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IFS challenges Lib Dems’ income tax estimates

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The Liberal Democrats’ estimates of the additional revenue that a higher rate of income tax would raise may be too optimistic, according to the Institute for Fiscal Studies.

The party announced further details of its proposals for an alternative Budget on Monday. It reiterated pledges to introduce an effective 50% top rate (comprising income tax at 49% and the existing 1% NIC levy) on earnings in excess of £100,000 a year, and to replace the council tax with a local income tax.

It also pledged to raise the stamp duty threshold for all residential properties from £60,000 to £150,000. Disadvantaged area relief for non-residential properties would be reduced.

The 50% top rate would fund free personal care for the elderly, the abolition of university tuition fees, and lower local taxes, the party said.

The IFS released an initial analysis of the party’s tax proposals.

It suggested that the additional revenue raised from such a change would be less than the party has estimated, because the party has not used the most recent available figures and has failed to take account of behavioural responses.

The IFS gave the following assessment of the proposal to increase the higher rate of income tax to 49% on income in excess of £100,000:

“This proposal would be a relatively large tax increase on a relatively small number of extremely high-income individuals. In 2004/05 only 419,000 individuals are estimated to have incomes in excess of £100,000. This represents 0.9% of the UK adult population, and 1.4% of those with incomes sufficiently high to pay income tax.

“The Liberal Democrats’ costings are based on Inland Revenue figures suggesting that this reform would raise £4.7bn in 2004/05 and £5.2bn in 2005/06, assuming that individuals do not change their taxable incomes in response to the reform. This would mean an average (mean) loss of £216 per week in 2004/05 for each individual whose income is over £100,000 per year, or £29.50 per week on average for each family in the highest-income tenth of the population (there are virtually no losers outside the top tenth of the income distribution).

“But there are reasons to believe that the actual revenue raised by the reform might be lower than this, eating into the reserve that the Liberal Democrats have incorporated into their plans. First, the Liberal Democrats’ figures are based on Inland Revenue estimates of September 2004. But more recent (December 2004) Inland Revenue statistics imply that there is only enough income above £100,000 to yield £4.2bn in 2004/05. How much a 49% rate would raise in future years will depend both on the growth in taxable income of those near to and above the new threshold and on how this threshold is indexed, but a 24% rise in the revenue raised to £5.2 bn in 2005/06 seems unlikely.

“Second, the estimates also assume that reform itself has no effect on taxable incomes. But the increase in the marginal tax rate facing these individuals (their combined income tax and employee National Insurance (NI) contribution rate would increase from 41% to 50% while their employer NI rate would be left unchanged) could encourage them to reduce their taxable incomes, since the financial penalty from doing so is diminished.

“There are many ways in which individuals might reduce their taxable incomes. They could decide to reduce their work effort, or to retire earlier than they otherwise would. They could even choose to leave the country, or high-income foreigners might be discouraged from immigrating. People could try to reduce their taxable income by engaging in greater tax avoidance measures.

“They might increase their contributions to private pensions, since they would receive tax relief at 50p in the pound and might only expect to be paying higher rate tax at 40p once in retirement. The likely extent of such behavioural responses is debatable, but to the extent that people do any of these things, the yield of the 49% rate would be reduced.

“Conversely, it is possible that people might choose to increase their pre-tax incomes (work harder etc) to make up for the extra tax they are paying. This would increase the revenue raised from this reform. However, to the extent that the revenue is redistributed to the population (used to reduce local tax rates, reduce the cost of long-term care, etc), we might expect the reduced work effort of the beneficiaries broadly to offset the increased work effort of the losers.”

Andrew Goodall
Editor, TaxZone

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