Tax is bad enough without needless complexity

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Sir Christopher Gent and a precinct of policemen provide some insights to our tax system.

Isn’t it unfair that a schoolteacher or policeman on £36,000 ($60,000) a year should pay the same rate of income tax as Sir Christopher Gent of Vodafone, whose £2.86m salary could pay for the staff of even the largest school? This is the thought that Peter Hain, the UK cabinet minister, trailed in the press and that Gordon Brown, chancellor of the exchequer, and Tony Blair, prime minister, would not allow him to utter.

But it depends what you mean by the same rate of tax. In Britain, you are liable to tax at 40 per cent on income above £35,000. That means someone on £36,000 a year pays £6,800 in income tax – 19 per cent of their income – while the unlucky Sir Chris has to pay £1.15m, almost 40 per cent. The effective tax rate on the larger income is twice as high. There is a difference between the average rate of tax – the total tax you pay on your total income – and the marginal tax – the additional tax you pay on additional income.

Confusing the two is a serious but common mistake. Since Mr Hain did not say what he planned, we shall never know whether the distinction between average and marginal rates was clear in his mind. It was not clear to many who commented on his proposal.

Both marginal rates and average rates matter. Marginal rates influence the decision to work more, or less. The policeman has to pay 40 per cent of his overtime earnings in tax. Sir Chris’s bonus is also cut by 40 per cent (he was able to take home a mere £952,000 from his £1.59m incentive payment). But the distributional effects of income are the product of average rates. Sir Chris not only pays a lot more tax than a policeman; he pays more than would a station full of policemen whose total income came to £2.86m.

There is also potential for confusing average and marginal rates at the bottom of the income distribution. Isn’t it wrong that poor people should pay the same rate of tax as the rich? It is true if you are talking about average rates; not obviously true if you are talking about marginal rates. Britain has the curious anomaly of a 10 per cent starting rate of tax on the first £1,960 of taxable income. Rather than paying their marginal rate on this £1,960, the 10 per cent concession is worth £588 to Sir Chris and the senior policeman but only £235 to a hospital porter or office cleaner. It is worth even less to those workers on £100 a week or so for whom that 10 per cent rate is the marginal rate of tax. Lowering the tax rate you face on additional earnings reduces the average rate only for people who are richer than you.

I know I am losing readers at this point, but there is worse to come. In a virtuoso performance in 1971, Sir James Mirrlees, who received the Nobel Prize for his ability to disentangle these sorts of problems, used complex mathematics to determine the ideal rate structures for income tax. His most paradoxical result was that you would want to have the lowest marginal tax rates on the very richest people – the people whom you could also expect to face the highest average rates.

This analysis seems exotic and abstruse. But it had a clear and beneficial effect on practical tax policies. Politicians and their advisers came to realise that because correct and careful analysis of tax structures was too difficult for sound-bites, much of the complexity they themselves had introduced was self-defeating.

During the 1980s, there was a move towards radical simplification of tax structures. Allowances and exemptions were rolled back and complex rate structures simplified. In 1975, Britain had 10 different income tax rates, with a top rate of 83 per cent; the US had 25 different rates, rising to 72 per cent; Italy 32 different rates, also rising to 72 per cent; and Japan 19 different rates, going up to 70 per cent. By 1990 there were two rates in Britain, three in the US, seven in Italy and five in Japan. In none of these countries was the top rate above 50 per cent. These are only examples of a worldwide trend.

Politicians grasped the futility of careful fine-tuning of tax structures to achieve complex social objectives. Mr Hain may be representative of a new generation of politicians too young to have learnt this. But the overwhelming message of history for tax policy is: keep it simple, stupid.

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