Only time will tell if income tax changes prove worthwhile

It is too soon to judge the effect of George Osborne’s reduction in the rate to 45 per cent last year

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The Independent Online

In 1974, Arthur Laffer drew a curve on a napkin and, in so doing, launched a million unresolved arguments.

The curve he drew represented a simple truth. It showed that if governments set income-tax rates at zero, they will receive zero revenues. Similarly, if they set income-tax rates at 100 per cent they will also raise zero revenues because no one will have an incentive to work. It follows that there is an optimum rate above which it becomes counter-productive for politicians to stray.

Most politicians agree on the existence of the Laffer curve in principle. But they disagree about where the optimum top tax rate lies. For some, such as Jeremy Browne and most Tory backbenchers, it lies below the current 45 per cent rate on incomes above £150,000. Labour, on the other hand, believes that if the Government put the rate back up to 50 per cent it would increase revenues.

What does the evidence say? It is too soon to judge the effect of George Osborne’s reduction in the rate to 45 per cent last year. Revenues are up sharply, but the rate shift was revealed 12 months in advance, thus providing a colossal incentive for rich people to delay registering their income. We don’t know yet whether the higher tax take will be permanent.

The Treasury’s own analysis suggests the optimum higher rate is around 48 per cent. Robert Chote, the head of the Office for Budget Responsibility, has described Britain as “strolling across the summit of the Laffer curve”, implying we are more or less at the optimum rate now. But these are judgements based in large part on an empirical analysis of the way people behaved the last time there were big reductions in higher income-tax rates, under Margaret Thatcher in the 1980s.

Our economy has changed a lot over the past 30 years. People might respond differently to changes in higher marginal rates today. The only way to know for sure where the summit of Mount Laffer lies is to change the rate and to wait and see.