45p: Power beats evidence

In yesterday’s Budget, George Osborne said:

Let me tell the House what HMRC say about the difference between 50p and 45p.
Their figures tell the story.
The direct cost is only £100 million a year.

However, it is not really HMRC figures (pdf) that tell this story. The estimate that the 45p rate will cost the Exchequer only £100m is based not so much upon the evidence of the impact of the 50p rate so much as upon a 2008 report (pdf) to the Mirrlees committee by Mike Brewer, Emmanuel Saez and Andrew Shephard.

The key thing here is the taxable income elasticity (TIE)- the extent to which people reduce their (reported) pre-tax income in response to a cut in their after-tax income. The higher is the TIE, the less a tax rise will bring in to the Treasury - and the less a tax cut will cost.

The Treasury’s estimate that the cut to 45p will cost only £100m is based upon a TIE of 0.45; it had earlier assumed a TIE of just 0.35.

This TIE is almost identical to Brewer, Saez and Shephard’s estimate, of 0.46.

The HMRC report corroborates this, in that it estimates a TIE of 0.48. But given the difficulties of distinguishing between genuine long-term behavioural responses and one-off forestalling responses (pulling income forward from 2010-11 into 2009-10), this estimate adds little to BSS’s work. The standard error around it is 0.33.

And even BSS's estimate is not precise. There’s a SE of 0.13 points around it. This implies that there’s a two-thirds chance that the TIE is between 0.33 and 0.58 - and a one-in-six chance that it is below 0.33.

If we take the TIE of 0.58, the cut in the top rate to 45p will save the Treasury almost £1bn*. Mr Osborne was keen to point that out. What he didn’t say is that if we take the lower TIE, of 0.33, then the cut in the top rate to 45p will cost the Treasury not £100m but over £1bn. In other words, it would be a big giveaway to the rich.

And the HMRC suggests a reason to believe a lower TIC. It says (par A.17):

There is some reason to believe that these elasticities may not be symmetric for reductions in tax rates that follow increases. This is because tax planning arrangements to mitigate the tax increase may not be unwound if the tax rate subsequently falls again, as the costs of making the arrangements have already been incurred. Individuals who have emigrated since the tax increase might not decide to return after the tax cut. Likewise, some individuals who have chosen to retire earlier in response to the tax rate may decide not to return to work if the tax rate falls. This suggests the elasticity for the rate reduction could be slightly lower than observed by HMRC for the preceding rate increase.

Now, I don’t say all this to take a definite view on whether the cut in the top tax rate will or will not raise money. We just don’t know.

And this is the point. The fact that Osborne was willing to take a decision based upon such flimsy evidence shows that policy-making is determined more by the interests of the rich than by the objective empirical evidence. And this, as Simon says, signals that there's a political problem which has potentially serious economic effects.

* My estimate, based on HMRC methodology described on p15 of their report.

Comments

[Jim]

A tax cut is not a 'giveaway' its just the State stealing slightly less of someone's income.

[Gareth]

Oh, here we go again.

There is a perfectly reasonable argument that lowering top marginal tax rates increases aggregate supply. Show me the countries which have been increasing their top marginal tax rates over the last 30 years and compare them with the countries which were decreasing them. Who is winning?

There is a perfectly reasonable argument that the UK is suffering from a supply-side crisis, with 2011's 5% CPI disaster despite (apparently) weak AD being evidence #1.

And hence there is also a perfectly reasonable argument that Osborne cares more about improving the supply-side than the short term revenue from the 50p rate, so long as he can hit his deficit targets.

And we can do all that without cooking up conspiracies about Osborne being in the pockets of the bad, bad men who wear suits.

[Richard]

"Show me the countries which have been increasing their top marginal tax rates over the last 30 years and compare them with the countries which were decreasing them. Who is winning?"

Why don't you? Easy to make a series of unfounded assertions (which is all your comment amounts to) when you're reluctant to provide the evidence for scrutiny by others.

[Paolo Siciliani]

Well done. One quibble, does the BBS estimate control for the economic cycle? I mean, the fact that the tax increase was levied during a global recessionary period were many high paid jobs were considered equally at risk (i.e., not as many outside options available as often claimed) may be another reason why this time around the TIE was lower than estimated.

[Gareth]

"Why don't you?"

OK, fair enough.

I looked at the OECD table for top marginal tax rates 2000-2011, and separated into two groups; those who had falling/flat top marginal tax rates, those who have had increases in top marginal tax rates.

