Does taxing the rich work?


8:00 am - November 29th 2009

by Chris Dillow    


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Tim and Richard are debating that old question, would higher taxes on the rich, as demanded by Compass, actually raise tax revenue, or would the rich emigrate, work less or fiddle their taxes with the result that less income would be raised?

Economic theory is absolutely no help here, as there are two competing effects. The income effect predicts that higher taxes might lead people to work harder, in order to maintain their post-tax incomes. The substitution effect says that if work becomes less remunerative, they’d do less of it and spend more time with the guitar or golf clubs.

It is an entirely empirical question as to which one dominates – in other words, as to where the Laffer curve is.

Here, though, is the problem – the empirics are also uncertain. Take, for example a recent paper (pdf) from IFS economists. It says:

If the richest 1% see a 1% fall in the proportion of each additional pound of earnings that is left after tax, then the income they report will rise by less than half that – only 0.46%. Although a tentative estimate, this suggests that the government would maximise the revenue it collects by imposing an overall marginal rate on the highest earners of 56.6%, very close to the 53.0% currently charged.

Victory to Tim, you might think.

No. For one thing, as they say, the estimate is tentative. Allowing for this gives us another interpretation. This is that the revenue-maximizing top tax rate is 95% likely to be in the range 45-75%. This encompasses Tim’s and Richard’s views.

And it could be that Richard is nearer the truth. The IFS’s estimate is for the top 1%. But these are those most likely to respond to higher taxes by reducing labour supply. The well-paid hedge fund manager can relocate to Bermuda. The CEO can stop work and take up some non-executive directorships. And guys who have made a few million can afford to retire.

However, those lower down the top decile – the ones Richard wants to tax more – have fewer such options. They might be tied to work. Remember, an income as low as just over £46,000 gets you into the top decile – and you can‘t retire on your savings from that.

Indeed, other IFS evidence (pdf) suggests that, for male workers in general, “hours of work are almost completely irresponsive to changes in work incentives.”

So, am I siding with Richard? Not entirely.

Put yourself in the shoes of someone on, say, £100,000 a year facing Richard’s higher tax. He might well figure: “I’ve got an ex-wife and kids to support: I’ve got to keep earning. And I’m not qualified to do anything else anyway. But I hear that some senior partners are thinking of retiring now they have to pay more tax. If I work hard, I might be able to get one of the jobs they leave.”

But now, think of a university student. He figures: “I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead.“

Now, in the short-run – which might be many years – the £100,000 a year man’s response is the most important one. But in the very long-run – decades – it’s the student’s response that determines our macroeconomic fate.

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About the author
Chris Dillow is a regular contributor and former City economist, now an economics writer. He is also the author of The End of Politics: New Labour and the Folly of Managerialism. Also at: Stumbling and Mumbling
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Story Filed Under: Blog ,Economy ,Equality

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Reader comments


I’ve more on this here:
http://adamsmith.org/blog/tax-and-economy/parsing-that-compass-report-200911294518/

Murphy’s told us a little more about precisely how he expects labour supply to rise. It’s, umm, a very *interesting* argument indeed.

2. astateofdenmark

Isn’t the title a little misleading, if Richard is talking about taxes on people earning 46k a year and up? 46k a year isn’t rich.

@astateofdenmark – anything over twice the median wage is rich.

“They might be tied to work. Remember, an income as low as just over £46,000 gets you into the top decile”

Is that quite right? Murphy’s talking about household incomes, not personal….

I absolutely hate the phrase “tax the rich” as I think it has taken on a certain connotation which tends to cloud the debate.

For me, there are powerful reasons to radically reform our tax system but a possible increase in tax revenues is just one and perhaps not the most important one.

Of course it works, and of course some people will choose to emigrate.

Morally we should be taxing people progressively and we should be seeking to narrow the wealth gap. The wealth gap can be extremely damaging, and it is widest in countries that have few taxes for the rich and little market regulation.

I was just going to add, if people leave the country because of tax, let them. It’s nonsense to believe it’ll be a large exodus, and if people care so little about their country and so much about their own personal wealth then I’d suggest we don’t need them here.

A simple question from a simple person: we demand that the poor pay their taxes, and punish them if they don’t. We ask the rich nicely if they wouldn’t mind paying some tax, then look the other way when they don’t. Why?

“@astateofdenmark – anything over twice the median wage is rich.”

According to who?

46K is certainly well-off but if you were to ask most people what they considered rich to be they’d probably put the figure a lot higher.

@Richard – although most people probably wouldn’t consider £46k “rich”, isn’t that because most people have no idea of the spread of incomes?
Twice the median wage sounds rich to me (given it’s probably only about 10% of people who earn this).
In a couple where both earn it, they’re really rich.
Obviously, they don’t seem so in comparison to Russian oligarchs. But in comparison to most people in the UK, they are rich.

“In a couple where both earn it, they’re really rich.”

Just to nitpick (haven’t been a pedant yet today anywhere!).

No, they’re not. Rich refers to wealth, which is a stock. High income refers to incomes which is a flow. If a couple earn £100,000 and spend £100,000 then they’re high income but they’re not rich.

You’re thinking about this the wrong way. As we now KNOW from Richard Wilkinson et al, inequality is a massive harm IN ITSELF. Thus it doesn’t even matter very much if taxing the rich more doesn’t raise much more money – reducing income differentials will have a huge positive social impact.

“reducing income differentials will have a huge positive social impact.”

Well, no, we don’t know that from his work. You’ve clearly missed the intellectual sleight of hand at the very beginning of the book.

The move from decreasing marginal utility of wealth (true) to a paragraph later claiming that further increases in wealth will do no good (untrue).

But this is necessary for them to then be able to dismiss those who would claim that greater redistribution would reduce growth in the total economy (which it would, for deadweight loss reasons).

