Did you know that tax rates can be too high?

We insist that this is true, shocking as the very thought is. It is possible for tax rates to be too high. Too high in that sense that the tax does not, in fact, achieve its aim:

Packs of illicit cigarettes manufactured in black market factories or smuggled into the UK by organised crime gangs are being sold for as little as a fifth of the retail price by corner shops. This equates to £4.5bn in lost tax to the Exchequer.

So why this outbreak of illegality?

Eighteen high street shops in the two towns were caught freely selling illegal cigarettes for between £3.50 and £7 a pack, a fraction of the £18.50 that should be charged for a legitimate pack of 20.

Seems fairly obvious that the demand would be there. While Britain has spent some centuries as a famously law abiding nation on the big stuff this was largely because we didn’t have the usual multitude of laws about the small stuff. There weren’t, therefore laws to break on the points where people would think that the law breaking was no big deal.

“If you smuggle in a kilo of cocaine into the country, you’re looking at 20 years’ imprisonment. If you smuggle in a lorry load of 10 million cigarettes with a profit margin of £3m, you might not get any imprisonment at all,” he said.

The incentive to law break at the other, supply, end also seems to be there.

One illegal factory in the north of England capable of producing 250 million cigarettes a year – or five million a week – was raided by police and HMRC three weeks ago.

“You can make cigarettes for 20p a pack in raw materials, so, once the factory is set up, the profit margins are massive,” said Mr O’Reilly.

That’s a lot of incentive.

That increase of the tax rate has led to cigarettes actually getting cheaper as the black market supplies increase. The tax rate is too high to achieve the stated aim - reduce the smoking of cigarettes by raising the price of them.

We all know that incentives matter. But the implication of all of this is that there’s an optimal tax rate. Optimal not meaning ever higher. A tax rate which does the job, whatever that particular job might be defined as - revenue raising, reducing climate change, cutting smoking, reducing inequality and all the rest. That this optimal rate is often lower than is currently charged is proven above - so, how often is this true across all the other taxes we are burdened with? We’d say most of them. OK, since you press us on the issue, all of them.

Let’s make taxation work - by cutting tax rates.

Tim Worstall