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.