Capping Taxes or Capping Revenue?

By Brandon Mitchell

Alex Estorick, an intern at ConservativeHome, has commented on top end marginal tax rates and an old New Zealand  Labour party proposal to cap the amount of income tax any given individual was expected to pay. It was difficult not to notice a slight mismatch between the rationale for supporting such a policy and that policy’s likely effect.

The rationale is straight-forward. Laffer curves are real and the phenomena which produce them can be observed amongst small groups, like the very wealthy, just as they can large sections of the economy. Let’s begin by outlining what I consider the two principal mechanisms which lead to the Laffer curve. We can call the first the ‘diminishing marginal utility of additional earnings.’ There becomes a point at which the value of the compensation I receive for working that extra day or putting in that extra effort is less than the opportunity cost. I could spend the day with my family or forget the stress of that additional venture. In all sorts of ways we weigh the likely costs and benefits of our efforts and actions, and for large enterprises or very wealthy and talented people, the situation is the same. Should I spend the day at the office or sailing the family to Spain in the yacht? How much an entrepreneur expects to benefit from a new venture or a talented executive from another promotion is largely determined by raw economic realities but taxation is a factor in direct proportion to the size of the top marginal income tax rate. When that rate is 50%, as it is in the UK, it becomes a factor of no small importance.

The second, we can call ‘the return on investment of tax avoidance.’ Individuals and businesses do many things to manage and structure their tax liability. Possibly the most well known example of this is evidenced by the long and diverse list of well known business which are incorporated in Luxembourg or Ireland but the number and variety of actions taken to limit tax liability are immense. People and businesses alike would prefer to have their money when and where they need it, but to a point they will tolerate these elaborate schemes in order to shelter their wealth. The amount of money saved in tax outweighs both the cost of hiring lawyers and accountants to manage elaborate systems and the inconvenience of often not being able to do what you’d like with your money. The important point here is that tax avoidance measures cost something. Corporations and individuals invest time, effort and resources into managing their tax liability to the extent that there is a return on that investment; that there is more money saved on the tax bill than the hassle and expenditure involved in making that savings.

What both of these mechanisms have in common is that their effect on people’s behaviour becomes greater in proportion to the rates at which tax is levied. The lower the top marginal income tax rate, the more the entrepreneur is compensated for starting that business, making it more likely that he will start the business rather than do something else with his time and money. The lower the taxes on individuals and businesses, the less they will find it worthwhile to do to avoid those taxes. In both instances, we move to the left-hand portion of the curve when people decide to pay taxes and more money is gathered in by the government. When rates lower, people stop spending on lawyers and accountants and instead, pay the tax, or they set up the business, make more money and pay more tax, in each instance keeping more for themselves in the process.

And so we arrive at the recommendation from ConservativeHome. Estorick writes, ‘How fair is it to cap the taxes of the highest income earners when so many other families are facing difficult times? The answer is, as optimal tax theory has shown, lower tax rates at the very top of the income distribution can potentially lead to higher income earners paying more, not less, tax. Given this, perhaps this is exactly the sort of approach that a fair tax system should take?’ He’s concerned that lowering the taxes paid by the wealthiest is not a politically popular thing to do, but if more revenue is raised, then do we really care? He sees an equitable solution in the 2001 McLeod Review, commissioned by the Labour government, where they recommended a cap, in nominal terms, on individual income tax liabilities. Estorick sees this proposal as lowering the rate of tax paid by many top earners, thereby moving us off the downward slope of the Laffer curve and back towards the top.

But it’s worthwhile to examine just what kind of mitigating effects we can expect from a nominal tax cap given the phenomena which cause the Laffer curve and whether those effects fall inline with the rationale for such a cap, that it will raise more revenue for HM Treasury. In the case of ‘diminishing marginal utility’ when someone’s tax liabilities have reached the nominal cap, taxes will no longer be a consideration in their decision to work to increase their income. However, the Treasury will receive precisely no benefit from the person’s decision to do additional work. In lowering the ROI of tax avoidance the policy is more successful. For those whose liabilities will inevitably hit the cap, they will forgo the cost of their tax avoidance measures. When liabilities may come in under the cap, cost-benefit characteristics similar to if there were no cap, remain. But in either case, does the avoidance of tax avoidance on the part of these tax payers create additional tax revenue? No. The cap is a cap on how much the government will raise from any given individual.

There exists a single tax avoidance measure that the policy addresses; avoiding UK income tax by not living in the UK. Capping income tax will tend to reduce the ROI of relocating to a lower tax jurisdiction. The policy is designed to sustain or increase the number of taxpayers. It fails, however, to capitalize on any of the other alterations of behaviour which result from a lowering of taxes, increased taxable incomes and an increased willingness to pay tax on current income.

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