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Labour hasn’t accounted for the ways tax affects behaviour

    This piece was originally published by the Times Red Box.

    It seems so simple, logical even. At first glance. First, you just calculate how much a tax rate generates for the Treasury. Then you do the simple calculation to show how much more the Treasury would get if you put up the rate. Increase the rate by 50 per cent and – bingo – forecast that the receipts to go up by 50 per cent. Simples!

    The real world is, of course, just that little bit more complicated. People, all of us, adapt our behaviour according to how much tax we pay. Watch passengers spend lavishly at the duty free shops in airports. Go to Calais and see the discount wine warehouses. Talk to your corner shop about how legal cigarette sales are falling (and black market sales are increasing) as higher and higher tobacco duties bite.

    All taxes affect all behaviour. Sometimes in small ways; at other times, significantly. What is striking about Labour’s tax plans, announced yesterday, is that they expect that higher earners and businesses – those who tend to adjust their behaviour most quickly to tax changes – will just carry on as they did before.

    Take the proposals for their three biggest tax increases: corporation tax, income tax for higher earners and a financial transaction tax.

    The economic illiteracy of higher rates of corporation tax
    The Labour Party has announced that it plans to increase the rate of corporation tax from 19 per cent to 26 per cent by 2020-21. In comparison, the government plans to cut the corporation tax rate to 17 per cent by 2020-21. Labour has claimed that their proposals would raise £19.4bn a year by 2020-21.

    According to HMRC, a one percentage point increase in corporation tax will raise around £2.4 billion. So, Labour seems to have calculated that an increase in corporation tax rate by seven percentage points to 26 per cent would yield £19.4 billion compared to the government’s planned cut to 17 per cent (there is a small adjustment because small businesses would see receipts go up more slowly).

    But this calculation is problematic. Not least it overlooks the fact that a cut in the corporation tax rate from 28 per cent in 2010-11 to 19 per cent has been associated with an increase in onshore corporation tax receipts of 44 per cent since 2011-12. Counter intuitive maybe, but undeniable. Perhaps the recent cuts in corporation tax have meant that more companies have chosen to invest in the UK, have employed more people (the UK is enjoying record employment rates) and have also encouraged more individuals to set up their own companies so that they can enjoy a lower rate of tax. In other words, over the last six years, companies and people have changed the way they behave so that they benefit from the lower rate of tax to such an extent that tax receipts have actually gone up. And yet Labour seems to believe that doing the exact opposite will increase tax receipts even more.

    Killing the golden geese through higher income tax rates
    Similarly, Labour has claimed that increasing income tax rates for the top 5 per cent of earners could raise up to £6.4 billion a year. If you ask the question of whether higher earners already pay their fair share of income tax, the answer you get will depend on who you ask. But what cannot be argued is that, since 2010, the rich are now paying a much greater proportion of income tax, while basic rate taxpayers have seen their income tax contributions fall significantly from nearly half of all income tax receipts to just over a third.

    For again we see that, if the government tries to take too much, then people act rationally in their own self-interest. Here, the trend in payments from the top 1 per cent of taxpayers is illustrative. When George Osborne cut the additional rate of tax for those earning above £150,000 from 50p to 45p in 2013-14, receipts from additional rate taxpayers went up by £8 billion in that financial year. A proportion of this was due to the deferral of income. Yet the increase in receipts was maintained in the following financial year, suggesting a lasting benefit to the exchequer from competitive tax rates. Despite the cut in rate from 50p to 45p, the yield has increased: top rate taxpayers have gone from paying under 23 per cent in 2010-11 of total income tax receipts to 28 per cent in 2014-15.

    And remember that the highest earners are the geese that lay the golden eggs. Forcing them to pay more might be popular and therefore politically tempting, but it is economically crazy. Many geese will either fly off to more attractive countries or just stop laying the golden eggs.

    Undermining the financial services through a financial transactions tax
    Finally, Labour claims that its suggested tax on financial transactions would bring in £5.6 billion a year. That well-known Conservative, Sadiq Khan, the Labour mayor of London, has previously criticised these plans, arguing that the tax could lead to companies going to other parts of the world where this is no such tax. Financial institutions, which contributed £71.4bn, or 11.5 per cent of total government tax receipts in 2015-16, have also warned that market participants may take their business elsewhere instead of paying the levy, saying that the tax would stall market activity, slow economic growth and lead to higher costs being passed onto investors. Does Labour really not understand that its proposals would risk driving these businesses away?

    Labour’s attempt to justify its tax proposals, Funding Britain’s Future, published alongside its manifesto, reads as if it has decided what it wants to do; and then to play with the calculations so that it appears affordable. The problem is that it simply ignores how companies and individuals would react to its proposed changes. In the real world, not a place which Labour appears keen to inhabit, that can only be dismissed as dangerously naive.

    Tim Knox was Director of the CPS from 2011-2017. Before he was Director, Tim was the Editor at the CPS - a position in which he was responsible for publishing papers by every Conservative leader since Mrs Thatcher as well as by hundreds of leading academics and opinion formers.

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