Tag: substitution effect

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Is a flat-rate income tax a good idea?

At an event at the London Palladium on 6 December staged to protest against elements in the recent Budget, the Conservative leader, Kemi Badenoch, was asked whether she would introduce a flat-rate income tax if the Conservatives were returned to government. She replied that it was a very attractive idea. But first the economy would need ‘rewiring’ so that the tax burden could be lightened.

A flat-rate income tax system could take various forms, but the main feature is that there is a single rate of income tax. The specific rate would depend on how much the government wanted to raise. Also it could apply to just income tax, or to both income tax and social insurance (national insurance contributions (NICs) in the UK), or to income tax, social insurance and the withdrawal rate of social benefits. It could also apply to local/state taxes as well as national/federal taxes.

Take the simplest case of a flat-rate income tax with no personal allowance. In this system the marginal and average rate of tax is the same for everyone. This is known as a proportional tax.

Most countries have a progressive income tax system. This normally involves personal allowances (i.e. a zero rate up to a certain level of income) and then various tax bands, with the marginal rate rising when particular tax thresholds are reached. In England, Wales and Northern Ireland, there are three tax bands: 20%, 40% and 45%. Thus the higher a person’s income is, the higher their average rate of tax.

A regressive tax, by contrast, would be one where the average rate of tax fell as incomes rose. The extreme case of a regressive tax would be a lump-sum tax (such as a TV or other licence), which would be same absolute amount for everyone liable to it, irrespective of their income. This was the case with the ‘poll tax’ (or Community Charge, to give it its official title), introduced by Margaret Thatcher’s government in 1989 in Scotland and 1990 in the rest of the UK. It was a local tax, with each taxpayer taxed the same fixed sum, with the precise amount being set by each local authority. After protests and riots, it was replaced in 1993 by the current system of local taxation (Council Tax) based on property values in bands.


Figures 1 and 2 illustrate these different categories of tax: see Figure 11.12 in Economics, 12th edition. (Click here for a PowerPoint.) Income taxes in most countries are progressive, although just how progressive depends on the differences between the tax bands and the size of personal tax-free allowances. A flat-rate income tax with no allowances is shown by the black line in each diagram, the slope in Figure 1 and the height in Figure 2 depending on the tax rate.

Arguments for a flat-rate income tax

Generally, arguments in favour of flat-rate taxes come from the political right. The two main arguments in favour are tax simplification and incentives.

Advocates argue that a flat tax system makes tax collection easier and makes tax evasion harder. If there are no exemptions, then it can be easier to check that people are paying their taxes and working out the correct amount they owe. It is argued that, in contrast, high tax rates on top earners can encourage tax evasion.

Flat taxes can also be part of a drive to reduce the size of the informal economy. As the VoxEU article states:

Unlike progressive taxes, which include complex and numerous exceptions left to the tax collectors’ discretion, the flat tax is clear cut. In combination with the low rate, its simplicity considerably reduces the stimuli for being informal.

Several post-communist countries in Eastern Europe adopted flat taxes, but for most they were seen as a temporary measure to reduce the informal sector and clamp down on tax evasion. Most have now adopted progressive taxes, with the exceptions of Bulgaria and until recently Russia.

The second major argument is that lower taxes for higher earners, especially for entrepreneurs, can act as a positive incentive. People work harder and there is more investment. The argument here is that the positive substitution effect from the lower tax (work is more profitable now and hence people substitute work for leisure) is greater than the negative income effect (lower taxes increase take-home pay so that people do not need to work so much now to maintain their standard of living).

Then there is the question of tax evasion. With high rates of income tax for top earners, such people may employ accountants to exploit tax loopholes and hide earnings. This could be seen as highly unfair by middle-income earners who are still paying relatively high rates of tax. Even though a move to flat taxes is likely to mean a cut in tax rates for high earners, the tax take from them could be higher. There is evidence that post-communist and developing countries that have adopted flat taxes have found an increase in tax revenues as evasion is harder.

The Laffer curve is often used to illustrate such arguments that high top tax rates can lead to lower tax revenue. Professor Art Laffer was one of President Reagan’s advisers during his first administration (1981–4): see Box 11.3 in Economics, 11th edition. Laffer was a strong advocate of income tax cuts, arguing that substantial increases in output would result and that tax revenues could consequently increase.

