Sunday 16 November 2008

Flat tax and The Laffer Curve

Here's a summary of the effective marginal tax rates faced by the UK economy*:


Commonsense tells us that if tax rates are high enough, the additional extra tax revenue generated by a further hike in rates is cancelled out by a corresponding fall in economic activity, or indeed straightforward tax evasion; a phenomenon known as The Laffer Curve.

Nobody knows what the rate at the top of The Laffer Curve is, my gut feeling is that it is sixty per cent or so; I once read a convincing argument that for employment income it was as high as seventy per cent. As a simplification campaigner, it strikes me that we'd be a lot better off if there were a flat rate on all types of income, let's say 40% for starters**. The fall in income tax collected from those currently suffering a 48% rate would not be 16% (i.e. 8/48), it might be half that, say 8%. Conversely, the tax collected from those currently paying 20% would nearly double. In other words, to achieve fiscal neutrality, a flat rate across all sources of income would be lower than a simple average of all the disparate rates.

It is also important to remember that the sectors of our economy that have benefitted the most from the house price and credit bubbles (the bursting of which has now caused a global recession, if not worse) are either exempt from VAT (banks, speculating in housing) or VAT zero-rated (construction of residential dwelling). But the real underlying distortion is that capital gains from housing are, by and large, tax exempt. 

Even assuming that house prices fall 40% from their peak by 2010, using Nationwide's figures, house prices have been increasing at a compound rate of 8% (not adjusting for inflation) for the past half a century. So if we accept that 40% is a fair rate**, in fairness we ought to have an annual 3.2% flat rate tax on housing wealth*** as well (in place of all existing property related taxes, such as Council Tax, Stamp Duty Land Tax, Inheritance Tax, TV licence fee, Insurance Premium Tax ...) to ensure that all types of income and gains are taxed at the same rate. Such a tax would also act like a higher interest rate and keep house prices low and stable in future.

* I have made a lot of simplifying assumptions; for marginal or loss-making businesses, the overall effective rate is over 100%. The maths is tortuous; the most important rate - the rate suffered by basic rate employees of a VAT-able business - is calculated as £100 gross income divided by 1.175 (to strip out VAT), divided by 1.128 (to strip out Employer's National Insurance) and multiplying the result by 69% (to strip out basic rate tax and Employee's National Insurance). The effective rate on reinvested business profits is only 0% or 15% if profits are spent on current expenditure that attracts full tax relief; the effective rate on expenditure qualifying for capital allowances will be higher than this, and the effective rate spent on land and property will be close to the rate on retained profits.

** Yes, forty per cent is much higher than I'd like, the lower the better obviously, but you have to start somewhere. Forty per cent just happens to be the average of the figures in the table.

*** i.e. 40% x 8%. Of course, conceptually, a tax based purely on location values rather than total property values is vastly preferable, that's a different topic. And in case you think this is a loonie left-wing idea, Professor Patrick Minford suggested in his Agenda For Tax Reform that notional rental income from owner-occupied housing be taxed at the same rate as any other income. OK, he assumed notional rental income of 6% of property values and a flat tax rate of 22%, but that's details.

9 comments:

Lola said...

What was wrong with 'thithes' anyway. 10% seems about right to me.

AntiCitizenOne said...

Scrap the transfer taxes, and run @7% property taxes.

11 Trillion in property value (IP and PP) *7% * (1/60,000,000) = 12K Citizens Dividend per year.

Mark Wadsworth said...

AC1, UK Land and buildings are worth about £4 trillion as we speak, are you sure there is £7 trillion's worth of IP?

Anonymous said...

Anecdotally, it's already over the limit.

I hear many people these days refusing overtime, saying "I won't be working for the taxman" or something like that.

Lola said...

I have clients who would work, but not bothering to because they have to pay higher rate tax. (These are not work refusniks - but people with pensions and investment income) Some of them will work, but only for cash (!) or only if the net rate is what they want, so the employer has to pay more. Ipso Factso PAYE is a tax on employment.

Mark Wadsworth said...

Anon, different people have different rates. Whether it's 60% or 40% is neither here nor; the point is, if we are heading towards 30% (clearly on the upward Laffer slope) we are heading in the right direction.

L, half the reason why people stay on the dole is because the total tax plus benefit withdrawal is between 70% and 110% of earned income.

And yes, of course PAYE is a tax on employment, but if the PAYE rate and the corporation tax rate were equalised, the overall impact on employment levels would be kept to a minimum.

Anonymous said...

With thousands being thrown out of work every month, do we really want people who are not claiming benefit (eg, people who have pensions or have cash in the bank) to enter the job market if they don't want to?

In fact, what is the point of the government forcing, for example, single parents on benefit, people in their 50s who are too old to do a physically or mentally demanding job, or people with long term illness or disablement to try to apply for jobs they are very unlikely to get?

You could say that if Stephen Hawking can get a job with his disabilities, anyone can - but in a recession, the addition of a large number of people competing for low paid jobs is likely to make things worse.

That's a different question from tackling obvious scroungers or malingerers.

And BTW I am in my 50s myself and don't mean to insult people in my age group - but I have to admit the range of jobs I can contemplate doing now is less than it was 20 years ago!

Anonymous said...

To the main subject - the trouble with simplified tax systems is that they are rarely fair - and fair (if we can agree on what is "fair") tax systems are rarely simple.

Presumably a flat rate tax would still have allowances at which the tax rate would kick in - or are we going to have a zero personal allowance so everyone pays income tax? Without tax credits low paid workers are worse off than those on benefit. OK - we could abolish benefits. Easy for people like me, who are unlikely ever to have to claim them, to say this - but I know people who DO have to claim them. And it's not exactly a life of luxury on the dole despite what the Mail and Express may tell you. I've talked to the MP Frank Field about this and he thinks it's a practical proposition to at least make benefits time-limited, based on the US experience. Not so sure myself.

So if we do have a system of income tax with allowances, plus tax credits, we have to have a withdrawal rate. A low withdrawal rate requires a low tax credit amount - or a higher amount but with a low taper it would be claimed by the majority of taxpayers even at very high incomes. OK - in effect this means taxpayers getting a discount off income tax - but in that case why not repackage the tax credit so it comes straight off PAYE and save a lot of admin costs and hassle (the tax credit forms are a nightmare to fill in)?

Tax credits have the effect of subsidising low paid jobs - and without a minimum wage the temptation for employers is to pay as little as possible, tax credits making up the difference. So - we do need a minimum wage IMO. I would however extend it to part time jobs (you can't normally claim WTC if part time) - better to have people working part time than not at all IMO.

Council tax - well, maybe this should be replaced by local income tax. The rich, who don't like CT very much, would find this even more expensive. The higher income tax rate would make the problems mentioned in the blog rather worse - but we would no longer have the very high withdrawal rates for CT benefit.

Mark Wadsworth said...

Exile, if we are going to have a welfare system at all, the least bad system is flat rate, non means tested, non taxable, non-time limited benefits, i.e. Citizen's Income.

What's "fair" got to do with anything? What politicians call "fair" is just pork barrel spending. A flat tax on incomes is less damaging to the economy than what we've got, so on the whole, people would be better off. And of course there'd be a generous personal allowance (unless you're claiming a Citizen's Income)

And Council Tax and a shedload of other property taxes would get replaced with Land Value Tax. That's the least bad tax.