Optimal tax rate for top one per cent may be as high as 83%

Paper suggests cutting taxes may divert attention to wasteful bargaining

Via Daniel Elton, a new(ish) paper (pdf) by economists Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva makes the case for the optimal tax rate of the richest one per cent could be as high as 83 per cent.

The authors look at three possible ways in which top incomes respond to marginal tax rates.

The first is the "supply side" channel cited by Arthur Laffer when he developed his concept of the Laffer curve. Under this channel, marginal tax rates that are too high result in people doing less work than they otherwise would. Lower tax rates thus respond to more economic activity, and greater growth and higher tax revenue. Laffer's work was used by the Reagan administration to justify cutting the top rate in the US, from 70 per cent down to 28 per cent.

The second is the "tax avoidance" channel. This is the model cited by the Chancellor when he made the decision to cut the tax rate for top earners in Britain from 50 per cent to 45 per cent. The argument is that high tax rates increase tax avoidance, but the authors argue – in common with many of the Chancellors critics – that tax avoidance can be dealt with directly, writing that:

A better policy would be to first close loopholes so as to eliminate most tax avoidance opportunities and only then increase top tax rates.

The third is the "compensation bargaining" channel. The authors argue that:

While standard economic models assume that pay reflects productivity, there are strong reasons to be sceptical, especially at the top of the income distribution where the actual economic contribution of managers working in complex organisations is particularly difficult to measure.

As a result, top workers have ample opportunity to set their own pay, through bargaining harder or influencing compensation committees. The incentives for this economically wasteful activity are higher the lower tax rates are. Just as with the supply side model, tax cuts increase the wealth of the richest in society, but unlike that model they do not also increase growth; rather, the extra money for the rich comes from those poorer than them.

The authors, using their estimates of the elasticity of the various channels (that is, the magnitude of the effect), then calculate what the optimum rates would be. Under the first model, they find it to be roughly 57 per cent – 5 per cent higher than the top British tax rate is until the cut takes effect (National Insurance for top earners is 2per cent). Assessing the second model (Osborne's preferred argument), they find that the optimal tax rate would be 62 per cent, but argue that if the correct anti-avoidance and simplification measures were put in place, it would be 71 per cent.

The third model, however, outputs an optimal rate of 83 per cent. The authors still assume a minor supply-side effect, making up 40 per cent of the total elasticity, which is why it isn't higher. That is, they still assume that high tax rates will encourage the rich to work less, but they also assume that they will encourage the rich to put more of their effort into actual work, and less of it into "compensation bargaining".

How to decide between models one and three (the authors assume that once anti-avoidance measures are put in place, model two is the same as model one)? The former predicts that lower tax leads to more work, the latter that it merely leads to higher pay. As a result, tax cuts should be correlated with higher growth. Are they? Well, no:

As a result, the bargaining model can at least be said to be as realistic as the supply-side model; and if that's the case, the optimal top tax rate for most nations is likely to be far in excess of where it is set now.

For more, see the authors in the Boston Review, VoxEU, or their original paper (pdf).

Pictured: Laffer. No, wait, laughers. Photograph: Getty Images

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

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Inside the progressive alliance that beat Zac Goldsmith in Richmond

Frantic phone calls, hundreds of volunteers, and Labour MPs constrained by their party. 

Politics for a progressive has been gloomy for a long time. On Thursday, in Richmond Park of all places, there was a ray of light. Progressive parties (at least some of them) and ordinary voters combined to beat Ukip, the Tories and their "hard Brexit, soft racist" candidate.

It didn’t happen by accident. Let's be clear, the Liberal Democrats do by-elections really well. Their activists flood in, and good luck to them. But Richmond Park was too big a mountain for even their focused efforts. No, the narrow win was also down to the fast growing idea of a progressive alliance. 

The progressive alliance is both a defensive and offensive move. It recognises the tactical weakness of progressives under first past the post – a system the Tories and their press know how to game. With progressive forces spilt between Labour, Liberal Democrats, Greens, the SNP, Plaid Cymru, the Women’s Equality Party and more – there is no choice but to co-operate, bring in proportional representation and then a whole new political world begins.

This move opens up the wider strategy – to end the domination of the City, and right-wing newspapers like the Mail, so Britain can have a real debate and make real choices about what sort of economy and society it wants. A pipedream? Well, maybe. But last night the fuse was lit in Richmond Park. The progressive alliance can work.

Months before the by-election, the pressure group for a progressive alliance that I chair, Compass, the Greens, and some Labour, Liberal Democrat and SNP MPs and activists, began considering this. The alternative after Brexit was staring into the void.

Then the Tory MP Zac Goldsmith stepped down over Heathrow. To be fair, he had pledged to do this, and we should have been better prepared. In the event, urgent behind-the-scenes calls were made between the Greens and the Liberal Democrats. Compass acted as the safe house. The Greens, wonderfully, clung onto democracy – the local party had to decide. And they decided to stand up for a new politics. Andree Frieze would have been the Green candidate, and enjoyed her moment in the autumn sun. She and her party turned it down for a greater good. So did the Women’s Equality Party.

Meanwhile, what about Labour? Last time, they came a distant third. Again the phones were hit and meetings held. There was growing support not to stand. But what would they get back from the Liberal Democrats, and what did the rules say about not standing? It was getting close to the wire. I spent an hour after midnight, in the freezing cold of Aberdeen, on the phone to a sympathetic Labour MP trying to work out what the party rule book said before the selection meeting.

At the meeting, I am told, a move was made from the floor not to select. The London regional official ruled it out of order and said a candidate would be imposed if they didn’t select. Some members walked out at this point. Where was the new kinder, gentler politics? Where was membership democracy? Fast forward to last night, and the Labour candidate got less votes than the party has members.

The idea of a progressive alliance in Richmond was then cemented in a draughty church hall on the first Tuesday of the campaign – the Unitarian Church of course. Within 48 hours notice, 200 local activist of all parties and none had come together to hear the case for a progressive alliance. Both the Greens and Compass produced literature to make the case for voting for the best-placed progressive candidate. The Liberal Democrats wove their by-election magic. And together we won.

It’s a small victory – but it shows what is possible. Labour is going to have to think very hard whether it wants to stay outside of this, when so many MPs and members see it as common sense. The lurch to the right has to be stopped – a progressive alliance, in which Labour is the biggest tent in the campsite, is the only hope.

In the New Year, the Progressive Alliance will be officially launched with a steering committee, website and activists tool-kit. There will also be a trained by-election hit squad, manifestos of ideas and alliances build locally and across civil society.

There are lots of problems that lie ahead - Labour tribalism, the 52 per cent versus the 48 per cent, Scottish independence and the rest. But there were lots of problems in Richmond Park, and we overcame them. And you know, working together felt good – it felt like the future. The Tories, Ukip and Arron Banks want a different future – a regressive alliance. We have to do better than them. On Thursday, we showed we could.

Could the progressive alliance be the start of the new politics we have all hoped for?

Neal Lawson is the Chair of Compass, the pressure group for the progressive alliance.

Neal Lawson is chair of the pressure group Compass, which brings together progressives from all parties and none. His views on internal Labour matters are personal ones.