The Laffer curve in Figure 3 shows tax revenues increasing as the tax rate increases – but only up to a certain tax rate (t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work. (Click here for a PowerPoint)

However, as Box 11.3 explains, evidence suggests that tax rates in most countries were well below t1 in the 1980s and certainly are now, given the cuts in income tax rates that have been made around the world over the past 20 years.

Arguments against flat-rate income taxes

The main argument against moving from a progressive to a flat-rate income tax in an advanced country, such as the UK, is that is would involve a large-scale redistribution of income from the poor to the rich. If the tax were designed to raise the same amount of revenue as at present, those on low incomes would pay more tax than now, as their tax rate would rise to the new flat rate. Those on high incomes would pay less tax, as their marginal rate would fall to the new flat rate.

If a new flat-rate tax in the UK also replaced national insurance contributions (NICs), then the effect would be less extreme as NICs are currently initially progressive, as there is a personal allowance before the 8% rate is applied (on incomes above £12 570 in 2024/25). But above a higher NI threshold (£50 270 in 2024/25), the marginal rate drops to 2%, making it a regressive tax beyond that level. Figure 4 shows tax and NI rates in England, Wales and Northern Ireland for 2024/25. (Click here for a PowerPoint.)

Nevertheless, even if a new flat-rate tax replaced NICs as well as varying rates of income tax, it would still involve a large-scale redistribution from low-income earners to high-income earners. The effect would be mitigated somewhat if personal allowances were raised so that the tax only applied to mid-to-higher incomes. Then the redistribution would be from middle-income earners to high-income earners and also somewhat to low-income earners: i.e. those below, or only a little above, the new higher personal allowance. If, on the other hand, personal allowances were scrapped so that the flat tax applied to all incomes, then there would be a massive redistribution from people on low incomes, including very low incomes, to those on high incomes.

One of the arguments used to justify a flat-rate tax is that its simplicity would ensure greater compliance. But in an advanced country, compliance is high, except, perhaps, for those on very high incomes. Most people in the UK and many other countries, have tax deducted automatically from their wages. People cannot avoid such taxes.

As far as the self-employed are concerned, they file tax returns online and the software automatically works out the tax due. There are no complex calculations that have to be performed by the individual. There is come scope for tax evasion by charging various expenditures to the business that are really personal spending, but the tax authorities can ask for evidence and sometimes do, with penalties for false claims.

What tax evasion does take place, could still do so with a flat tax. At a rate of, say, 20%, it would still be financially beneficial for a dishonest person to lie if they could get way with it.

Conclusions

If the government did try to introduce a flat-rate income tax, there would probably be an outcry. Also, as some rich people would gain a very large amount of money, the number of people gaining would be lower than the number losing if the total revenue raised were to remain the same. In other words, it would be politically difficult to achieve if the number of losers exceeded the number of gainers.

It is true that if the top rate of income tax were very high, then reducing it might bring in more revenue. But at 45%, or 47% if you include NICs, the top marginal rate in the UK is relatively low compared with other countries. In 2024, the UK had the second lowest top rate of tax out of Western European countries (behind Norway and Switzerland) and only the 16th highest out of 33 European countries when Central and Eastern European countries are also included (see the final ink below under ‘Information’). Reducing the UK’s top rate would be unlikely to bring in more revenue and would redistribute income to high-income earners.

Articles

Information

Questions

  1. What are the income and substitution effects of changing tax rates?
  2. Explain the Laffer curve and consider whether it is likely to be symmetrical.
  3. Discuss the desirability of having a flat tax set at a relatively high rate (say 25%) with tax-free personal allowances up to the level of income considered to be the poverty threshold. (In the UK the poverty threshold is often defined as 60% of median income.)
  4. In the London Palladium event where Kemi Badenoch stated that flat taxes were a very attractive idea, she also said that ‘We cannot afford flat taxes where we are now. We need to make sure we rewire our economy so that we can lighten the burden of tax and the regulation on individuals and on those businesses that are just starting out, in particular’. What do you think she meant by this?
  5. Find out what Bulgaria’s experience of a flat tax of 10% has been.
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The growing gap between rich and poor

A recent report published by the High Pay Centre shows that the median annual CEO pay of the FTSE 100 companies rose by 15.7% in 2022, from £3.38 million in 2021 to £3.91 million – double the UK CPIH inflation rate of 7.9%. Average total pay across the whole economy grew by just 6.0%, representing a real pay cut of nearly 2%.

