The coalition’s confusion over its plan to remove child benefit from people in the 40% tax band raises an issue that all politicians would rather ignore: namely, the structure of marginal taxes.
The problem with withdrawing child benefit is that someone earning just under £42,745 faces a massive marginal tax rate because she would lose child benefit if she gets a pay rise.
Of course, marginal deduction rates of several hundred per cent are undesireable. The best way to demonstrate that we‘re “all in this together“ is not to remove child benefit from the rich, but to tax them more heavily.
And this is where economics and politics collide violently, because there is a sound economic case for having higher marginal tax rates on the middlingly rich - those in the current 40% tax band - than on the super-rich.
This is because the super-rich are more likely to reduce their taxable income in response to higher marginal rates than the middling sorts. And as Greg Mankiw wrote in his nice survey (pdf) of optimal tax theory:
If high-income workers are particularly elastic in how their taxable income decreases with higher tax rates, this would imply lower optimal marginal tax rates on high incomes
Empirical work (pdf) in the US by Gruber and Saez has demonstrated just this - that there’s a case for lower marginal taxes on very high incomes than on slightly lower ones.
There are (at least) four reasons why the super-rich are more likely to be on the “wrong” side of the Laffer curve than the middling sorts:
1. They are footloose. A hedge fund manager can move to Switzerland more easily than can a head teacher.
2. There are deadweight costs of dodging taxes. Paying fancy accountants and lawyers is not worth the effort for a middling earner aiming to save a few hundred quid, but it for someone aiming to save a few thousands.
3. The very rich can afford to retire if they think the government is ripping them off. Those of us on middling incomes cannot.
4. The super rich might have lower tax morale than others. The very fact that they are rich is evidence that they are more motivated by money than the rest of us, which suggests they might resent higher marginal taxes more. And this, combined with points 1 -3, might lead them to cut their taxable income in response to high marginal taxes. It more efficient to tax the compliant than the non-compliant.
These points all argue for lower marginal taxes on the very rich than the middlingly so - though whether this points to a 40%-10% structure or a 60%-50% is a separate issue.
Such a structure is, however, politically infeasible. But it needn’t be.
This is because low marginal taxes on the rich are quite consistent with progressive average taxes. Imagine an income tax system in which the first £10k is tax-free, the next £30k is taxed at 20%, the next £110k at 60% and incomes above £150k are taxed at 30%. Then someone on £25k faces an average tax rate of 12%. This is only one-fourth the average rate paid on £150k, and one-third that paid on £200k. Over most incomes - 99% - the tax system is progressive. Yes, average tax rates fall as incomes rise beyond £150k. The guy at the bottom of the top percentile might complain. But so what?
What’s more, income tax is not the only redistributive tool. I’d like to see it accompanied by: land value tax; worker democracy to rein in bosses’ rent-seeking; and a culture war against managerialist ideology.
Lower marginal rates on the rich, then, might be consistent with more egalitarianism than we presently have.