The Chancellor Philip Hammond has outlined in recent weeks that he is preparing for life without a Brexit deal by building up a ‘fiscal buffer’ of £15.4bn so that he can ‘maintain enough fiscal firepower to support our economy’. Quite what that means precisely is still uncertain, but some ministers are suggesting it could be used to drastically cut income tax and corporation tax rates.
The hope, presumably, is that by lowering income taxes, the UK economy will receive a shot in the arm by supporting existing wealth-creators and attracting new ones. The idea being that these individuals will make investments and create jobs, resulting in a ‘trickle-down’ effect so we all benefit from the economic growth.
Similarly, some economic theories like the Laffer Curve Theory, made famous during Ronald Reagan’s presidency as the inspiration for his tax cuts, argue that there is an optimum level at which an individual should be taxed. As the theory goes, the higher you tax an employee, the less likely they may be to work hard as they see less return for their efforts. The conclusion of the theory being that finding the optimal level of tax will increase productivity and in turn tax revenues for the government.
In contrast to the potential ‘tax haven’ cuts, the plans in Labour’s latest manifesto were to introduce increases in the income tax rates of 45 per cent for those earning over £80k and 50 per cent for those earning over £123k. Predictions at the time of the last election were that this would generate additional tax revenues of around £4.5bn a year.
The contrast in the two potential approaches is stark and whether the arguments advanced by either side will hold up in practice is up for debate. Guidance on the possible results of each approach might be taken from research undertaken by the International Monetary Fund (IMF) and the Institute for Fiscal Studies (IFS).
Looking at the impact of personal income tax cuts in the USA, the IMF found that income tax cuts did indeed provide stimulus for the US economy, but ultimately that growth was insufficient for the tax cuts to pay for themselves (another tax like VAT would probably be needed to make up the shortfall).
The study also suggests that the economic benefit of income tax cuts differs depending on who benefits from them. Tax cuts for the wealthiest in society produced the most economic growth but resulted in even greater inequality whereas tax cuts for the middle class resulted in weaker economic growth but actually decreased inequality.
What of tax increases then? The IFS research looks at how wealthy individuals might respond to Labour’s manifesto pledges and concludes that, whilst likely to be overstated, the proposals may generate additional revenues for the government.
However, based on how individuals responded to the previous 50 per cent tax rate, those with income over £200k would be more likely to take steps to minimise the impact of the new tax rate and most of the additional tax revenues would come from those with income between £80k and £200k. Hardly the result that the Labour Party were hoping for.
The IMF states that those considering a change in the top rates of income tax will need to ‘reconcile themselves to uncertainty’. Definitely a feeling that many of us can relate to at the moment.