Back to the Golden Rule

Recently I wrote about the curiously stable 35% share of GDP which the British government takes in tax. I want to add something about that.

In March 1974, Labour Chancellor Denis Healy raised the top rate of income tax from 75% to 83%. The effect of that on the share of GDP taken in tax (the government’s allowance) over the next five years is shown below

A 75

Source: The Guardian

In 1979, Conservative Chancellor Geoffrey Howe lowered this to 60%. Again, the effect of that on the government’s allowance over the next five years is shown below

A 60

Source: The Guardian

Finally, in 1988 Howe’s successor, Nigel Lawson, reduced the top rate of income tax to 40%. As before, the effect of that on the government’s allowance over the next five years is shown below

A 40

Source: The Guardian

What I think this does is to isolate from the previous chart the effects of quite large changes in the top rate of income tax on the government allowance. Quite simply, there isn’t one, as the chart below illustrates

GA

Source: The Guardian, Institute for Fiscal Studies

Why not? If these changes in income tax rates are not producing commensurate changes in total tax revenues that must be because top rate taxpayers are reducing their tax exposure elsewhere. The lesson is one of the oldest in economics; people respond to incentives. If they are taxed differently they will act differently. There are three things to take away from this.

First, is that estimates you see which say ‘an increase in the x tax rate of x% will bring in £x more revenue’ need to be clear that they mean revenue from that tax, not total revenue. The evidence is that that will be largely unaffected.

Second, ideas, prevalent on the political left, that Britain can increase the top rate of income tax to close the deficit are fantasy.

And, third, the idea, prominent on the political right, that slashing tax rates will ‘shrink the state’, reduce the share of GDP accounted for by government activity, are equally misguided. As well as showing the minimal effects of tax rate rises on that 35% figure, the chart above also shows the minimal effect of tax cuts.

Once again, the British people seem to have decided, collectively but individually, that 35% of their income is what the government is going to get. The sooner fiscal policymakers reconcile themselves to that fact, the better.

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One thought on “Back to the Golden Rule

  1. Pingback: Whoever won the debate, economics lost | Phelanomics

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