Friday, January 31, 2014

Inequality and Taxation: Bleed the Rich?

Labour has taken an uncharacteristic turn this week and embraced a policy which would have made Tony Blair choke on his morning coffee, were he the remotest bit interested in contemporary party politics. Ed Balls has revived the 50% tax rate on earnings above £150K, slaughtering several New Labour sacred cows in one go. Redistribution: check. Upset business leaders: check. Unrealistic fiscal ambitions: check.

What is different now, of course, is that the couple of decades since New Labour was born have seen a spectacular rise in the GDP share of top earners, a devastating economic collapse caused by the reckless behaviour of some of those top earners, and lately a prolonged stagnation in average living standards. The notion that helping the rich enrich themselves would benefit all is no longer widely believed, and the 50% tax rate appears to be polling well, even though the Institute for Fiscal Studies suggests it won't actually raise any money (they estimate £100 million a year).

January - the month of the UK self-assessment tax deadline -  is always a good time to think about tax and incentives. Certainly the prospect of losing half of any extra pound earned has a disincentive effect, but then again, so does the prospect of losing 40%, which is the situation currently facing anyone earning between about £42,000-149,999 (not to mention the disincentive effects of reducing/eliminating child benefit for 40% taxpayers) . Moreover, the current coalition government did not simply abolish the 50% tax rate introduced by Gordon Brown in 2010; it lowered it to 45% instead. If 45% doesn't have disincentive effects, why should 50%? In short, a 5% increase in tax on earnings above the £150K barrier may encourage a bit of inventiveness in reporting incomes, but I don't envisage Wayne Rooney hanging up his boots in protest any time soon.

Labour's proposal is a handy piece of populism, but it is also a good opportunity to think a little more about why top earners earn what they do, and what effects taxing the rich might have for the economy as a whole. As Simon Wren-Lewis reports, recent research suggests that lower taxes for the rich may not encourage productivity as much as it provides top executives with even greater incentives to plunder the coffers of their companies, redistributing rents to themselves. The classic Laffer curve argument may be true, but in a way which has no real economic costs - if taxes are higher, executives will expend less wasteful energy in extracting greater rewards for themselves out of an existing pool of resources. In some cases, higher taxes could disincentivize rent-seeking behaviour that has dramatic negative externalities, such as reckless risk-taking in the financial sector.

Estimates of the effects of these tax changes are very approximate, since the 50% tax rate only survived a couple of years (current projections are based on only one year of data), and these were years in which the economy remained more or less stationary, so any fiscal consequences of the tax hikes need to control for the depressed state of the economy (which no-one to my knowledge has attempted to pin on the 50% tax rate). All taxes are distortionary, but at the same time all income is conditional on the complex infrastructure of a market economy, which is inconceivable without the state raising a large share of GDP in tax revenue.

The 1% enjoy their property thanks to the public goods our taxes provide, and society's willingness to tolerate and cooperate with an economic system which rewards the rich so handsomely. As the 1%'s share of income grows, the 99%'s tolerance of inequality is bound to be stretched. Countries where the rich don't pay tax tend not to be very safe places to live. It is a cliché, but taxes are the price we pay to live in a civilised society, and advanced economies need to be civilised, resting as they do on the complex and dynamic interactions of highly educated citizens. There is no such thing as a free lunch, even for the rich.