The pay of top US CEOs is higher still. The median annual pay of S&P 500 CEOs in 2022 was a massive $14.8 million (£11.7 million). However, UK top CEOs earn a little more than those in France and Germany. The median pay of France’s CAC40 CEOs was €4.9 million (£4.2 million). This compares with a median of £4.6 million for the CEOs of the top 40 UK companies. The mean pay of Germany’s DAX30 CEOs was €6.1 million (£5.2 million) – lower than a mean of £6.0 million for the CEOs of the top 30 UK companies.

The gap between top CEO pay and that of average full-time workers narrowed somewhat after 2019 as the pandemic hit company performance. However, it has now started widening again. The ratio of the median UK CEO pay to the median pay of a UK full-time worker stood at 123.1 in 2018. This fell to 79.1 in 2020, but then grew to 108.1 in 2021 and 118.1 in 2022.

The TUC has argued that workers should be given seats on company boards and remuneration committees that decide executive pay. Otherwise, the gap is likely to continue rising, especially as remuneration committees in specific companies seek to benchmark pay against other large companies, both at home and abroad. This creates a competitive upward push on remuneration. What is more, members of remuneration committees have the incentive to be generous as they themselves might benefit from the process in the future.

Although the incomes of top CEOs is huge and growing, even if they are excluded, there is still a large gap in incomes between high and low earners generally in the UK. In March 2023, the top 1 per cent of earners had an average gross annual income of just over £200 000; the bottom 10 per cent had an average gross annual income of a little over £8500 – just 4.24% of the top 1 per cent (down from 4.36% in March 2020).

What is more, in recent months, the share of profits in GDP has been rising. In 2022 Q3, gross profits accounted for 21.2% of GDP. By 2023 Q2, this had risen to 23.4%. As costs have risen, so firms have tended to pass a greater percentage increase on to consumers, blaming these price increases on the rise in their costs.

Life at the bottom

The poor spend a larger proportion of their income on food, electricity and gas than people on average income; these essential items have a low income elasticity of demand. But food and energy inflation has been above that of CPIH inflation.

In 2022, the price of bread rose by 20.5%, eggs by 28.9%, pasta by 29.1%, butter by 29.4%, cheese by 32.6% and milk by 38.5%; the overall rise in food and non-alcoholic beverages was 16.9% – the highest rise in any of the different components of consumer price inflation. In the past two years there has been a large increase in the number of people relying on food banks. In the six months to September 2022, there was a 40% increase in new food bank users when compared to 2021.

As far as energy prices are concerned, from April 2022 to April 2023, under Ofgem’s price cap, which is based on wholesale energy prices, gas and electricity prices would have risen by 157%, from £1277 to £3286 for the typical household. The government, however, through the Energy Price Guarantee restricted the rise to an average of £2500 (a 96% rise). Also, further help was given in the form of £400 per household, paid in six monthly instalments from October 2022 to March 2023, effectively reducing the rise to £2100 (64%). Nevertheless, for the poorest of households, such a rise meant a huge percentage increase in their outgoings. Many were forced to ‘eat less and heat less’.

Many people have got into rent arrears and have been evicted or are at risk of being so. As the ITV News article and videos linked below state: 242 000 households are experiencing homelessness including rough sleeping, sofa-surfing and B&B stays; 85% of English councils have reported an increase in the number of homeless families needing support; 97% of councils are struggling to find rental properties for homeless families.

Financial strains have serious effects on people’s wellbeing and can adversely affect their physical and mental health. In a policy research paper, ‘From Drained and Desperate to Affluent and Apathetic’ (see link below), the consumer organisation, Which?, looked at the impact of the cost-of-living crisis on different groups. It found that in January 2023, the crisis had made just over half of UK adults feel more anxious or stressed. It divided the population into six groups (with numbers of UK adults in each category in brackets): Drained and Desperate (9.2m), Anxious and At Risk (7.9m), Cut off by Cutbacks (8.8m), Fretting about the Future (7.7m), Looking out for Loved Ones (8.9m), Affluent and Apathetic (8.8m).

The majority of the poorest households are in the first group. As the report describes this group: ‘Severely impacted by the crisis, this segment has faced significant physical and mental challenges. Having already made severe cutbacks, there are few options left for them.’ In this group, 75% do not turn the heating on when cold, 63% skip one or more meals and 94% state that ‘It feels like I’m existing instead of living’.