I then compared against the IMF WEO database for real GDP over the same period, and worked out the average annual growth rate of real GDP over the same period. Here are the results:

countries with falling top marginal rates:
average real gdp growth: 2.4%

countries with rising marginal rates:
average real gdp growth: 1.6%

The only countries with significant (>1%) rises in top marginal tax rates were... can you guess? Europe's finest:

UK +12% (average rGDP growth 2000-2011: 1.4%)
Portugal +9% (0.4%)
France +4% (1.2%)
Italy +5% (0.3%)

Sources:

http://www.oecd.org/document/60/0,3746,en_2649_34533_1942460_1_1_1_1,00.html

http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/weoselgr.aspx

[Account Deleted]

@Gareth,

The correlation of a trend in the top rate of tax and GDP growth, over the same period, does not prove causation. Even if it did, you'd still be left with the chicken and egg problem. Is the reduction in the top rate of tax the cause of growth, or is it merely a symptom of it?

If an economy is growing, this will increase the quantum of tax revenue and will also reduce public expenditure as unemployment drops. This would provide scope for tax cuts (see Nigel Lawson in 1988).

Conversely, if an economy is contracting or struggling to grow, revenues may drop and expenditure increase as unemployment grows. This might prompt tax rises to help fund the deficit (see Alistair Darling in 2009).

George Osborne is betting that cutting the tax of corporates and the wealthy will stimulate growth. This is essentially the same trickle-down concept that has been around since the 80s. As we now know, this produced rapid growth in wealth at the top end of the social scale, but growing impoverishment at the bottom end and stagnation in the middle.

What evidence do we have that history will be different this time?

[Paolo Siciliani]

BTW, much of the so-called behavioural reaction to the 50% tax rate was due to income brought forward in 09/10 to avoid the higher tax rate in fiscal year 10/11. The IFS estimates that this "forestalling" accounted for 16b to 18b being shifted. That is to say, the mistake wasn't as much the 50p tax rise but its pre-announcement. But this suggest that this trick is a one-off, you cannot bring forward more than one or two years of future expected income! That is to say, to presume that this behavioural reaction is permanent (stationary) is highly debatable. By the same token, if next year we find out the 45p raised above expectations this might simply be because this one-off forestalling effect has run out, not because people has reacted positively by working more or paying taxes!

[Account Deleted]

@Paolo,

The trick is not quite a one-off. As well as advancing your 10-11 salary in excess of £150k to tax year 09-10, you can now defer your 12-13 salary in excess of £150k to 13-14.

This means the only year that will be a true measure of the 50p rate's effectiveness (ignoring other methods of avoidance) will be 11-12. Due to self-assessment, we won't have the figures on this till March 2013.

When we come to debate higher top rates of tax in future, you can be sure one camp will insist on looking at the aggregate take over the 3 years 10-13, rather than the most effective year of 11-12.

[Keith]

I agree with the criticism of Gareths' argument, made above. It also seems to me that it is open to the additional objection that the european countries he mentions are suffering from a very bad monetary regime, the euro, run by deflationists, or ECB as they are called. The dissapearing growth caused by the new gold standard is why they have been forced to cut spending and raise taxes. This illustrates I believe the more general point that growth depends on many more factors then personal tax rates. As I asserted in an earlier comment. The mythical power of tax cuts for the rich to transform economy and society for the betterment of the many is a zombie that refuses to die a natural death.

The extrodinary notion that the rich bastards who tanked the world economy deserve tea and sympathy and tax cuts while disabled children and low paid workers are savaged by the Coalition is vile self serving and contemptible. As is the coalition who do this and the people who support it.

[Tim Newman]

"This is essentially the same trickle-down concept that has been around since the 80s"

What you describe is not the trickle-down concept, although I concede this is a mistake made on a regular basis by most people. Trickle-down is not a case of the less wealthy getting more money as a result of the more wealthy getting more money, it is the concept whereby goods arriving on the market are the preserve of the wealthy but eventually become affordable for all (i.e. makes them wealthier). It is impossible to deny that this occurs, with even poor Africans now all owning a mobile phone, something that 25 years ago only millionaires could afford.

[Account Deleted]

@Tim

The term "trickle-down" is commonly used as shorthand for supply-side theories in economics. This can be summarised as the belief that "freeing-up the wealth creators" (i.e. companies and the better-off) leads to an aggregate increase in economic growth, which thereby benefits the less well-off. See:
http://en.wikipedia.org/wiki/Trickle-down_economics
http://www.thefreedictionary.com/trickle-down
http://www.ldoceonline.com/dictionary/trickle-down-effect

The "trickle down effect" you cite is a distinct term, primarily used in marketing, however this is less prevalent than "trickle down economics".

[prodaja čelika]

"Trick down" very interesting term I have to admit.

[dirigible]

"policy-making is determined more by the interests of the rich"

This isn't even their interests (assuming Osborne is right). It's their egos.