Equality vs big government

Imagine a tax system in which the first £10,000 of income is tax-free, the next £40,000 is taxed at 20%, and incomes above £50,000 are taxed at 50%.

Imagine then that the income distribution moves from A to B in my table. B is a poorer society and, by most measures, a more unequal one. Such a move could happen if the financial sector, which has a few mega-incomes, increases in size whilst it imposes a negative externality onto the rest of the economy. Or it could happen because bosses increase the rate of exploitation of workers by engaging in rent-seeking which impoverishes society as a whole.

What happens to tax revenues when we move from A to B?

The answer is that they rise significantly, from 77 to 107. This is despite the fact that B is poorer.
The message here is awkward. Given a reasonable tax system, a government which wants to maximize tax revenue will welcome a rise in inequality - even if that inequality is associated with lower GDP.

This, it is alleged, is what New Labour did. Nick writes:

In the bubble, Labour let the City rip and used the taxes to fund handouts to the poor and social improvements.

And the Spectator's leader says:

Brown's greed for tax was just as pernicious as the bankers' greed for profits. Every bonus paid in the City was split 60/40 with HMRC; it was a joint venture with the banks.

These complaints hint at a genuine trade-off - that, under a progressive tax system, the Left faces a choice between increasing equality and increasing tax and thus public spending.

Now, you might object that this trade-off isn't as acute as I've pretended:

1. "To the extent that higher tax revenues really do help the poor, the social wage rises and so inequality doesn't increase as much as I've painted." But what if the revenues are spent on corporate welfare, or are lost through stagnant public sector productivity?

2. "Given high indirect taxes, the overall tax system is not terribly progressive." True. But I'm not sure this is something the left will welcome.

3. "A clampdown on tax-dodging would allow a leftist government to increase both equality and tax revenue, thus overcoming the trade-off." However, if such activity is as widespread as claimed, it is evidence that the state lacks either the will or ability to eliminate it, which raises another awkward problem.

If there is the sort of trade-off I've described, then Labour has a problem. On the one hand, the case for reducing inequality is very strong - either as a direct goal of policy or as a by-product of putting the financial sector in its rightful place. But on the other hand, doing so would jeopardize tax revenues and thus make it harder to reverse the Tories' squeeze on spending - especially if Labour is committed to fiscal conservatism.

Comments

[Luis Enrique]

I was going to comment that if Labour could actually increase equality, then maybe it wouldn't face this problem, because the level of required spending would be lower, because more people would be better off, and hence less in need of state help (in your example A, you might say only the two individuals with income 10 need help). But on second thought I'm not sure how much of state spending is actually tied to the prevalence of poverty. Everybody in example A might still demand costly state-provided schools, health, pensions etc.

[Etzel]

In more equal society (A), do you think that there would be less need for the state provision of public goods? For example, because greater equality is associated with lower crime, thus reducing need for policing?

Society A may also be more appealing to people of a Conservative bent because it seems to be more in tune with the contributory principle, where everyone puts in, rather than society B which (artificially at least) seems to represent more of a hand-out society, with a dichotomy of rich 'wealth-creators' and poor scroungers living off public goods.

Either way, interesting read.

[Account Deleted]

"Progressive", in the context of the tax regime you outline, is questionable. As the IFS noted at the time of the budget, it's better-off families that gain most from a high personal allowance. http://www.ifs.org.uk/publications/6045

The cliff-edge at £50k is also a poor design. A properly progressive regime would have a steadier incline, i.e. starting very low and with many more steps, with the step rate accelerating towards the top. This has been perfectly practicable since they invented those new-fangled computer thingummies (so in answer to your point re tax avoidance, it's a matter of will rather than ability).

Your tax regime is also cumulative, which means that not only do the top decile enjoy a £10k tax-free allowance, they only pay 20% on their 10-40k income.

Everyone (including those on benefits) should pay some tax, if only to reinforce tax morale and head off any "no representation without taxation" nonsense, and their effective rate should be their marginal rate.

If you went for a system where the tax rate applied to the total income and rates were 0-10: 3%, 11-20: 7%, 21-30: 12%; 31-40: 18%, 41-50: 28% and 50+: 40%, your total tax take would be 117.

Re Luis & Etzel's comments, realistically, B will not result in a decision to increase public expenditure. The primary decision is how much we wish to spend as a % of GDP, so you can expect B to be marginally lower than A, even though need may be marginally higher.