Many of those on slightly higher incomes fall into the second group (Anxious and At Risk). ‘Driven by a large family and mortgage pressure, this segment has not been particularly financially stable and experienced mental health impacts. They have relied more on borrowing to ease financial pressure.’

Although inflation is now coming down, prices are still rising, interest rates have probably not yet peaked and real incomes for many have fallen significantly. Life at the bottom has got a lot harder.

Articles

Reports

Data

Questions

  1. What are the arguments for and against giving huge pay awards to CEOs?
  2. What are the arguments for and against raising the top rate of income tax to provide extra revenue to distribute to the poor? Distinguish between income and substitution effects.
  3. What policies could be adopted to alleviate poverty? Why are such policies not adopted?
  4. Using the ONS publication, the Effects of taxes and benefits on UK household income, find out how the distribution of income between the various decile groups of household income has changed over time? Comment on your findings.
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From Reaganomics to Trussonomics

In her bid to become Conservative party leader, Liz Truss promised to make achieving faster economic growth her number-one policy objective. This would involve pursuing market-orientated supply-side policies.

These policies would include lower taxes on individuals to encourage people to work harder and more efficiently, and lower taxes on business to encourage investment. The policy would also involve deregulation, which would again encourage investment, both domestic and inward investment from overseas. These proposals echoed the policies pursued in the 1980s by President Ronald Reagan in the USA and Margaret Thatcher in the UK.

On September 23, the new Chancellor, Kwasi Kwarteng, presented a ‘mini-Budget’ – although the size of the changes made it far from ‘mini’. This, as anticipated, included policies intended to boost growth, including scrapping the 45% top rate of income tax, which is currently paid by people earning over £150 000 (a policy withdrawn on 3 October after massive objections), cutting the basic rate of income tax from 20% to 19%, scrapping the planned rise in corporation tax from 19% to 25%, scrapping the planned rise in national insurance by 1.25 percentage points, a cut in the stamp duty on house purchase and scrapping the limit placed on bankers’ bonuses. In addition, he announced the introduction of an unlimited number of ‘investment zones’ which would have lower business taxes, streamlined planning rules and lower regulation. The policies would be funded largely from extra government borrowing.

Theoretically, the argument is simple. If people do work harder and firms do invest more, then potential GDP will rise – a rise in aggregate supply. This can be shown on an aggregate demand and supply diagram. If the policy works, the aggregate supply curve will shift to the right. Real GDP will rise and there will be downward pressure on prices. In Figure 1, real GDP will rise from Y0 to Y1 and the price level will fall from P0 to P1. However, things are not as simple as this. Indeed, there are two major problems.

The first concerns whether tax cuts will incentivise people to work harder. The second concerns what happens to aggregate demand. I addition to this, the policies are likely to have a profound effect on income distribution.

Tax cuts and incentives

Cutting the top rate of income tax would have immediately given people at the top of the income scale a rise in post-tax income. This would have created a substitution effect and an income effect. Each extra pound that such people earn would be worth more in post-tax income – 60p rather than 55p. This would provide an incentive for people to substitute work for leisure as work is now more rewarding. This is the substitution effect. On the other hand, with the windfall of extra income, they now would have needed to work less in order to maintain their post-tax income at its previous level. They may well indeed, therefore, have decided to work less and enjoy more leisure. This is the income effect.

With the diminishing marginal utility of income, generally the richer people are, the bigger will be the income effect and the smaller the substitution effect. Thus, cutting the top rate of income tax may well have led to richer people working less. There is no evidence that the substitution effect would be bigger.

If top rates of income tax are already at a very high level, then cutting then may well encourage more work. After all, there is little incentive to work more if the current rate of tax is over 90%, say. Cutting them to 80% could have a big effect. This was the point made by Art Laffer, one of Ronald Reagan’s advisors. He presented his arguments in terms of the now famous ‘Laffer curve’, shown in Figure 2. This shows the total tax revenue raised at different tax rates.

If the average tax rate were zero, no revenue would be raised. As the tax rate is raised above zero, tax revenues will increase. The curve will be upward sloping. Eventually, however, the curve will peak (at tax rate t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work.

