HMRC is putting forward what might to many sound like a very strange argument. That the 40p tax rate makes people work harder:
Pushing people into the 40p rate will make them work harder to recover the money they have lost to the taxman, an official report has found.
The thing is, they could well be right.
Taxation of incomes affects the desire to work in two ways, the income and substitution effects. One is that we have some idea of how much we want to get into our hot and sticky little paws and we'll do sufficient work to gain that much. If tax rates rise then we'll work more to get that amount. We do know that this applies to most of us some of the time and is indeed a feature of the real world (studies of piece workers like cab drivers confirm that many do indeed have a daily target for earnings which when reached means they go home). The other is that at some point we look at the amount of work we have to do to gain extra income and instead shout blast this for a game of soldiers and we wander off to go fishing instead. Here a rise in tax rates will lead to a reduction in working hours and more leisure. We also know that this applies to most of us at least some of the time.
So, the effect of a rise in tax rates upon working hours is a little complex. It depends upon the individual decisions of us all and in aggregate we can see that at some point the blast this effect will outweigh the desire for a certain income. It is the interplay of these two that gives us our famed Laffer Curve.
Which is why I can't say that I'm all that surprised at HMRC saying that the income effect is greater than the substitution one at the 40p tax rate. For this is the same HMRC that also said that the substitution effect dominated the income one at a tax rate of 50p. Which is why that top rate was lowered to 45p. A 40p rate is thus below the peak of our Laffer Curve and that's exactly where we would expect income to predominate over substitution. For that's how we've initially calculated our curve in the first place.
Of course, there's nothing at all that says that we should in fact be taxing at the peak of the curve. We can have other goals in mind, for example the freedom and liberty of people deciding how to spend their own damn money instead of handing it over to the cage of monkeys in Westminster. But all of that's a rather different point. That people might well work harder at a 40p tax rate is the flip side of our knowing that they don't at a 50p one.