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Fiscal Drag Means The Top Tax Band Is Over The Laffer Curve Peak



OK, you can argue against this idea if you’re one of the fools who thinks that there is no such thing as the Laffer Curve. You can also argue against it if you think – again wrongly but not necessarily foolishly – that we’re nowhere near that peak.

But imagine that you’re a Tory Chancellor. OK, you could still be a fool, that’s true. Imagine also that you’re a Tory Chancellor who believes what Tory Chancellors insisted upon a decade ago. OK, that too could be evidence of foolishness. But go on, just imagine.

More people than ever face paying the 45pc rate of income tax on the top band of their earnings following a decade-long threshold freeze.

Some 440,000 are forecast to lose 45p for every £1 they earn over £150,000 this financial year – 10pc more than paid in 2018-19, official figures published yesterday revealed.

The £150,000 additional rate threshold – the point at which the top 45pc rate kicks in – has not changed since it was first introduced in 2010-11, despite steady inflation and wage rises. More have been caught as a result through what is known as “fiscal drag”.

That means that the top tax band is now over the Laffer Curve peak.

No, really.

Think back to what was actually being said back in 2010 etc. Brown had raised the top tax rate to 50% as a poison pill for any incoming Tory. I think I’m right in saying that it didn’t even come into effect until after the likely election date.

So, the argument from Osborne etc was that 50% was over the Laffer Peak. They might well be right too – that Diamond and Saez paper tells us that in a system with allowances that peak is 54%. But that’s taxes upon income, not income taxes, so we must include employers’ and employees’ NI to get to the full rate. Yes, their paper really does say this.

Sp, 50% income tax only is too high. 45% income tax only might be fractionally on the high side but it’s closer to the peak at least.

However, the peak is created by the interaction of the income and substitution effects. We know that these weigh differently upon decision making dependent upon income levels. Low paid piece workers are definitely more influenced by the income effect. As we’ve seen with doctors’ pensions those on three and five times median wage definitely react to the substitution effect.

Hmm, OK. So, the Laffer Curve peak in terms of income is going to rise with inflation and also more general wage increases.

Cool. The insistence in 2010 was that 45% at £150k was the peak of the Laffer Curve. Given inflation and general wage increases since then this must mean that it’s above that peak.

Now, whether we believe this or not depends upon whether we believe Osborne’s insistences back then. But those insistences were viable at least.



  1. “I think I’m right in saying that it didn’t even come into effect until after the likely election date.”. For practical purposes, yes. Gordon Brown lost the election on 6 May 2010. The 50% tax rate started in the 2010/2011 tax year, so theoretically started in April 2010 and people might have noticed the effect on their payslips for April 2010, but as that was the first month of the tax year, so different for many people (e.g. due to predicted payments into pension funds and other changes from the previous tax year), it would have been hard to tell from your payslip – and that assumes that someone earning significantly over £150k would be checking their payslip every month, which seems exceedingly unlikely.

    However, the 50% rate was announced in Alistair Darling’s budget of 22 April 2009, so people would have known it was coming.

    To address the substantive argument of the article, there is no reason to suppose that “the Laffer Curve peak in terms of income is going to rise with inflation”. That is to commit the homo economicus fallacy. There’s a difference between losing something you have (or expected to have), and failing to get something you never expected to get. So someone whose salary increases to over £150k will feel the loss of the extra money a lot less than they would if their salary stayed the same and the tax rate changed even if the effect in real money is the same. This is one of the reasons why the Laffer curve does not exist in the real world.

    The reference to doctors’ pensions is a bit of a red herring. Their biggest problem was that overtime earned them salary but not extra pension contributions. This meant that for tax purposes it reduced their pension allowances, leading to a tax liability. At certain income levels this led to >100% effective marginal tax rate.

    • The doctors’ pension pot issue in large part related to the maximum size of that pension pot for which there were deferred tax advantages (something like 1.25mill, can’t recall exactly). Once you’d maxed out your pot, then the effective tax rate on additional hours work was that 53.5% if you were a consultant on 150k plus.
      Neo-liberal solutions involve permitting more people to enter medicine to restrain labour costs, and liberalising planning so building unaffordable spectacular housing with a paddock and pool is easier, so top consultants have something to gain that is worth working for.

      • That was indeed part of it, but it also involved the pension contribution allowance of £40,000. That decreases by £1 for every £2 earned above a threshold. For doctors, whose pension contributions is a fixed 14% of salary, that sometimes ended up with them having an amount of salary deemed taxable but the money going into their pension. In theory they were better off, but the money in their pension could not be used to pay the tax bill, so they ended up where earning more meant less disposable income. The fact that this would give them a bigger pension when they retired was no help to paying the tax bill now (especially as the pension pot is at the mercy of future government raids on it).


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