax from the top earners. The ratio saw the top 1% contributing over 29% of the nation's income tax. Not only was it less when the rate was 50p, we can contrast it with the ratio in the 60p mid-eighties top rate when we had the top 1% contributing only 14% of the nation's income tax. You may also be interested to know that as things stand with the 45p tax rate, the tax gained from the top 1% is apparently at a record high. They earn 13% of the income but now pay 30% cent of income tax collected.  Even the top 0.1% (stress that's nought point one percent, not one percent) pay a comparably astronomical 14% of the total income tax paid, which is an increase by a factor of 140.

Consequently, the way the system is set up at present, my best guess for the optimal top tax rate would be somewhere between the CEBR's 36% and the current 45% rate - although in actual fact, I suspect that as the government continues to get smaller and smaller in the coming decades even 36% will seem unthinkably high - particularly if a little known and abstruse mathematical proof called the Chamley-Judd Redistribution Impossibility Theorem ever becomes more well known, as it demonstrates a proof that the optimum capital tax rate is zero, because it’s actually impossible to make the workers in an economy better off by taxing capital.

Finally, Arthur Laffer, on whose wisdom the aforementioned Laffer curve is based, looked thoroughly at specific US state tax policies against economic growth. It's no surprise that the USA saw the same kind of results that we saw in the UK:

"Laffer compared the nine states with no income tax with the nine states with the highest income tax rates over the last 10 years. The nine with no income tax have experienced higher revenue growth rates, higher productivity growth and lower unemployment growth. Similarly, he looked at the 11 states that have introduced a progressive income tax in the last 50 years. Each of those states has experienced a decline in gross state product as a share of the total U.S. product and a decrease in revenue as a share of the total state tax receipts. Laffer concluded that a tax structure that includes a progressive income tax “not only causes a state economy to grow more slowly, but leads to a lower standard of living, lower productivity growth, and thwarts expectations of revenues.”

Laffer, like most people who understand economics, advocates a low flat tax with no deductions as the best tax structure for economic growth. If only our politicians had the courage to put growth ahead of votes.