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Tax cuts for top earners won’t deliver bang for your buck

Ideology vs reality on the additional rate of income tax
September 30, 2022
  • As borrowing costs rise, government spending must deliver high impact 
  • Evidence suggests that tax cuts for high earners won't do much to boost productivity or consumer spending

Since the 'mini' Budget, an old line has been doing the rounds: “I’ve got a joke about trickle-down economics – but 99 per cent of you will never get it.” Last week’s fiscal statement saw the government introduce a slew of tax cuts, including the now-scrapped removal of the additional rate of income tax from next April.

This made up a small proportion of the package’s £45bn total cost. The move was targeted at those earning £150,000 or more, who would have seen their personal income tax rate fall from 45p to 40p. But would this effort have paid off?

The spectre of ‘trickle-down’ economics looms large here. The term is controversial: referring to the idea that a policy might benefit wealthy individuals in the short run, before ‘trickling down’ to boost wider living standards over the long term. ‘Trickle-down’ is more of a colloquialism than a formal economic theory: as early as 1983, development economist Heinz Arndt dismissed it as a “myth” that “no reputable development economist ever, explicitly or implicitly, entertained”. It has few defenders (even among the most free-market of economists) as a means of redistributing income from rich to poor.

The stronger economic argument for tax cuts hinges on their incentive effect, and ability to boost the supply side of the economy, driving growth. The chancellor is an ardent believer – stating repeatedly last week that slashing tax was “crucial” to growing the economy. Kwarteng also argued that cutting the additional rate of tax will bring the UK in line with international rivals, allowing us to “attract the best and the brightest to the UK workforce, helping business to innovate and grow”. 

There may be an economic rationale behind the government’s latest move, but empirical evidence is less encouraging. Research in 2020 by political economists David Hope and Julian Limberg for the London School of Economics looked at data from 18 OECD countries over the past five decades. They found that tax cuts for the rich did not have a significant impact on economic performance, finding no evidence that lower taxes increased working hours or effort. Hope concluded that “our research shows that the economic case for keeping taxes on the rich low is weak”.

Will the cuts at least help the government to reach its 2.5 per cent growth target in the short term? The Office for Budget Responsibility estimates that tax cuts have a relatively low ‘multiplier’ effect – likely to be even smaller when focused on high earners. Samuel Tombs, chief UK economist at Pantheon Macroeconomics, argues that high earners already accumulated high levels of cash during the pandemic, arguing that “simply adding more to their cash pile will not necessarily prompt them to spend more”.

Data from the US gives us an indication of just how underwhelming the impact on demand could be. In the first wave of the pandemic, qualifying households were given cash payments under the Cares Act – and this included almost 30 per cent of high income ($200,000 plus) households. As the chart below shows, these households proved much more likely to save their windfall, while those on lower incomes largely spent theirs. 

 

 

Will these tax cuts give the chancellor any bang for his buck? The government faces a perilous financial position – even earning a warning from the IMF this week, who cautioned that “we do not recommend large and untargeted fiscal packages at this juncture”. The chancellor may be convinced that tax cuts are key to faster growth, but he faces soaring borrowing costs and damaged credibility as he looks to fund them – as last week’s bond market sell-off showed. 

Capital Economics estimates that every 100 basis point increase in government borrowing costs requires an additional improvement in the primary budget balance of 0.3 per cent of gross domestic product to keep the public debt ratio stable. Group chief economist Neil Shearing now thinks that spending cuts are all but inevitable, meaning that “at some point in the coming years, fiscal policy will be a drag on real economic growth”.

Low-multiplier tax cuts for high earners look like increasingly bad value for money.