ChainWhat it assumes · how to break it
Start
The government raises the 45% additional rate of income tax, aiming to raise revenue from the highest earners.
1
As a result, each pound of income above the additional-rate threshold yields more tax, so revenue rises if taxable income at the top stays the same.
tax revenue · tax base
tax revenue · tax base
Assumes: Top earners' taxable income does not change.
But: High earners can respond quickly, for example by bringing income forward before the rise takes effect.
2
At the same time, high earners reduce their taxable income through avoidance, such as larger pension contributions or taking income as dividends, and some work less or move abroad.
tax avoidance · incentives
tax avoidance · incentives
Assumes: High earners are able to reduce their taxable income.
But: Many high earners are employees taxed through PAYE, with limited scope to change how they are paid.
3
Consequently, the tax base at the top shrinks, offsetting part of the gain, and beyond the peak of the Laffer curve a higher rate raises less revenue in total.
Laffer curve
Laffer curve
Best link to attack
Assumes: The current rate is close to the revenue-maximising rate.
Assumes: The current rate is close to the revenue-maximising rate.
But: The position of the peak is uncertain, and if the current rate is well below it, a rise still adds revenue.
4
Therefore, the budget deficit narrows by less than a simple calculation suggests, and may not narrow at all if the rate is pushed too high.
budget deficit
budget deficit
Assumes: The deficit depends heavily on top-rate revenue.
But: The extra revenue at stake is small compared with total government borrowing, so the effect on the deficit is modest either way.
End
Tax revenue rises by less than expected, and the budget deficit narrows only a little or not at all.
Evaluation chain
- E1However, whether the higher rate raises revenue depends on where the current rate sits on the Laffer curve.
- E2If top earners' taxable income is very responsive to the tax rate, then the revenue-maximising rate is low and the current rate may already be near it.
- E3As a result, the gain from the higher rate is largely cancelled out by avoidance, reduced effort and migration.
- E4So a higher top rate may narrow the deficit only slightly or not at all, while a rise from a lower starting rate is more likely to raise revenue.
Another way to attack it: Avoidance tends to grow over time as advisers find new routes, so first-year revenue can overstate the long-run yield. Tighter anti-avoidance rules can protect the revenue.
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Questions this answers
- Assess whether raising the top rate of income tax will increase tax revenue.
- Discuss the usefulness of the Laffer curve for tax policy.
- Evaluate higher taxes on top earners as a way to reduce the budget deficit.
Diagram
Laffer curve: mark the current top rate relative to the peak. A rise to the left of the peak raises revenue; a rise beyond the peak lowers it.
Reverse and related
Cut in the top rate → less tax per pound at the top, partly offset if avoidance falls and work rises → revenue may fall by less than expected.