Flat taxes and equality

Oliver Kamm says:

Mr Osborne claims that a flat tax might enhance incentives to work while improving the position of the worst-off. But those claimed benefits would materialise only if the tax rate were set low enough and personal allowances set high enough. The Labour Party’s script almost writes itself: a Conservative Government would mean a burgeoning fiscal deficit, or a huge tax break for the rich, or a hidden agenda of massive cuts in public spending.

This is far from obvious – and might be plain wrong.

To see why, imagine a flat tax rate (incorporating NI) were set at 55%, alongside a tax-free basic income of £200 per household per week. And imagine – for the sake of simplicity – that the economy consists equally of just two types of household: single parents with one child; and married couples with one child. Earnings range, in equal numbers, from £160 per week to £900*.

Our flat tax system imposes higher taxes upon anyone earning over £640 a week than the present system. So it’s certainly not “a huge tax break for the rich.” And it’s slightly revenue-positive (in static terms), so it doesn’t mean “a burgeoning fiscal deficit…or a hidden agenda of massive cuts in public spending.”

What’s more, our flat tax system benefits married couples earning less than £600, and raises the take-home income of married couples on £240-£440 by over 10% a week. So it does improve the position of poorer workers. A flat tax system is not inherently inegalitarian.

And even a tax rate as high as 55% means a lower deduction rate for all single parents earning less than £570 a week, and for all married couples earning less than £380 a week. (For others, of course, deduction rates rise – particularly for people earning £600-700.)

Current marginal withdrawal rates are so high that the flat tax rate doesn’t have to be particularly low to improve incentives for many people.

So, for one particular type of flat tax, and one simplified type of society, Osborne is right and Kamm wrong. The question is: how does the greater complexity of the UK economy alter the picture? There are many problems, among them:

1. Under this flat tax system, poorer single parents lose heavily. This is because they now get huge tax credits, which a flat tax system abolishes.

2. Families with more than one kid, who get tax credits in the current system, gain less.

3. I’ve assumed no-one earns more than £900 a week. In the real world, a few people do. They lose under this flat tax system.

4. The wage distribution isn’t linear, as I’ve assumed, but is bunched around £400 a week – a level at which there are many gainers (for one-child families). This might be politically convenient, but it’s expensive in terms of revenue.

5. The impact on labour supply is ambiguous. Maybe the adverse incentives imposed upon higher earners would cause a fall in labour supply greater than the increased supply caused by the lower marginal rates imposed on poorer workers. Opinions on this issue are, I suspect, stronger on either side than the evidence.

Note that points 1-3 imply that the flat tax system is more (statically) revenue-positive in the real world than in my simple one. This might offset the problems raised by points 4 and 5.

This is, of course, only a very rough first sketch. All I’m showing is that Osborne isn’t obviously grossly wrong, and Kamm’s claims are way too glib.

An intelligent debate about the flat tax – to which Mr Kamm has not contributed – would fill in these complications.

* I’m using tables 1.2e and 1.5b of this pdf.

Comments

[dsquared]

Chris, it pains me more than I can say to come to the defence of Kamm (no really, you'll never know) but this looks more like a textbook example than a practical proposal. In the real world, would anyone ever propose a flat tax system with a marginal rate of 55%? It would certainly mean that you would need a rigorous anti-avoidance system.

[Matthew]

I don't follow the figures. A single parent on £200 a week according to table 1.2e takes home £337 a week. Under your system it would be £200 a week, unless you have the various benefits, which surely would raise the marginal rate past 55%?

[chris]

What's so unrealistic about a 55% rate? According to the Treasury (table 4.2 of the 2005 red book), over 2 million people currently face a marginal withdrawal rate of over 60%. And for 8 of the 10 years of Thatcher's premiership, top earners paid a 60% tax rate.
I'll grant you that no politician will propose it in the real world. But how many politicians in the real world have any good ideas?
Matthew - you're right. Lone parents do lose heavily in this scheme.
Note that I'm not advocating such a scheme. I'm merely showing that, in theory, a flat tax can be progressive and revenue neutral. The objections to this sort of flat tax, contra Kamm, are not that it's a tax break for the rich, but that it penalizes some groups (big families, lone parents) and/or imposes disincentivizing tax rates.
Whether these objections are decisive is, in my view, unclear.

[Matthew]

Ok, fair enough. Though if 2mn people (1.7m families, so perhaps more) face marginal rates over 55%, doesn't that mean 28m or so, don't? And if so wouldn't it be hard to justify it increasing incentives to work?

[dsquared]

Just from a political point of view, a flat tax proposal with a marginal rate higher than the current higher rate of income tax is going to attract support from absolutely nobody; higher earners will see it (correctly) as a tax rise and lower earners will assume that they will do better out of a progressive system. Also it is not just marginal rates which matter given that people vote on budgets which determine their average rates as well as the marginal; giving someone housing benefit might raise their total withdrawal rate from 25% to 60% but nobody's going to believe that it's a bad thing to get housing benefit.