The Pre-Budget Report: will Atlas shrug?

One of the most noteworthy elements of the 2008 Pre-Budget Report was the planned increase in income tax rates to 45% for those earning over £150,000. This measure is intended to help address the budget deficit once the economy starts to recover.

The tax increase is, however, likely to reduce the work incentives for the entrepreneurs that drive growth. Many of the brightest and best may choose to leave the UK for countries where tax rates are lower and their efforts are more generously rewarded. Britain will also be less attractive to highly-skilled immigrants.

Higher income taxes will also encourage wasteful tax avoidance strategies. Moreover, some high earners may eschew promotion and longer hours to avoid paying the top rate.

While the UK is unlikely to experience the kind of scenario described in Atlas Shrugged – where entrepreneurs decide to exit a society en masse – it is clear that the government’s tax plans will significantly hamper the production of wealth. Since it deters creativity, effort and investment, and therefore lowers economic growth, higher income tax is also likely to reduce long-term tax revenues – the opposite of its intended effect.

I don’t believe in Keynesian “solutions” in any case, but the government’s approach is most odd:
1. People are retrenching because they are in debt so we reduce their taxes and increase government debt – leads to more retrenchment.
2. Tell people they have a huge tax rise round the corner – yet more retrenchment.
3. Hit the supply side of the economy over the head with a large mallet as we crawl out of recession in two years time.I fear another Japan.

The logic is far more mundane than that. It is said that they hope to raise £2 bn from this, which on a static basis looks about right. If 10,000 very high earners with an average income of £500,000 leave the UK, that would reduce the total take by 10,000 x £500,000 x 45% = £2.25 billion.

Quite, the Lib Dems dropped their higher rate tax proposal because the IFS computed that they would actually raise less revenue than the margin of error surrounding the calculations (eg the IFS might have calculated, say, that they would raise £100m plus or minus £110m).

The ‘price effect’ implies that high earners may work less because their marginal after-tax rate of pay has fallen; while the ‘income effect’ implies that they may actually work more in order to achieve the same level as before of after-tax income. One cannot tell a priori which effect will dominate; and the evidence is not clear-cut either way. A possible compromise might be a ’sunset clause’, allowing for the top marginal income tax rate to revert to 40% after, say, five years.

They are surfing the wrong side of the Laffer curve. Believe me, I am laughing al the was the the Kantonalbank from my vantage point in low tax Switzerland.What I don’t get is how come they didn’t know this already? Is there really no one left in the treasury who can explain this basic economic principle? Strange days.

@William
I don’t believe Swiss politicians are per se more literate in economics. It is rather that inner-Swiss tax competition, between cantons and even municipalities, gives citizens a powerful protection against overtaxation. Most crucially, Swiss local tax autonomy is combined with local fiscal responsibility. It is the only country I know of where a regional government can go bankrupt, like a private firm, and there will be no bail-out (isn’t that what happened in Leukerbad?).

@KrisI agree – it is tax competition that keeps things on an even keel. Also a great degree of local autonomy. For example, my local town council (population 5000ish) has greater powers than the UK does within the EU.To be honest I find talk of how Swiss institutions can go bankrupt a little difficult to take in while a well known bank is being bailed out and even my local barber has a council-enforced monopoly that allows him to change about 8x what it costs in London for a man’s hair cut.

I don’t believe in Keynesian “solutions” in any case, but the government’s approach is most odd:
1. People are retrenching because they are in debt so we reduce their taxes and increase government debt – leads to more retrenchment.
2. Tell people they have a huge tax rise round the corner – yet more retrenchment.
3. Hit the supply side of the economy over the head with a large mallet as we crawl out of recession in two years time.I fear another Japan.

The logic is far more mundane than that. It is said that they hope to raise £2 bn from this, which on a static basis looks about right. If 10,000 very high earners with an average income of £500,000 leave the UK, that would reduce the total take by 10,000 x £500,000 x 45% = £2.25 billion.

Quite, the Lib Dems dropped their higher rate tax proposal because the IFS computed that they would actually raise less revenue than the margin of error surrounding the calculations (eg the IFS might have calculated, say, that they would raise £100m plus or minus £110m).

The ‘price effect’ implies that high earners may work less because their marginal after-tax rate of pay has fallen; while the ‘income effect’ implies that they may actually work more in order to achieve the same level as before of after-tax income. One cannot tell a priori which effect will dominate; and the evidence is not clear-cut either way. A possible compromise might be a ’sunset clause’, allowing for the top marginal income tax rate to revert to 40% after, say, five years.

They are surfing the wrong side of the Laffer curve. Believe me, I am laughing al the was the the Kantonalbank from my vantage point in low tax Switzerland.What I don’t get is how come they didn’t know this already? Is there really no one left in the treasury who can explain this basic economic principle? Strange days.

@William
I don’t believe Swiss politicians are per se more literate in economics. It is rather that inner-Swiss tax competition, between cantons and even municipalities, gives citizens a powerful protection against overtaxation. Most crucially, Swiss local tax autonomy is combined with local fiscal responsibility. It is the only country I know of where a regional government can go bankrupt, like a private firm, and there will be no bail-out (isn’t that what happened in Leukerbad?).

@KrisI agree – it is tax competition that keeps things on an even keel. Also a great degree of local autonomy. For example, my local town council (population 5000ish) has greater powers than the UK does within the EU.To be honest I find talk of how Swiss institutions can go bankrupt a little difficult to take in while a well known bank is being bailed out and even my local barber has a council-enforced monopoly that allows him to change about 8x what it costs in London for a man’s hair cut.

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