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.

Chuka Umunna speaks at the launch of Labour's education manifesto during the general election. Photograph: Getty Images.
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After so badly misjudging the leadership contest, how will the Blairites handle Corbyn?

The left-winger's opponents are divided between conciliation and aggression. 

When Labour lost the general election in May, the party’s modernisers sensed an opportunity. Ed Miliband, one of the most left-wing members of the shadow cabinet, had been unambiguously rejected and the Tories had achieved their first majority in 23 years. More than any other section of the party, the Blairites could claim to have foreseen such an outcome. Surely the pendulum would swing their way?

Yet now, as Labour’s leadership contest reaches its denouement, those on the right are asking themselves how they misjudged the landscape so badly. Their chosen candidate, Liz Kendall, is expected to finish a poor fourth and the party is poised to elect Jeremy Corbyn, the most left-wing leader in its 115-year history. For a faction that never ceases to underline the importance of winning elections, it will be a humbling result.

Though the crash has been sudden, the Blairites have long been in decline. Gordon Brown won the leadership unchallenged and senior figures such as John Reid, James Purnell and Alan Milburn chose to depart from the stage rather than fight on. In 2010, David Miliband, the front-runner in the leadership election, lost to his brother after stubbornly refusing to distance himself from the Iraq war and alienating undecided MPs with his imperiousness.

When the younger Miliband lost, the modernisers moved fast – too fast. “They’re behaving like family members taking jewellery off a corpse,” a rival campaign source told me on 9 May. Many Labour supporters agreed. The rush of op-eds and media interviews antagonised a membership that wanted to grieve in peace. The modernising contenders – Chuka Umunna, Liz Kendall, Mary Creagh, Tristram Hunt – gave the impression that the Blairites wanted to drown out all other voices. “It was a huge mistake for so many players from that wing of the party to be put into the field,” a shadow cabinet minister told me. “In 1994, forces from the soft left to the modernising right united around Tony Blair. The lesson is never again can we have multiple candidates.”

While conducting their post-mortem, the Blairites are grappling with the question of how to handle Corbyn. For some, the answer is simple. “There shouldn’t be an accommodation with Corbyn,” John McTernan, Blair’s former director of political operations, told me. “Corbyn is a disaster and he should be allowed to be his own disaster.” But most now adopt a more conciliatory tone. John Woodcock, the chair of Progress, told me: “If he wins, he will be the democratically elected leader and I don’t think there will be any serious attempt to actually depose him or to make it impossible for him to lead.”

Umunna, who earlier rebuked his party for “behaving like a petulant child”, has emphasised that MPs “must accept the result of our contest when it comes and support our new leader in developing an agenda that can return Labour to office”. The shadow business secretary even suggests that he would be prepared to discuss serving in Corbyn’s shadow cabinet if he changed his stances on issues such as nuclear disarmament, Nato, the EU and taxation. Were Umunna, a former leadership contender, to adopt a policy of aggression, he would risk being blamed should Corbyn fail.

Suggestions that the new parliamentary group Labour for the Common Good represents “the resistance” are therefore derided by those close to it. The organisation, which was launched by Umunna and Hunt before Corbyn’s surge, is aimed instead at ensuring the intellectual renewal that modernisers acknowledge has been absent since 2007. It will also try to unite the party’s disparate mainstream factions: the Blairites, the Brownites, the soft left, the old right and Blue Labour. The ascent of Corbyn, who has the declared support of just 15 MPs (6.5 per cent of the party), has persuaded many that they cannot afford the narcissism of small differences. “We need to start working together and not knocking lumps out of each other,” Woodcock says. There will be no defections, no SDP Mk II. “Jeremy’s supporters really underestimate how Labour to the core the modernisers are,” Pat McFadden, the shadow Europe minister, told me.

Although they will not change their party, the Blairites are also not prepared to change their views. “Those of us on this side of Labour are always accused of being willing to sell out for power,” a senior moderniser told me. “Well, we do have political principles and they’re not up for bartering.” He continued: “Jeremy Corbyn is not a moderate . . .
He’s an unreconstructed Bennite who regards the British army as morally equivalent to the IRA. I’m not working with that.”

Most MPs believe that Corbyn will fail but they are divided on when. McFadden has predicted that the left-winger “may even get a poll bounce in the short term, because he’s new and thinking differently”. A member of the shadow cabinet suggested that Labour could eventually fall to as low as 15 per cent in the polls and lose hundreds of councillors.

The challenge for the Blairites is to reboot themselves in time to appear to be an attractive alternative if and when Corbyn falters. Some draw hope from the performance of Tessa Jowell, who they still believe will win the London mayoral selection. “I’ve spoken to people who are voting enthusiastically both for Jeremy and for Tessa,” Wes Streeting, the newly elected MP for Ilford North, said. “They have both run very optimistic, hopeful, positive campaigns.”

But if Corbyn falls, it does not follow that the modernisers will rise. “The question is: how do we stop it happening again if he does go?” a senior frontbencher said. “He’s got no interest or incentive to change the voting method. We could lose nurse and end up with something worse.” If the road back to power is long for Labour, it is longest of all for the Blairites. 

George Eaton is political editor of the New Statesman.

This article first appeared in the 03 September 2015 issue of the New Statesman, Pope of the masses