Some economists say the 50p tax rate “is doing lasting damage to the UK economy.” I’m not sure I agree.
As Richard and Duncan say, the economists provide no strong evidence for this. Their concerns that the rate is “making us less attractive as a destination for both foreign investment and talented workers” certainly don’t jump out of the data. Emigration actually fell last year, prime London house prices are rising and in the year after April 2010, there was £40bn of FDI into the UK - bang in line with the average for 2001-05*.
There’s another data point which seems to contradict those economists. This is that in the 22 years we had a 40p top tax rate, UK GDP growth averaged just 2%. That compares to the 2.5% growth we had in the previous 22 years - a time when the top tax rate hit 83% on earned income.
Granted, there are countless other things that affect growth. But many of these are things that supporters of low top taxes would expect to have boosted growth after 1988, such as weak trades unions and the absence of the wage and price controls we had in the 70s.
Of course, these facts don’t settle the matter. But they do draw attention to a possibility - that low top tax rates do not obviously promote growth, and might even retard it.
There are three reasons for this:
1. Low taxes have ambiguous effects on labour supply. Yes, they increase the returns to work, thus making work more attractive. But they also increase post-tax incomes, thus making leisure attractive. One effect of the cut in taxes in 1988, for example, was to allow older investment bankers to take early retirement in the 90s and 00s.
Empirically, it’s not clear which effect dominates
2. Insofar as low tax rates do encourage greater work effort, this needn’t be productive. Low tax rates encourage greater competition for senior jobs, which might divert effort away from productive labour and towards rent-seeking and office politics and might encourage a “yes-man“ mentality that leads to groupthink and poor decisions. Or they might encourage excessive risk taking and speculation, which ends in a financial crisis.
3. Even if some people do stop productive work as a result of higher taxes, the loss is often second order. Imagine a good CEO were to quit because taxes were too high; you‘ll have to imagine it because, AFAIK it hasn‘t actually happened. The firm would hire a replacement. The loss of GDP would be the difference between the CEO’s managerial ability and that of his successor, which will probably be small.
I fear that advocates of low top taxes subscribe to some Randian “great man” theory of economic growth, in which prosperity is driven by a few stars. But this is questionable. If it were true, we’d expect firms who lose CEOs to high taxes to announce their replacement by saying: “This guy’s not as good as his predecessor; you should revise down your earnings estimates.” This doesn’t happen.
I don’t say this to asset that higher top taxes are definitely a good thing, merely to point out that both theory and evidence are more mixed than those economists who wrote to the FT say. As IFS researchers say (pdf) there is “considerable uncertainty” about the effect of top taxes. My suspicion is that they won’t much affect growth either way, simply because so few policies do, especially those that affect only a tiny minority.
Which brings me to my biggest complaint against those economists. To worry so much about the 50p tax rate at a time when real incomes are being squeezed, unemployment is rising and some benefit claimants face real hardship is to display a rather warped set of priorities.
* Yes, FDI is sharply down from 2005-07, but that was the peak of a boom/bubble.