|By Tim Harford|
|Thursday, May 24, 2007|
Most people reading this column probably believe that taxes are a bad thing, but why? Popular wisdom is that taxes are bad because it’s painful when you pay them. That’s pretty much the opposite of the truth: taxes are a bad thing only when you don’t pay them.
When you pay a pound’s worth of tax, the government collects a pound’s worth of tax. The economy has not shrunk. (It might shrink, if the government then spent the money unwisely – but we’re talking about taxes here, not government spending.)
The problem comes when you don’t pay the tax. If Gordon Brown plans to tax your overtime pay at 41 per cent, you may decide to stay at home. You’re denied your income, and Mr Brown is denied his tax revenue. For this reason, economists like taxes that avoid such problems – which we call ”deadweight losses” – as much as possible. But this leads to some arresting concepts: the rich should pay lower tax rates than the poor, for instance, and there should be a tax on being middle-aged. It’s not as crazy as it sounds.
Take the idea that the rich should pay less than the poor. By this I don’t mean that the rich should pay less of their incomes in tax, but that if the Duke of Westminster earns one extra pound, he should pay less tax on it than I would pay if I earned one extra pound. Organising the tax system in this way reduces deadweight loss. If you raise taxes for the low-income bracket – as Gordon Brown did by abolishing the 10p rate of income tax – then you discourage overtime for people in that bracket. But you collect cash from those earning above the bracket without discouraging work and causing deadweight loss, because their overtime pay will not attract extra tax.
Since raising the tax on an income tax bracket discourages those in the bracket, but collects cash from those who are richer, it’s not hard to see the argument for raising taxes on the lowest income brackets. Taxing the Duke of Westminster’s overtime, on the other hand, discourages him from working, without raising revenue from anyone else.
But shouldn’t the rich pay more tax? Surprisingly, you can make the Duke pay lots of tax without gouging his overtime. How much tax the Duke pays overall and how much he pays on his last pound are not the same thing. For instance, imagine a tax-free personal allowance of ?10,000, then a 50 per cent tax rate on the next ?10,000, then a 30 per cent rate on all income above that. A poor journalist earning ?15,000 would pay ?2,500 tax – less than 17 per cent of his income. The Duke of Westminster would pay very nearly 30 per cent on everything, since he’d hardly notice the tax-free allowance and the 50 per cent rate. He would pay 30 per cent on his overtime, while the journalist would pay 50 per cent.
What about the tax on the middle-aged? If Mr Brown cut taxes on the ?20,000 to ?30,000 income bracket, he would encourage more work from everyone in that group, but lose tax revenue from everyone above that income bracket. Ideally, he would offer the tax cut only to low earners. One way to do that is to offer the tax cut only to the young: not many 25-year-olds make more than ?30,000, but plenty of 45-year-olds do. By offering the tax cut to the 25-year-olds, Mr Brown would motivate them; and by excluding the 45-year-olds, he keeps their cash.
It’s not unfair, since most of us will pay the middle-aged tax in the end – unless you die young. And that really would be a deadweight loss.
The Undercover Economist (Little, Brown) will be published in paperback on May 3.