If the economy were currently to the right of t1, then cutting taxes would increase revenue as there would be a major substitution effect. However, most commentators argue that the UK economy is to the left of t1 and that cutting the top rate would reduce tax revenues. Analysis by the Office for Budget Responsibility in 2012 suggested that t1 for the top rate of income tax was at around 48% and that cutting the rate below that would reduce tax revenue. Clearly according to this analysis, 40% is considerably below t1.

As far as corporation tax is concerned, the 19% rate is the lowest in the G20 and yet the UK suffers from low rates of both domestic investment and inward direct investment. There is no evidence that raising it somewhat, as previously planned, will cut investment. And as far as individual entrepreneurs are concerned, cutting taxes is likely to have little effect on the desire to invest and expand businesses. The motivation of entrepreneurs is only partly to do with the money. A major motivation is the sense of achievement in building a successful business.

Creating investment zones with lower taxes, no business rates and lower regulations may encourage firms to set up there. But much of this could simply be diverted investment from elsewhere in the country, leaving overall investment little changed.

To assess these questions, the government needs to model the outcomes and draw on evidence from elsewhere. So far this does not seem to have happened. They government did not even present a forecast of the effects of its policies on the public finances, something that the OBR normally presents at Budget time. This was one of the reasons for the collapse in confidence of sterling and gilts (government bonds) in the days following the mini-Budget.

Effects on aggregate demand

Cutting taxes and financing them from borrowing will expand aggregate demand. In Figure 1, the AD curve will also shift to the right and this will push up prices. Inflation is already a serious problem in the economy and unfunded tax cuts will make it worse. Higher inflation will result in the Bank of England raising interest rates further to curb aggregate demand. But higher interest rates, by raising borrowing costs, are likely to reduce investment, which will have a negative supply-side effect.

The problem here is one of timing. Market-orientated supply-side policies, if they work to increase potential GDP, will take time – measured in years rather than months. The rise in aggregate demand will be much quicker and will thus precede the rise in supply. This could therefore effectively kill off the rise in supply as interest rates rise, the exchange rate falls and the economy is pushed towards recession. Indeed, the mini-Budget immediately sparked a run on the pound and the exchange rate fell.

The rising government debt may force the government to make cuts in public expenditure. Rather than cutting current expenditure on things such as nurses, teachers and benefits, it is easier to cut capital expenditure on things such as roads and other infrastructure. But this will have adverse supply-side effects.

Effects on income distribution

Those advocating market-orientated supply-side policies argue that, by making GDP bigger, everyone can gain. They prefer to focus on the size of the national ‘pie’ rather than its distribution. If the rich initially gain, the benefits will trickle down to the poorest in society. This trickle-down theory was popular in the 1980s with politicians such as Margaret Thatcher and Ronald Reagan and, more recently, with Republican presidents, such as Goerge W Bush and Donald Trump. There are two problems with this, however.

The first, which we have already seen, is whether such policies actually do increase the size of the ‘pie’.

The second is how much does trickle down. During the Thatcher years, income inequality in the UK grew, as it did in the USA under Ronald Reagan. According to an IMF study in 2015 (see the link to the IMF analysis below), policies that increase the income share of the poor and the middle class do increase growth, while those that raise the income share of the top 20 per cent result in lower growth.

After the mini-Budget was presented, the IMF criticised it for giving large untargeted tax cuts that would heighten inequality. The poor would gain little from the tax cuts. The changes to income tax and national insurance mean that someone earning £20 000 per year will gain just £167 per year, while someone earning £200 000 will gain £5220. What is more, the higher interest rates and higher prices resulting from the lower exchange rate are likely to wipe out the modest gains to the poor.

Podcast

Articles

Analysis

Questions

  1. Distinguish between market-orientated supply-side policies and interventionist ones. Consider the advantages and disadvantages of each.
  2. Explain why bond prices fell after the mini-Budget. What was the Bank of England’s response and why did this run counter to its plan for quantitative tightening?
  3. How might a tax-cutting Budget be designed to help the poor rather than the rich? Would this have beneficial supply-side effects?
  4. Find out about the 1972 tax-cutting Budget of Anthony Barber, the Chancellor in Ted Heath’s government, that led to the ‘Barber boom’ and then rampant inflation. Are there any similarities between the 1972 Budget and the recent mini-Budget?
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Economists and the real world

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?
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Debating a possible mansion tax

There has been considerable discussion recently about whether the government should introduce a property tax on high value properties. The government, finding it difficult to reduce the public-sector deficit and yet determined to do so, is looking for additional measures to reduce government expenditure or raise tax revenue.

