How taxing will the budget be?
The Laffer curve and tax revenues
The famous Laffer curve is back in debate. Mr Laffer said if you put the rate of a tax up too much you will collect less revenue.
Why would the rich stay and the rest work if income tax was set at 100% of income? Before you say that is a ludicrous extreme, the UK marginal rate of income tax on better-off people with savings was 98% as recently as 1978. Not surprisingly there was something called the brain drain, where many talented and higher earning people, or people with accumulated savings, fled the country for more realistic lands. In 1978 the top 1% of income taxpayers paid just 11% of total income tax. Today, with a marginal rate of 45% or under half the 1978 level for savers, they pay 30% of the total income tax.
The Treasury counters by saying that revenues are up despite recent increases in income tax charges on the better-off and reports of more rich people leaving the country. This does not prove the point that higher rates make you more money. Higher incomes have been on the rise, so there would have been more revenue even if the government had not increased the effective tax rate on these higher earners. In the 1980s the UK government took decisions to slash the 98% tax rate first to 60%, then to 40%. After the changes the rich paid more income tax in cash terms, more income tax in real terms after inflation, and paid a higher proportion of all income tax than at the higher rates.
The reasons were simple. More people stayed as they thought 40% fair and internationally competitive. More people returned to the UK from tax exile. More people worked harder and longer, more savers took more investment risks, as it was worthwhile to do so. It boosted growth and left the government more money to cover spending. This reinforced the idea of a Laffer curve. As Mr Laffer said, at a tax rate of zero you get zero tax income, and at a tax rate of 100% you get zero too. The issue is how the curve of tax rate versus revenue earned moves between those two points. The more avoidable a tax, the lower the rate which maximises the revenue.
The UK budget and maximising tax revenue
The budget comes up against this issue of how much tax revenue will be collected. The government wants to spend more and failed to make two cuts to spending following the last budget, where they were needed to make the numbers add up. The Treasury and OBR believe that higher rates and more taxes increase revenues. They are reluctant to accept that there can be Laffer effects. However, we see that Capital Gains Tax receipts have now fallen for two years in response to successive reductions in the tax-free allowance by the previous and this government. It is a good example of a tax with a low Laffer threshold. People with shares and second homes sitting on big profits do not have to sell, and now often instruct their wealth managers not to, as the replacement asset would need to perform so much better to justify the tax hit. We also see that UK corporation tax receipts following the large increase in rate from the last government continue to run well below Ireland's at a much lower rate of tax. Ireland collects three times as much business tax per head as the UK thanks to the attraction of low rates. Revenue from alcohol duty on spirits is down after the last budget's rise in rates.
Raising Employer's National Insurance of course raised substantial extra revenue, as employers are locked into contracts and cannot - and do not want to - fire people as soon as extra tax comes in. The extra tax did, however, have an immediate impact on new jobs. Vacancies fell, as employers set about a longer-term adjustment of their workforce. There will be fewer new jobs, many lost older jobs through natural wastage, and some redundancies as companies are forced to adjust their cost base, especially in the labour-intensive areas like hospitality and retail. As a result, these tax rises, whilst raising more tax from National Insurance, will also lose tax revenues on activity and incur higher benefits costs for more unemployed.
The danger of the budget is the Chancellor will alight on more tax rises that do harm to growth and investment. She is likely to keep to the election promise of no increase in Income Tax, VAT or National Insurance (as clarified for employees). This will drive her to more taxes on property, other assets, savings, capital gains and environmental issues. She will probably be hoping to score substantial revenues from introducing a CBAM or carbon tariff on imports, but this will also have a negative impact on future inflation. She is very likely to extend the freeze on income tax allowances for longer, which gives her a big saving in later years. In the long run up to the budget some businesses and individuals are putting off spending and investing as they await news on which taxes will go up. We read that the tax-free pension lump sum or the ability to save for retirement benefitting from top rate relief may be under fire. There is talk of more property taxes, whether a new higher band of Council tax or a new tax altogether, of higher business rates for large companies and a gambling tax rise. People working in partnerships might face higher National Insurance. The good news is they will not do all of these. The bad news is any of them will harm the economy and slow growth.
About the author
The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board.
John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.
In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios.
He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.