Ignoring the economic arguments – now that’s living in cloud cuckoo land

Civitas, 1 August 2011

Speaking on the Andrew Marr show the Chief Secretary to the Treasury Danny Alexander described those who call for the abolition of the additional income tax as living in ‘cloud cuckoo land’. Yet funnily enough those who inhabit cloud cuckoo land, while perhaps insane in Alexander’s opinion, could draw on academic support for their position from the Institute for Fiscal Studies.

The additional income tax rate is 50 per cent for those earning above £150,000. Criticism of the tax is not just a case of the rich moaning; there is significant evidence that calls into question the economic benefit of the tax. It is this evidence that Mr Alexander seems intent on ignoring.

I have discussed the Laffer curve previously on this blog, in a theoretical sense, yet an IFS study from 2009 attempts to model Laffer curves on predicting the effect of the previous Government’s plan to raise the tax rate. This was a plan, laid out in the 2008 Pre-Budget Report, to increase the income tax rate to 45 per cent for those earning above £150,000.

The IFS’ conclusion on the economic effect of this increase, based on its own assumptions, was that:

‘the current rate of 40% is estimated to be the revenue-maximising rate. The proposed income tax rate of 45% on incomes above £150,000 would therefore cost rather than raise money.’

However the IFS’ assumptions did differ from the Government’s. In particular the Government had a lower ‘taxable income elasticity’, which measures how individuals respond to changes in their marginal tax rate. The Government assumed that top-rate tax payers would be less able to alter their tax arrangements, to reduce their tax burden, than the IFS did.

Using the Government’s estimated taxable income elasticity the IFS concluded:

Our estimate, using the Treasury’s elasticity but considering the impact on revenues from National Insurance and consumption taxes as well, would be £0.6 billion.

Not the £1.6 billion that the Government predicted. In this estimate the IFS also assessed (‘considering the impact….’) the extent to which national insurance and spending by top-rate tax payers would be affected by the change, something which the Government failed to do.

As we now know the additional income tax rate was eventually increased to 50 not 45 per cent, buttressing the IFS’ conclusions.

The upshot of all this is that it is Danny Alexander who is perhaps failing to engage with reality, or at least economic reality. Politically he may feel that abolishing the 50 per cent additional income tax rate would be complete madness but this point is not supported by the economic evidence. Slinging pejorative terms around is a blatant attempt to politicise the debate over the tax, this is seldom a good thing. Politicians should be looking at the arguments for and against the tax and not looking to close off discussion.