It’s GCSE economics: high taxes don’t work

Dr Eamonn Butler explores the Chancellor’s lack of understanding of basic economic theory, whilst pin pointing, through basic science, why his policy on tax will have a harmful effect on the public.

The Chancellor would get a C for his new tax rises and fail history outright. He will also leave the Treasury worse off.

Given the damage that the new 50 per cent tax rate will probably inflict on the UK economy, the Chancellor seems to have been very cavalier about it. When the House of Commons Treasury Select Committee asked how he decided to impose the new rate on everyone earning £150,000 or more, he replied: “There was no science behind it. It was simply my judgment.”

No science? If there is one part of economics that lends itself to scientific analysis, it is tax policy. Taxation has been under the microscope ever since Adam Smith first distilled the principles of good and bad taxation in the 18th century. Two hundred years of evidence later the science is clear: high taxes don’t work. They bring the Treasury less revenue, not more. And on the way, they really mess up your economy.

It’s shocking that the Chancellor, in his desire to wrongfoot the Tories, has simply ignored this evidence. In the science of taxation, he wouldn’t merit a grade C at GCSE. And he would fail history outright, having completely forgotten the lessons of an earlier Labour Chancellor, Denis Healey.

Healey actually relished the “howls of anguish” from the 80,000 people rich enough to pay his top tax rates of 83 per cent – or even 98 per cent for those who lived off investments. But as capital took flight and brains drained from Britain, Healey was forced to go to the IMF for a bailout. Labour’s reputation never recovered and, 30 years ago this week, the country fell sobbing into the arms of Margaret Thatcher.

Despite these economic and political warnings, the Chancellor’s “judgment” is that it makes sense to impose higher taxes not on just 80,000 people but, according to Treasury figures, on 283,000 – the top 1 per cent of UK taxpayers. That’s a lot of folk.

And the tax rise is massive, too. It might sound like just another 10 per cent, but if you’re paying tax at 40 per cent and the rate goes up to 50 per cent, you are actually shelling out 25 per cent more than you did before.

Which means a lot of people face a lot more tax, and Darling’s unscientific tax rise will have a large – and damaging – effect, just as Healey’s did. A 25 per cent tax hike is well worth avoiding, even if you earn £150,000. People will simply hire expensive accountants to find ways round it, or do what Sir Michael Caine is threatening and shift themselves or their money abroad. Or take longer holidays and retire early.

In fact the Treasury itself thinks that 69 per cent of those hit by the new tax will find ways to escape it. That’s why the respected Institute for Fiscal Studies figures that the tax won’t raise anything like the £1.3 billion that Darling forecasts – if it raises anything at all. And the Centre for Economic and Business Research reckons that 25,000 entrepreneurs may simply emigrate, costing the UK £800 million.

Raising taxes, then, can leave the Treasury worse off – a simple piece of tax science popularised by the American economist Arthur Laffer with his “Laffer Curve”, and of which the Chancellor should be fully aware.

And contrariwise, scrapping high tax rates actually boosts both the economy and tax revenues. In 1979 the Conservative Chancellor Geoffrey Howe slashed the top rate from 83 per cent to 60 per cent. Before the cut, the top 1 per cent of taxpayers – Darling’s target group today – paid just 10 per cent of the total tax take. By 1988 they were paying 14 per cent of it.

Then Nigel Lawson cut top rates even more, from 60 per cent to 40 per cent and revenues surged again. By the time of the 1997 election, the top 1 per cent of earners paid a whopping 21 per cent of the total tax bill. By halving the top rate of tax, Howe and Lawson had doubled the amount paid by top earners.

Other countries back up this simple science. The United States has had four big tax cuts over the past century. In 1921, President Coolidge cut the top rate from 63 per cent to 25 per cent. Five years later the top earners (people on incomes over $100,000) were paying 86.3 per cent more than they had before. The economic boost fuelled the Roaring Twenties.

In 1964 President Kennedy cut the top rate from 91 per cent to 70 per cent. Two years later the top 5 per cent of earners were paying 7.7 per cent more in taxes, while the bottom half were paying 9.2 per cent less.

When President Reagan cut the top rate from 70 per cent to just 28 per cent between 1981 and 1988, the share of revenues paid by the top 1 per cent of taxpayers rocketed from 17.6 per cent to 27.5 per cent. He cut capital gains tax as well, from 28 per cent to 20 per cent – and again, revenues leapt by half, from $12.5 billion to $18.7 billion in only two years. The cuts launched the longest period of wealth creation the world has known. And under George Bush’s cuts too the wealthy ended up paying more, not less.

Nearer home, a dozen of the former Soviet countries, including Russia, Estonia and Latvia, have replaced their high, complicated, dysfunctional tax rates with a single-rate flat tax as low as 10 per cent. They enjoyed a huge economic boost as a result. Ivan Miklos, the former Finance Minister of Slovakia, told me that slashing taxes was the only decision he lost sleep over: but in fact his flat tax was a huge success, and Slovakia never looked back.

Alistair Darling, by contrast, has made several mistakes all at once. His new tax is so high that people will do their darnedest not to pay it. He won’t pull in the revenues he needs to pay off his spiralling public debts.

At the same time, his changes to allowances and national insurance further complicates a tax code that runs to 10,000 pages – great for accountants and tax bureaucrats, perhaps, but not for the rest of Britain.

Third, he has forgotten that “the rich” don’t just inherit their money any more. Most of them today earn it. His new tax on work will simply drive the UK’s entrepreneurial spirits – and their money – abroad.

It’s science, Mr Darling. But it’s not rocket science.

Dr Eamonn Butler is director of the Adam Smith Institute and author of The Rotten State of Britain

Published in The Times here