December 10, 2012

On Tax Policy, Obama Could Learn From the British

By: AFF Editors

In the weeks following his victory over Mitt Romney, President Obama has stuck a more strident tone than the last time the Bush tax cuts were up for debate, saying at his first post-election press conference that he will not “extend Bush tax cuts for the wealthiest 2 percent.”

Some of his Democratic colleagues on Capitol Hill have been even more forceful in their insistence that tax rates must rise for high income Americans.

Republicans saying they would be open to raising more revenue through closing loopholes or capping deductions were dismissed. Nancy Pelosi went so far as to say that she would reject any fiscal cliff deal that did not raise the tax rates on high income Americans, regardless of whatever other measures might be included, or how much said deal would improve the nation’s fiscal health.

In that same press conference, the president was equally dismissive of  dynamic scoring “What I will not do is to have a process that is vague, that says we’re gonna sorta, kinda raise revenue through dynamic scoring or closing loopholes that have not been identified.”

In some ways, the president does have a valid point mixed in with his dismissal of dynamic scoring: too often, Republicans use dynamic scoring and overly optimistic estimates of future growth as a panacea to make their budget math work, or to save them from the always vexing ordeal of actually having to point to specific places they would cut spending or end popular tax breaks.

It is disappointing, if not surprising, that the same people who so often point to countries in Europe as a model for the United States in terms of health care and a robust social safety net, failed to take into account the lesson that could be learned from the United Kingdom’s experience in an eerily similar episode, where an attempt to pursue deficit reduction through tax increases on the wealthy failed so miserably that the government has already reversed course.

Remarks by President Obama and other Democrats mirror those of  former British Chancellor of the Exchequer Alistair Darling  when he introduced an increase the top marginal income tax rate to 50 percent, saying:

“I believe that it is fair that those who have gained the most should contribute more. Only… 2 per cent of the population… will be affected.”

The tax increase went into effect shortly thereafter. The initial report from the government projected that the measure would raise 6.5 billion pounds in gross revenue in the first year. The authors of the report, wonks in the employ of Her Majesty’s Treasury, hardly known for being supply-side ideologues, recognized that there would be a loss in revenue due to the behavioral effects in response to this tax increase, which they estimated at 4.1 billion pounds, leaving a projected net revenue gain of 2.4 billion pounds in the first year. Unlike many of the Democratic lawmakers in America currently clamoring for higher taxes on the rich, these British bureaucrats at least recognized that the relationship between an increase in tax rates and its effect on revenue generation was more complicated than simple arithmetic. Unfortunately for these authors, they still significantly underestimated the behavioral effects of the tax increase. A later study by British treasury economists found that due to emigration by high income people and forestalling (moving forward income to before the tax increase takes effect to avoid the higher rate), in the first year after the new rate took effect, the revenue generated after accounting for these behavioral effects was 5 billion pounds lower than it would have been if the rate had never been increased. Recent reports from the U.K. show the extent of these behavioral responses: in the 2009-10 tax year, more than 16,000 people declared an annual income of more than one million pounds, but this number fell to just 6,000 after the new 50% rate was introduced.

In this same report, these economists found that cutting the rates back down to 45% from their peak at 50% would essentially pay for itself, the behavioral effects of the rate cut, in this case positive, would replace almost 97 percent of the static revenue loss. In response to the findings of this report and the poor revenue generation resulting from the tax increase, the government announced they would indeed be cutting the rate down to 45% starting next April. Again, the behavioral effects were plain to see; following this announcement, the number of people declaring annual incomes exceeding one million pounds has risen back to 10,000

The UK’s experience, while it is very similar to the current situation in the US, is only one specific case. Their experience does not mean that higher tax rates like the ones proposed by President Obama will lead to lower revenue, but it does mean that increased tax rates to not lead to increased revenue in a linear relationship, and that neither the president, nor anyone else, really knows how much revenue increasing tax rates on high income Americans will generate, pronouncements of $800 billion in new revenue over a decade aside.

The UK’s experience shows that the behavioral effects of changes to tax rates are very real and they should be seriously considered. It is not arithmetic; it is much more complicated than that.

Charles Hughes is a research assistant and writer in Washington D.C. Image of the Houses of Parliament in London courtesy of Big Stock Photo.