We’re told that there’s no way that the Laffer Curve will have any influence upon the ability of an independent Scotland to raise more tax revenue from higher earners by upping the income tax rate. We’re specifically told that this is proven by the work of those associated with Thomas Piketty. This is a dangerous misreading of what is actually being said by those associates. What is actually being said is that in a taxation system in any manner resembling the current one then income tax rates are about has high as Scotland can have them without losing tax revenue.
That is, the Laffer Curve is already a binding constraint upon revenue collection from high earners in the UK’s current system, the one an independent Scotland will be starting from.
But then the insistence comes from the Senior Lecturer at Islington Technical College, not a known source of accurate information on matters taxation. He says:
In particular, there is a worrying suggestion that the so-called ‘Laffer Curve’ might be relevant in a Scottish context and that there are limits to the tax rates that it might wish to consider. I suggest that this is wrong. The work of economists working with Thomas Piketty has made clear that there is no tax rate that Scotland might reasonably consider where an increase in tax rate would reduce tax yield.
The work being referred to there is this paper from Diamond and Saez – Saez being a frequent collaborator with Piketty, Diamond having a Nobel. Serious researchers doing serious work.
What the Senior Lecturer is referring to is this part of that paper:
The key remaining empirical ingredient to implement the formula for the the key remaining empirical ingredient to implement the formula for the
optimal tax rate is the elasticity of top incomes with respect to the net-of-tax of top incomes with respect to the net-of-tax
rate. With the Pareto parameter a = 1.5 ife = .25, a mid-range estimate from the empirical literature, then τ * = 1/(1+ 1.5× .25)= 73 percent, substantially higher
than the current 42.5 percent top U.S. marginal tax rate (combining all taxes).
Woo, Hoo, charge it to ’em Danno!
Except that’s the estimate before we meet the structure of the tax system. Do note something very important about these rates, they’re not the income tax rate, they’re the rate of tax upon incomes. So, add in – they are explicit about this – taxes such as Social Security, national insurance and so on. Yes, employer paid such taxes too.
And we also need to add in that interface with the taxation system:
When a tax system offers tax avoidance or evasion opportunities, the tax base in a given year is quite sensitive to tax rates, so the elasticity is large, and the optimal top tax rate is correspondingly low.
Avoidance is such things as “allowances” in this expansive definition. Being able to switch income to capital gains at a different rate for example. Hey, maybe we don’t allow that to happen.
As an illustration using the different elasticity estimates of Gruber and Saez (2002) for high-income earners mentioned above, the optimal top tax rate using the current taxable income base
(and ignoring tax externalities) would be τ * = 1/(1+ 1.5× 0.57)= 54 percent, 54 percent, while the optimal top tax rate using a broader income base with no deductions
would be τ * = 1/(1+ 1.5× 0.17)= 80 percent.
What’s a good allowance? A decent manner of tax avoidance? Leaving the country. Note that this formal paper is examining the US tax system, where that is not possible. Taxation is done on a passport basis. A Scottish income tax system would face the fact that people could simply move to England to avoid that entire taxation system. Or, if Scotland tries to disallow that, they will be able to move to any EU state – and no, Scotland could not pursue a passport based taxation system within the EU.
The peak of the Laffer Curve is therefore 54%. That’s for all taxes upon income. Income tax plus employers’ and employees’ NI. Which is the rate we’re about at today.
The Laffer Curve will indeed limit Scottish taxation possibilities precisely and exactly because it already limits the current UK system, the presumed starting point for any independent Scottish system.
But then do you want your tax advice from a Professor at MIT who also has the Nobel or from the Senior Lecturer at Islington Tech?