But would it favour a mansion tax as a means of raising additional revenue?

The imposition of such a tax is favoured by both Liberal Democrats and the Labour Party. It is strongly opposed, however, by Conservatives. But just what would such a tax look like and what are the arguments for and against it?

One alternative would be to impose a one-off tax on property valued over a certain amount, such as £2 million. Alternatively it could be levied only for as long as the government is seeking to make substantial inroads into the deficit.

Another would be to add one or more bands to council tax. At present, council tax in England is levied in 8 bands according to the value of a person’s property. The highest band is for property valued over £320,000 in 1991 prices, with the amount of tax due for each band varying from local authority to local authority. (Average UK house prices in 2012 are 135% higher than in 1991.) In Scotland the bands are lower with the top band being for property valued over £212,000 in 1991 prices. In Wales, there is an additional band for property valued over £424,000, but properties are valued in 2003 prices, not 1991 prices.

With low top bands for council tax, people in mansions end up paying the same as people in much more modest property. It would be relatively easy to add additional bands, with the top band applying only to property worth, say, over £1 million or more.

The arguments in favour of a mansion tax are that it is progressive, relatively easy to collect, hard to evade and with minimal disincentive effects. The arguments against are that it would make the tax system ‘too progressive’, would not necessarily be related to an individual’s ability to pay and could have substantial disincentive effects.

The progressiveness of the UK tax system is illustrated in the chart, which looks at the proportion of income paid in direct, indirect and all taxes by quintile groups of households – that is, households grouped into five equal sized groups ranked from lowest to highest gross income. (Click here for a PowerPoint of the chart.)

The following articles look at the debate as it has raged over the past few weeks. Try to unpick the genuine arguments from the political rhetoric!

Articles
Clegg Says U.K. Could Apply Mansion Tax ‘in Five Seconds’ Bloomberg, Robert Hutton (25/9/12)
Two thirds back mansion tax on £1m homes Metro, Tariq Tahir (8/10/12)
Mansion tax would ‘tackle inequality’ This is Tamworth (27/9/12)
Council tax: the easy way to make mansion-dwellers pay Guardian, Simon Jenkins (25/9/12)
Rich must pay fair share in tax BBC Andrew Marr Show, Nick Clegg (23/9/12)
We will get mansion tax on £2 million homes through next budget, promise Lib Dems The Telegraph, Rowena Mason (25/9/12)
Trying to tax the wealthy not worth the price The Scotsman, George Kerevan (31/8/12)
Tax on wealth is true to Tory principles Financial Times, Janan Ganesh (24/9/12)
How would Clegg’s emergency wealth tax work? Guardian, Hilary Osborne (29/8/12)
Labour considers mansion tax on wealthy Financial Times, George Parke (5/9/12)
Conservative conference: Cameron rules out ‘mansion tax’ BBC News (7/10/12)
Don’t make wealth tax a habit Financial Times, Howard Davies (29/8/12)
George Osborne blocks mansion tax, but insists wealthy will pay more The Telegraph, Robert Winnett (8/10/12)
Why George Osborne had to kill the mansion tax The Spectator, Matthew Sinclair (7/10/12)
David Cameron rules out mansion tax and plans further welfare cuts Guardian, Hélène Mulholland (7/10/12)
Viewpoint: Would a wealth tax work? BBC News, Mike Walker (29/8/12)
For all the claims made about wealth taxes, it’s not correct to say the rich are paying their fair share Independent, Jonathan Portes (2/10/12)

Data
House price data links Economics Network
The Effects of Taxes and Benefits on Household Income, 2010/2011 ONS (26/6/12) (see especially Tables 2 and 3 and Table 26 for historical data)

Questions

  1. Explain the distinction between direct and indirect taxes, and between progressive and regressive taxes. For what reasons do the poor pay a higher proportion of their income in indirect taxes than the rich?
  2. What forms can a tax on wealth take?
  3. How progressive are taxes in the UK (see the ONS site in the Data section above)?
  4. Assess the arguments in favour of a mansion tax.
  5. Assess the arguments against a mansion tax.
  6. What type of wealth tax would be hardest to evade?
  7. What are the likely income and substitution effects of a wealth tax?