Tax and Fiscal Policy

The higher rate of income tax and fiscal drag

I have nothing to say either in support of or in opposition to the resignation of Iain Duncan Smith. There are so many issues tied up in the debate about this decision that it seems perfectly reasonable to fall on one side in relation to part of the apparent disagreement and fall on the other side in relation to a different aspect of the disagreement.

For example, there is no doubt that the government has been targeting spending cuts on a very small proportion of its spending which must be making reform of working age welfare very difficult (that being one of the areas where cuts have been targeted). As the IEA pointed out in 2011, the pensioner part of the welfare budget has not only been protected but, through promises such as the ‘triple lock’, expanded. Others are now echoing the work that the IEA published at that time, but public choice pressures make it very difficult for the government to act. Not only are pensioners numerous, they are especially vocal. After the paper we published in 2011, not only did the IEA receive a large amount of abuse (the letters and phone calls I received far outnumbered letters and phone calls I have received on all other research put together over the last 14 years), but one member of staff even received a death threat.

However, the other plank of the complaint from the former Secretary of State – that the rich benefitted to an unreasonable degree from the 2016 budget – is much more difficult to defend. It is true that there were reductions in capital gains tax. However, there is evidence to suggest that capital gains tax is beyond its revenue maximising point and it can be argued that it involves unjustified double taxation of returns to capital. Nothing was done about the 62 per cent tax rate that exists on a band of income over £100,000 and the ‘temporary’ 45 per cent tax band remains.

Much of the focus of discussion over the weekend was on the rise in the level of income at which individuals will start to pay higher rate tax. This is a measure that helps the quite-well-off much more than the super-rich. But, more to the point, the measure was not as radical as it seemed on announcement (there’s a surprise!) as much of that rise in the point at which individuals pay higher rate tax comes about as a result of the rise in the personal allowance. Moreover, the measure comes after prolonged and extremely large falls in the higher rate tax entry point relative to earnings (which is the correct metric against which to judge the size of different tax bands):

·         Between 1980 and 1997, the ‘tax-cutting’ Conservative governments allowed the point at which people started to pay higher rate tax to fall by 31 per cent relative to wages.

·         Under ‘prudence with a purpose’ the not-quite-so-scary ‘new’ Labour allowed the point at which people pay higher rate tax to fall by a further 11 per cent relative to earnings.

·         Under George Osborne the entry point for higher rate tax has fallen by a further 12 per cent relative to earnings.

These numbers are not additive, by the way, but the total fall in the level of earnings before which people pay higher rate tax was an incredible 47 per cent between 1980 and 2016. It should also be noted that there was a big rise in the entry point for higher rates of tax in 1979 so, if these figures are calculated from 1979, the fall is only 37 per cent.

If we allow for the fact that parental contributions to their children’s higher education were tax deductible, and for the existence of a married couples allowance, and mortgage interest allowance, as well as for life assurance premium relief, all at the highest marginal rate of tax, entry into the higher tax brackets belonged to an even more exclusive club back in 1980.

All-in-all, to return the level of earnings at which people pay higher rate tax to its level in 1980 would require an increase to about £64,000, not just to the £45,000 proposed by George Osborne. In other words, this budget went a tiny way towards reducing the fall in the point at which people pay higher-rate tax.

In a sense, George Osborne has been the victim of his own rhetoric. Perhaps if he had said: “My government has brought a huge number of people into the higher rate tax band. This is regrettable, but I am no worse than my predecessors. However, today, I shall go some way towards rectifying 35 years of bad tax policy”, the budget might have been received differently and the Secretary of State for Work and Pensions might have been a little less hostile. But, the main point is that we should surely stop focusing on the implications for very specific (and not very important) budget measures and think more about the tax system as a whole: Is it coherent? Does it do the job it is supposed to do? And how has it evolved over time?

Prof Philip Booth is the IEA’s Academic and Research Director, and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. 

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

2 thoughts on “The higher rate of income tax and fiscal drag”

  1. Posted 21/03/2016 at 13:30 | Permalink

    I do find it irritating when people talk about ‘tax cuts’, say to Capital Gains Tax, when what they mean is a reduction in the rates of tax. As Philip Booth says, the result may actually be to increase the small amount of revenue raised by the tax. I blame Keynes for this confusion, since in his General Theory eighty years ago he continually confused ‘wage rates’ with ‘total wages’. (My opinion is that this was not due to any intention to deceive.)

  2. Posted 23/03/2016 at 13:29 | Permalink

    If that annoys you, D.R. Myddelton, I can only imagine how you feel about references to “a tax giveaway”. You’ve got to admire the Orwellian logic, though: “By taking less money from you, I am giving away money too you.”

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