[Account Deleted]

To clarify, that's 117 for society B. The same regime would produce 118 for society A. In other words, there is also a benefit in terms of revenue stability.

[chris]

@ From AtoE - you're simply proposing higher taxes on the poor, which is hardly a painfree way of avoiding my dilemma.
My point is simply that, for any moderately progressive tax system, there's a potential tradeoff between tax take and equality.
@ Etzel - I've no view on the demand for public services in either case. Ex hypothesi, the rich in society B are not wealth creators but rentseekers and exploiters. If they were wealth creators, my tradeoff wouldn't be so troubling.

[Account Deleted]

Chris, I'm not proposing higher taxes on the poor, merely illustrating that alternative tax regimes are possible, so the dilemma you note is not inevitable.

A reform of income tax along the lines I suggest could be part of a larger overhaul to shift the net burden away from the poor: a land value tax, a reduction in VAT, higher coporation tax and CGT etc.

The point is that debate on income tax suffers from the anachronistic assumption that the tax regime should have minimal bands. This encourages some on the right who advocate a flat tax, while some "progressives" limit their ambition to increasing the tax-free allowance.

[George Hallam]

"The point is that debate on income tax suffers from the anachronistic assumption that the tax regime should have minimal bands."

I agree. we need to use a logistic (sigmoid)curve.

Let's raise more money through income tax and less through VAT (revive purchase tax on luxury goods).

Corporation tax should be abolished (or at least drastically reduced) because it is too easy to evade.

Income Tax should be levied on all British citizens whatever the source (Lord Ashcroft here we come). This would bring us into line with the US. People who renounce their citizenship would still be liable to income tax for ten years after they give up their passports.

We don't need to abolish tax at the bottom end.

If we were to reduce VAT then people on low incomes would be better off so they would be able to pay at least some income tax.

[Sam]

and their effective rate should be their marginal rate.

This isn't possible. There is precisely one curve for which the marginal rate is equal to the effective rate for all incomes, and that's the single flat tax with no allowances, which I don't think is what you're proposing.

It seems as though a marginal tax rate of something like, say, 0.5/(1+exp(-1.7(X-2.5))) might do the trick, where X is income in units of 10,000 pounds. You can fiddle with the 1.7 and 2.5 to control the shape of the curve (whether you pummel the poor or milk the middle). This is just as easy to calculate as any other system.

The big problem with this, or any other scheme with fine-grained bands, is that it makes PAYE really hard to get right. One would have to move to a more American system where everyone makes an end-of-year tax computation and settles up with HMRC.

[Account Deleted]

@Sam, if the rate of tax is applied to total income, then the marginal (and only) rate is the same as the effective rate (within the bounds of income - i.e. I'm not taking indirect taxes into consideration).

For example, 18% on an income of £38k should produce £6,840. This is a feature of a tax regime that does not include any tax-free allowance.

PAYE shouldn't be that big a problem. Modern systems already handle employees with variable pay over the tax year, such as commission.

The one potential problem you have with retrospection is where a pay rise in month 11 puts you into a higher rate band, requiring a surcharge for YTD that exceeds one month's pay. In practice, this would simply lead to most pay rises coinciding with the start of the tax year.

[Paolo]

Well I suppose that the cost-benefit comparison should be between B with higher tax revenue but also negative externalities and A with less tax revenue and no negative externality....is this really a dilemma?

[Keith]

It strikes me that the argument sited is wrong headed. If there is a boom in asset prices it is perfectly proper that the state share in the proceeds of the boom. In the same way Thatcher used some of the revenue from North sea oil to pay benefits to the people made unemployed by her Governments Sado monetarism. Booms end and the revenue with them. That is a problem for all Governments not any one party.

Debates about Tax like this are based on a misconception. Social Democracy does not aim to make everyone equal in the economic sphere but to provide security against risks. The main transfers under social democracy take place between different stages in a persons life not between groups. The reason for a progressive tax system is it provides a simple way to assess taxable capacity; Without speculating about future contingency. Some one paying a high rate of income tax today may need very expensive medical treatment next year or in five years time. If the hypothetical tax payer ends up getting back more then they paid in tax so be it. That is the idea behind the NHS. If you are poor but healthy you end up worse off net as you may pay more then you get back. That is not a failure of policy but the goal of policy. It is called collectivism and is often the only practical way to get round the failures of the market system. It is the most effective way to run health care, social care, and pensions. Always has been and probably always will be.