Recent comments by Defence Secretary Gavin Williamson that the Conservatives should return to their core value of “giving people more power over their own money” by cutting taxes instead of raising them to generate revenue got me to thinking about tax theorists like Arthur Laffer and Donald Trump.
Yes, I thought that might raise an eyebrow.
The background to Williamson’s observation is Prime Minister Theresa May’s decision to fund a £20bn NHS boost with a range of tax rises, including lifting the eight-year freeze on fuel duties.
It all prompted me to re-examine the basic principles of taxation and behaviour.
Williamson references former chancellor Nigel Lawson in support of his argument that raising taxes is not necessarily the best way to bring down public sector debt and boost Treasury income. Lawson cut the top rate of tax from 60 to 40 per cent in 1988 and, within a decade, the amount of total tax paid by the UK’s top 1 per cent of earners had risen from 14 to 21 per cent.
While there is often more to these outcomes than immediately meets the eye, that is compelling data nonetheless. President Trump appears to be seeking to emulate such outcomes with his latest round of tax cuts.
So, what impact does taxation have on financial decision making? At a very obvious consumer level, governments have long used tax incentives to influence behaviour.
In the UK, we currently have pension tax relief, a large range of Isas, enterprise investment schemes, venture capital trusts, business property relief and agricultural property relief, to name just a few, all aimed at incentivising particular types of investment and spending decisions.
Does it cause more people to invest than would without the incentive? Most likely. The big question is whether the benefit to the economy of this additional investment (which, to my knowledge, has not been quantified) is worth the cost to the Exchequer.
This consideration will continue to exercise the minds of the Treasury in relation to the incredibly expensive pension tax relief, costing over £30bn a year, although most do not expect any changes to be made while the government remains pre-occupied with Brexit.
Patient Capital Review
Value for tax spend will have also been at the heart of the recent Patient Capital Review. Fortunately, EIS, SEIS and VCT investments will be with us for some time to come. The conditions will just be refined.
The EIS, SEIS and VCT rules now deny relief to tax-motivated investments: those where the tax relief provides most of the return with limited risk to the original investment (effectively preserving an investor’s capital). Qualifying for relief now depends on taking a “reasonable” view as to whether an investment has been structured to provide a low-risk return.
The company must have the objective to grow and develop over the long term, and there must be a significant risk of loss of capital to the investor of an amount greater than the net return.
Optimal tax rates
But back to the tax rates themselves. To what extent do they influence behaviour? If we assume the goal would be to set rates that result in the optimum amount collected for the government to implement its economic and social plans, then what is that for, say, income tax?
There are many theories on optimal tax rates but, as we get closer to the Autumn Budget, one can hope a review of former chief economist at the US Office of Management and Budget Arthur Laffer’s takes place.
Granted, the theory avoids being specific on the actual tax rate break points but the principle on which it is founded is definitely worth a look.
As the chart below shows, at 0 per cent the government collects zero tax revenue. Revenue increases to a point at C but falls with further rate rises.
The decrease in tax revenue arises because higher tax rates create disincentives for people to work harder and invest. At a 100 per cent tax rate, people will have no incentive to work at all.
If tax rates decrease, leisure time becomes more expensive, so people might work more. But at the same time disposable income increases, so people are more willing to have fun.
What is clear is that economists do not agree on where the all-important point C lies. But many politicians use the concept behind the Laffer Curve to justify cuts nonetheless. The idea is that cuts would increase revenue because the current rates lie beyond point C.
Laffer himself said his theory does not guarantee whether a tax cut will raise or lower revenues. Those who believe any cut at all will raise revenue is wrong. If tax rates are actually at the optimum level then further cuts will not help. Just as merely raising rates will not raise revenue where the rate is at the optimum level.
I can already see the Sun headline the day after the Budget in the unlikely event Williamson’s suggestion is taken up by the Chancellor:
“Tax cuts? Your ‘avin a Laffer”.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn