George Osborne’s marginal revolution: Why Britain’s top rate of tax is unsustainable

The so-called marginal revolution in economics occurred in the nineteenth century. George Osborne’s marginal revolution in taxation needs to start next Wednesday, with decisive steps towards a more sensible tax system. In many ways, next week’s Budget will reveal the real Osborne. Freed from the shackles of coalition politics, will we see a markedly free market Budget? A great place to start would be top marginal tax rates. 

 

The latest KPMG 2015 comparison of the highest rates of individual tax across the globe shows that around 125 countries have a lower top rate of tax than the 45 per cent figure in the UK. Top rates of tax are higher in the UK than the global average (31.1 per cent), across the OECD (41.6 per cent), Europe (31.8 per cent), the EU (37.8 per cent), and the US (39.6 per cent). Those countries with higher top rates than the UK fall broadly into three categories: (1) the Nordics; (2) small economies such as Austria and Belgium; (3) unknown economies such as Aruba and Sint-Maarten. In other words, those who are not our major competitors.

 

So let’s dispense with the tired and inaccurate rhetoric that the UK is a low tax economy. It isn’t. Indeed, the more you focus on the UK tax system, the more perturbed you become. Headline rates are only part of the story. In reality, there are multiple marginal effective rates across the tax system (as discussed by Ryan Bourne in Morning Wire earlier this week). Let’s take just one example. The progressive withdrawal of the personal allowance starting at £100,000 creates a marginal rate of tax of 62 per cent (for every extra £1 you earn, the state takes 62p). This is an absurdity on a par with the highest tax rates imposed by governments in the 1970s. 

 

Since the 62 per cent absurdity was introduced into the tax system, sadly it has disappeared off the political radar. There is no clamour of MPs calling for reform. You can hear the political cogs turning – it’s not a headline rate, the electorate don’t realise, and as long as they don’t twig there’s no pressure for reform. But do the politicians really think that a 62 per cent marginal rate has no negative impact on the economy?

 

Now, I hear you say, the chancellor might want to reduce the top rate of tax, but he simply doesn’t have the money to do it. In other words, the spirit is willing but the body is weak. I’m not so sure. When the top rate of tax was reduced from 50 per cent to 45 per cent, the associated analysis published by HMRC made it pretty clear that there was little or no extra revenue associated with the 50 per cent rate, so reducing it to 45 per cent would involve a minimal revenue loss. Reading between the lines of the analysis also made you think that taking the top rate back down to 40 per cent wouldn’t involve much revenue loss either. Indeed, I would argue that a total all-embracing analysis of the impact of moving from a 45 per cent to 40 per cent top rate would conclude that it would increase revenues in the long term.

 

The global average top rate of individual income tax is 31 per cent. With the UK economy skewed towards financial services and London, a top rate of tax at 45 per cent strikes me as unsustainable. At some point, the UK and global rates will need to converge, and almost certainly from a lower top rate in the UK.