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Marginal tax rates: new research on why they matter, and why the IFS is wrong to suggest raising them

    Last week, our tax expert David Martin argued that the marginal tax rate structure on income in the UK had no logic. Marginal tax rates are of course the rate of tax that you’d pay on the next £1 of income, and so are a good proxy for your financial incentive for moving into work or working extra hours, or working harder to earn more income. This is because 100% minus the marginal tax rate represents the proportion of your next earnings that you are able to keep.

    So, for example, David showed that someone earning £100,000 faces a marginal tax rate on income of 62%, meaning he only gets to keep 38p of every extra £1 earned (in fact, the situation in terms of marginal tax on employment is much worse than this, because the incidence of employers’ National Insurance Contributions will fall, at least in part (though evidence suggests significantly), on the employee as well).

    Classical and supply-side economists think lowering marginal tax rates has positive effects on economic growth. This is because lowering rates improves incentives to work, produce and invest. This can improve the level of economic activity – it might increase labour force participation, make people work longer hours etc.. But it could also raise the growth rate of the economy, which is ultimately driven by improvements in productivity brought about through ideas and innovation. If incentives and the return to work are improved, it would seem logical to think the incentive to work on new ideas is higher.

    How should this inform policy? Well, the government obviously needs to raise revenue. But to maximise growth and dynamic prosperity we should try to keep marginal rates as low as possible to raise the revenue required. Thus, ideally we would have a system where there as few deductions, allowances and exemptions as possible, but instead use a broad-based, low-rate tax system.

    Now this gets a bit more complicated when politicians have other aims than maximising growth. Almost all politicians these days want a “progressive tax system” to ensure “the rich” pay their so-called “fair share”. What this means in practice is that there is pressure for higher marginal tax rates, like the populist 50% additional income tax rate, on high earners. Yet the revenue effects of high taxes on those with the most ability to avoid taxable income or change their work patterns is unclear. And they also assume that “revenue maximising” is optimal – when this is not the same thing as growth maximising.

    A common misconception of the above analysis is that supply-side economists are in favour of marginal tax rate cuts to “stimulate demand”. Thus, some have attempted to label Ronald Reagan’s tax cuts as “Keynesian”. But this is not the supply-side justification at all. What matters to the productive potential in the long-run is not the amount of money in your pocket per se, but what the incentives are to undertake economic activity. Left-wing economists tend to play down these incentive effects.

    It’s in this context that a new paper by Karel Mertens at Cornell University should be seen. It finds “large income responses to marginal tax rates that extend across the income distribution” in the US – i.e. when marginal tax rates are cut, they lead to relatively big behavioural responses and are associated with increases in real GDP. Once some of the statistical flaws of previous measures of responses are corrected for, her conclusions are:

    (i)                  Income responses to marginal tax rate changes are not restricted to the top 1% of tax payers but are much more broad based;

    (ii)                There is no systematic evidence that top 1% incomes respond more strongly to marginal rate changes than incomes below the top 1%;

    (iii)               The income responses are hump-shaped and are larger in the first couple of years following a change in marginal rates than in the first year, although this again to some extent reflects a time aggregation bias.

    From a policy perspective the analysis is clear:

    • “they reinforce the findings by a number of recent macro studies of large effects of aggregate tax changes on real GDP both in the US and internationally”
    • “raising marginal tax rates to resolve budget deficits comes at a high price”
    • “a proportional across-the-board tax cut provides successful stimulus that does not necessarily lead to greater income concentration at the top"

    This is important for the UK debate about how to close the remainder of the structural deficit here (because there's no reason to expect significantly different results here). The Coalition government front-loaded tax hikes, including bringing more people into the 40p income tax (and thus hiking their marginal rates). They have also left the higher tax band thresholds unadjusted to inflation, which will lead to significant fiscal drag.

    Having done the tax hikes, the Government is now cutting significantly on current spending in some departments, but leaving large areas of spending protected. The Institute for Fiscal Studies think the Government won’t be able to continue cutting to the extent required to see through closure of the structural deficit, and so have suggested allowing even more significant fiscal drag (i.e. not adjusting tax bands to reflect inflation and so raising many individuals’ marginal tax rates). Yet this academic work suggests this would be a big economic mistake. Instead, the government should re-examine the role of the state, and reflect of the wisdom of the current ring-fencing arrangements.

    Incentives matter. So obsessed are policymakers with attempting to control and manipulate the aggregate economy, this is all too often forgotten. Tax reform which broadens tax bases and lowers rates to boost incentives is the dog that hasn’t barked so far as part of the Coalition’s supply-side agenda. But raising marginal tax rates even more would be economic madness.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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