Two big reasons why popular thinking about tax undermines the fight against inequality
By Max Lawson
The unfairness of the UK tax system, a story in five charts, and what this tells us
Our next Davos paper goes into some detail on taxing the richest people, and whilst working on it with my brilliant colleagues I did some detailed work on the UK tax system and its impact on inequality.
Top tax rates on income from work are seen as a proxy for the whole tax system
The top level of taxation of income from work is taken as a proxy for the whole tax system by the public and by politicians. It is totally understandable it seems to me. People get the top rate of income tax, and it is no surprise that battles over this top rate of tax become the and important way people interpret the broader intentions of a government in terms of tackling inequality and unfairness.
This was very much in evidence recently with the disastrous budget of our very short-lived Prime Minster Liz Truss, who was forced in the face of popular revolt to reverse her proposal to cut the top rate of tax here in the UK, which currently stands at 45% on earnings over £150,000.
Of course, 45% is itself very low in contrast to the period up until 1979. This was the year that saw the election of Mrs Thatcher, Liz Trusses’ hero. Prior to this, the top rate of income tax in the UK was 83%. Mrs Thatcher cut it to 45% in her first budget, and subsequently again to 40% in 1988. In 2010, after the financial crisis, a new top rate of 50% was introduced by the Labour government of Gordon Brown. This was once again cut back to 45% in 2013 by the coalition government of Conservatives and Liberal Democrats led by David Cameron.
Although of course there were many other factors involved, it is amazing how the cut in the top rate of tax maps onto the income share of the richest 1% as this chart shows.
I also agree the battle over the top rate of tax on incomes from work is tremendously important, but primarily for the signal it sends to society about the morality of such huge incomes. In the post war period, the intention of these high top rates of income tax was not just to raise revenue- it was about deterring people from earning so much in the first place. In this way the income tax was a form of sin tax, seeking to change behaviour, and act as a form of pre-distribution in fact. And it is certainly the case that the sky high salaries of executives we now see, with bosses earning 200 or 300 times more than the average worker, did not exist during that period. Why fight for a million pound pay rise when 980,000 pounds of it will go to the tax man?
But nevertheless, I do think focusing only on the top tax rate for work income misses two important other issues, one at the bottom, and one at the top.
Problem number one: ‘The poor don’t even pay any tax anyway’. If you take direct taxes alone, of which income tax is by far the largest, it is clear that in the UK, the richest 10% pay a significantly higher proportion of their income in tax than the rest of society; they pay about one third.
Yet this chart is misleading because it does not include the impact of indirect taxes, of which VAT at 20% is the most important in the UK. Because VAT is a flat tax, it is has a higher impact on those at the bottom. Regardless of my income, I pay the same amount of money in VAT when I purchase something. This means if I am poorer, I am paying a higher share of my income to the tax authorities.
If we factor the impact of VAT into the picture, things look quite different.
In this picture, the richest 10% still pay a higher share than others, with the exception of the very poorest 10% of households, where their effective tax rate leaps up to 44%. The impact extends beyond the bottom 10% though; for the whole of the bottom 50% of UK households, the inclusion of VAT basically doubles their effective tax rate.
This is important politically, because one of the things that governments on the right have done in the UK over the last decade is raise the threshold of earnings before which you have to pay any income tax. They are effectively removing the requirement for the poorest in society to pay any income tax.
Financially, this is a good thing, but politically it is I think a bad one. Because paying income tax is seen by the public as synonymous with paying any tax, then it makes everyone think, including the poorest people themselves, that they are not paying any tax at all. In fact, they are paying large amounts of tax, just indirectly through VAT.
This is true elsewhere in the world too. In Kenya I often heard richer Kenyans claim that most Kenyans did not pay tax, when in fact they mean income tax. This in turn was linked to voting- why should people who pay no tax get a say? It is also linked to public services and social welfare- if the poor don’t pay tax, then such benefits are simply charity from those who do. In fact, as tax payers themselves through VAT, the poorest have actually contributed to the payments and services they receive from governments.
Problem number two: Taxing the money earned whilst sleeping
The other big missing part of the picture if you focus simply on income tax is at the top. This is because the top rate of income tax discussed in the UK and in most parts of the world is the top rate of tax on income form work. But the richest people in every country derive the majority of their income not from work, but from the returns on their capital.
It seems common sense to me that the income that people get from working hard every day should be taxed less than the income rich people receive from their capital, the interest paid and returns on their investments. As John Stuart Mill said, ‘Landlords grow rich in their sleep without, working, risking or economising". In official parlance such income is either called ‘unearned’ or even ‘passive income’ and that nicely sums it up; money you get just by virtue of having money in the first place.
This common-sense logic was indeed the case in countries after WW2; income from capital in the US for example was taxed more than income from work. But as with so many things, neoliberal thinking upended this and created a new common sense. By taxing capital and capital gains higher than work, we were instead deterring investment and undermining the actions of the ‘wealth creators’. This has meant that taxes on this passive income from capital gains have collapsed, and are in most countries significantly lower than taxes on income from work.
Anyhow, returning to the UK and the taxing of unearned income- one recent study- uses confidential tax return data to build a fuller picture of incomes across the UK, specifically by including taxable capital gains.
The study revealed that because capital gains are taxed at a lower rate than income from work, and the richest get most of their income from this source, the richer people are the lower their effective rate of tax.
In fact, the very richest often pay even lower rates of tax than this, because they avoid declaring any income altogether, employing an army of ‘wealth managers’ to keep their money away from the tax man.
The focus of the public conversation on the top rate of tax paid on wages completely obscures the main source of income for most rich people, which is not their work, but their wealth.
Putting this all together- richest 0.01% pay half the tax rate of the poorest 10%
A situation where the poorest ten percent of people in the UK are paying more than twice the effective tax rate of the richest (44% versus 21%).
VAT and non-taxation of wealth: a worldwide problem
This analysis is about the UK, but I do think these two problems: underestimating the tax paid by the poorest because VAT is ignored; and overestimating tax paid by rich people through a focus on work income are found in most countries.
This is not just a static problem either. Over the last forty years, taxes on wealth have collapsed, and tax raised via flat taxes like VAT have risen dramatically. Country after country had introduced VAT across the developing world, often with the assistance of the IMF, whilst taxes on wealth have been either cut or in fact never even implemented. At the same time taxes on the wealth of the richest have been cut or abolished.
All this is important, because it means that the tax system in many countries is simply not doing what it could to reduce inequality. It is either making very little difference at all, or it is increasing inequality.
It is important that people everywhere have a much better idea of how much the poorest and richest actually pay in tax, to build greater support and momentum behind the push for tax systems that actually play a key role in reducing the gap.