For example, there is abundant evidence that increasing GDP (from whatever level to whatever level) in itself makes people happier. That a static society makes people, in and of itself, unhappier.

Tim: sure – I do have an economics degree, but it was a long time ago 😉

But this whole page is framed in terms of taxing income, and referring to those with high income as rich. So don’t blame me for the pendantry (sic)!

Taxing the rich to promote equality is just fiddling with the system so long as remuneration is as arbitrary as it is now.

People should be rewarded for effort and for the social benefits of their work (or penalised for the social costs, if necessary) rather than simply their ability to turn a profit.

People make money…because they make other people money. Or – as has become obvious in the last couple of years – because they can convince others they can make more money, and that the State will bail them out if they can’t.

This isn’t a problem which can be fixed just by taking money from one group, it needs a fundamental reappraisal of the work people do, how they do it, the control they have over their working lives and the way in which they are rewarded.

I’d like to know about the mind sets of the rich and super rich (entrepreneurs who create companies, sell them, and start all over again) and well paid employees.

There are many examples of entrepreneurs who make their wealth, then spend their days at ease or become a school teacher. Others start another business, often in a different sphere. If the state increases income tax, what do entrepreneurs think? There are examples that suggest that businesses develop because they are in the right place at the right time, and that income tax is not a disincentive. I’m thinking of IKEA and Maersk in particular.

If I was setting up a business from scratch, selling a product with universal appeal, I’d do it in the UK. Because even if I have misjudged the desires of consumers, I’m probably closer to understanding the UK market than a foreign one. Going abroad would be a daft option.

Even big companies find it difficult to expand beyond national boundaries. El Corte Ingles (big Spanish department chain, 70 years old) has started to open stores in Portugal. It is a culture that is similar to Spain, but with sufficient difference to require sensitive marketing. Compare with the crass attempt to introduce Marks and Spencer to France; the M & S halfwits still haven’t even learned to go to Luton airport to interview the Scandinavians who’ve popped over for a shopping and theatre weekend.

A banker (probably young, male, single) may hop off if income tax is increased. I’m less convinced that wealth creators would be so inclined.

Sorry folks. That £46,000 refers to equivalized household income. Looking at individuals earnings, you need an hourly wage of £25.88 to get into the top 10% – that’s £54,000p.a.:
http://www.statistics.gov.uk/StatBase/Product.asp?vlnk=15313

18. Richard Blogger

Chris.

But now, think of a university student. He figures: “I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead.“

It is very unlikely that a university student will think “what will be the salary of this job in 20 years time?”. They are more likely to look at the salary now (dullish job? sure but it still pays well, and I am under the higher tax rate).

Of course, where your argument really falls flat is that most of the lower paid jobs are dull too. Interesting, challenging, well-paid are three descriptions that just never get applied to any attainable job.

19. david brough

“I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead.“

Isn’t it better if young people become teachers or do some other worthwhile job rather than becoming City banker scum and paying themselves fortunes in bonuses, paid for by my taxes propping up a failed and discredited system?

Given Tory Blair and Tory Brown failing to restrain banker scum, people are doing it themselves by joining the mutuals in droves. You don’t see the Co Op or John Lewis going broke and having to be maintained by the state because you don’t see them exploiting the workers to maintain their filthy lifestyles.

Interesting, challenging, well-paid all apply to my job. But then I _like_ playing with computers for a living.

@19. david brough

Given that there is a market for “City banker scum”, would it not be wiser to analyse why they are paid so much money? A serious argument rather than a polemic?

I don’t think that Tesco (capitalist organisation) is going to go bust this year.

22. david brough

They are paid so much because they award themselves the money. And they can’t fucking well afford it, without Brown bailing out they’d have to behave responsibly and actually serve the useful people that they lend money to.

Yes, without the utter fucking shame and disgrace of Lloyds being given £5 billion, they could have folded and the stampede to the mutuals would have continued.

My dad would be 82 if he was still alive. He was a miner, and he always said how much the owners were hated and how everyone was glad to see them gone. But under the nationalisation, too much power was given to agents of the state and too little to workers.

Likewise, Brown has fundamentally wasted an opportunity to either mutualise failing banks or let them die because he is obsessed with restoring the Thatcherite status quo ante.

We have learnt nothing from the credit crunch and will never move on because of such fucking feeble leadership. This is why I voted NO2EU and will be seeking similar parties to support in 2010. Believe me, you’ll be hearing from us if this Tory vermin Cameron wins as well.

23. astateofdenmark

david brough – ‘Isn’t it better if young people become teachers’

I feel the anger in your post mate, but if you step back, who is going to pay the teacher’s wages?

Shatterface,

People should be rewarded for effort and for the social benefits of their work (or penalised for the social costs, if necessary) rather than simply their ability to turn a profit.

How would we establish the value of their effort and social benefits of their work?

25. Just Visiting

Dave

22 – your Dad a miner?

My grand-dad was too.
Between 1850 ad 1920 it was well paid, I’ve read.
My grandad paid off the mortgage on his new house in 7 years, had a new motorbike. Earned £50k pa in today’s money.

Tough job though on the coal face, where the money was best: don’t know what percentage of miners were coal-face.

Of course, once other countries started mining and exporting coal, demand for UK dropped, and the miners’ salaries and the industry profitability with it.

Globalisation!

[24] “How would we establish the value of their effort and social benefits of their work?”

Through a quango. That’s how all other centralist, subjective solutions are solved, why would this one be any different?

“an income as low as just over £46,000 gets you into the top decile – and you can‘t retire on your savings from that”

And that sums up this country nicely. Why do we have a serious upcoming problem with an ageing population? Because even someone in the top 10% of earners can’t support themselves in retirement. How depressing.


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