Bigger income tax doesn’t work; fairer does

According to some sources, Top Gear star Jeremy Clarkson makes £2 million a year. Sounds like a large amount of money, but the sad truth is, he only sees less than a half of it. According to a tax calculator, Jezza’s net wage is a mere £978,618.96. Total taxes amount to £1,021,381.04 of which income tax is a whopping £978,000. Moreover, this tax year, he’s by over £20,000 worse off compared with last year.

The reason to this is Labour’s “rich tax” that the Conservative-led Coalition has refused to drop. Income exceeding £150,000 a year is therefore still taxed with a 50% income tax rate, which in case of incomes as Jezza’s mean almost half of their entire salaries. One could argue that they make enormous amounts of money anyway (at least compared with the median wage earners), but the point remains that the government takes away half of a man’s hard-earned money.

On 14 August investor Warren Buffett published an op-ed in the New York Times, saying that he and other rich people should be taxed more heavily. He argues that last year the income tax he “paid was only 17.4 percent of my taxable income—and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.” He does have somewhat a valid point there; however, there’s another side to this coin—perhaps his staff pays way too much? Moreover, most of Buffett’s income is taxed with capital gains tax which in some economies is kept separate from income tax and is usually a lot lower than income tax.

Which brings me to my point. Last Friday’s Economist argues that “on both sides of the Atlantic there is room to narrow the gap between tax rates on salaries and bonuses and those on dividends and capital gains. That gap explains why Mr Buffett, most of whose income comes from capital gains and dividends, has a lower average tax rate than his secretary. It is also the one hedge funders and private-equity people have exploited to keep the billions they rake in.”

The magazine continues:

Imagine a tax system which made the top rates on wages and capital more equal, and which eliminated virtually all deductions. To avoid taxing investments twice, such a system would get rid of corporate taxes. It would also allow for a much lower top rate of income tax. The result? A larger overall tax take from the rich, without hurting the dynamism of the economy. Now that would be worth blowing your horn about.

This can only be agreed with. In a separate article on the same subject, The Economist points out that historically, “low taxes on the rich encourage investment and growth”.

With many economies weak, now is not the time to saddle capitalists with greater taxes, particularly since the rich are among society’s most mobile: the footloose wealthy will simply move, taking their taxes with them. This debate is particularly fiery in Britain, always fearful for its London financial centre, and a 50% top marginal tax rate which came into effect in 2010. A number of economists believe it is doing lasting damage to the British economy.

The rich already pay enormous amounts of money in taxes. In Britain, the rich pay 39% of the total taxes, in the United States, a whopping 45%. The share paid by the top 1% of earners in the United States was 40% in 2006; in the UK it was 28% this year. Look at it from wherever you will, that is a considerable amount of money.

The simple fact is, the rich don’t want to pay more, no matter what Warren Buffett says. And another simple fact is, the rich tend to be more globally mobile than others and they can always move to a friendlier tax climate. The article in The Economist points out that “After Britain’s Thatcher-era tax reforms, the share of foreigners among top earners grew much faster than did the share in the middle and bottom of the income distribution, reflecting the mobility of international talent”. During Margaret Thatcher’s premiership, the top income tax level was slashed from 83% to 40%. People like lower taxes, and they especially like tax havens. How else can one explain their existence?

Another thing that has historically proven to stimulate the economy and make people want to be more successful is flat-rate income tax. Admittedly, left-wingers say it’s unfair for the rich to pay the same percentage than the poorer; however, right-wingers (usually better budgeters than left-wingers, at least that’s what this writer believes) say that it indeed is fair to tax everyone with the same percentage, because only the percentage is the same for everyone, the rich anyway pay larger amounts of money than the poorer.

A strong argument for flat-rate income tax is incentivising success. With flat-rate tax, people know that when they work harder, become more successful and earn more, they won’t be punished by bigger taxes and they can actually lead a better life. The effect is the opposite with progressive income tax; higher tax rate for higher incomes feels like punishment for trying to be “better than others”. But a society should encourage success, not punish for it.

An excellent example of flat-rate income tax working in practice is a small Nordic country of Estonia. Currently, the rate is set at 21%, which means that if one earns €10,000 a year, one pays €2,100 income tax. If one earns €1,000,000 a year, one pays €210,000, etc. Estonia is a shining example of fiscal success: it has the lowest government debt-to-GDP ratio in the entire EU (and in the eurozone). This small Nordic country that only 20 years ago was occupied by the Soviet Union is tens of times better off than any EU country today. And only a few days after Standard&Poors lowered the US credit rating to AA+, it upgraded Estonia’s by two notches to AA-. This is how you run an economy—you treat (tax) people fairly, incentivise them to work, keep your finances in top-notch order, don’t over-borrow and overspend. This writer believes a government that takes away half of a person’s earnings doesn’t have a place in the 21st century.

The bottom line is, the wealthy generate growth by investing. And today growth is something most economies in the civilised world need. The key to get a state’s finances in order is to drastically (and sometimes cruelly) cut spending, not invent new ways to apply higher taxes on people in order to spend more.

Getting the economies growing and the people working again should be a top priority. When the wealthy reinvest their earnings in the economy, they create jobs. And for a state it’s better to have people working and paying reasonable income tax, rather than having people on unemployment benefits.

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