How Should Governments Tax Earnings Fairly?

TL;DR

Effective tax rates on earnings depend on income tax, National Insurance, indirect taxes, and the withdrawal of means-tested support. Policymakers must balance revenue, inequality, employment, and incentives to earn more, while recognizing that responses differ across groups and that estimates of the revenue-maximizing top rate remain highly uncertain.

Transcript

um and so let me start off first of all by saying uh a little about each of these three things um as they affect the taxation of earnings um so first of all how the world has changed um from the point of view of taxing earnings while the population looks very different and we've got more single person households uh and more single parent households... Read More

Key Insights

• The taxation of earnings includes more than statutory income tax, because National Insurance, indirect taxes, and the withdrawal of benefits and tax credits also affect the gap between employment costs and what workers can purchase with their earnings.
• The labor market has shifted away from the traditional single-earner couple, with more couples having either no earners or two earners. This polarization reflects, among other changes, increased employment among women and reduced employment among men, especially at older ages.
• Income tax rates fell substantially, with the basic rate declining from 33% to 20% and the top rate falling from 83% to 40%. However, thresholds failed to keep pace with earnings, expanding the taxpayer population and increasing higher-rate taxpayers fivefold.
• Independent taxation replaced a largely joint system in 1990, while the married couple's allowance and additional personal allowance were mostly abolished. Means-tested tax credits continued to assess couples jointly, partially counteracting the movement toward individual treatment within income taxation.
• Hours worked within an existing job appear to respond little to taxation, but the decision to take a job can be more responsive. Stronger employment responses appear among single mothers, women with working partners, lower-skilled groups, and mothers of school-age children.
• The revenue-maximizing income tax rate for the top 1% was tentatively estimated at around 40%, based on responses to rate reductions during the 1980s. The estimate was highly uncertain, with about a two-thirds chance of lying between 33% and 57%.
• The overall tax rate affecting incentives can exceed the headline income tax rate because employer National Insurance contributions and indirect taxes widen the difference between employment costs and purchasing power. A 40% income tax estimate corresponded to an overall rate closer to 56%.
• Means-tested support creates a trade-off between encouraging employment and encouraging higher earnings. Increasing working tax credits can make entering work more attractive, but gradual withdrawal as income rises can reduce incentives for existing workers or second earners to increase family income.

Questions & Answers

Q: What taxes determine the effective tax rate on earnings?

The effective tax rate on earnings is determined by more than the statutory income tax rate. National Insurance operates much like a second income tax, while indirect taxes affect what earnings can purchase. At lower incomes, benefit and tax-credit withdrawals create an additional implicit tax. Employer National Insurance contributions also matter when measuring the full gap between employment costs and workers' purchasing power.

Q: How has the labor market changed for couples and families?

The labor market has moved away from the traditional single-earner couple toward greater polarization. More couples now have no earners, and more have two earners. Women and mothers are more likely to work, while fewer men work, particularly at older ages. There are also more single-person and single-parent households, and external childcare is used more frequently by working mothers.

Q: How did income tax policy change over the period discussed?

The basic income tax rate fell from 33% to 20%, while the top rate fell from 83% to 40%, with a planned increase to 50%. At the same time, tax thresholds did not keep pace with earnings growth. Consequently, the number of taxpayers increased, and the number paying higher rates rose fivefold despite substantial reductions in headline statutory rates.

Q: How did the tax treatment of families change?

The tax system moved from largely joint taxation to independent taxation in 1990. The married couple's allowance was gradually almost abolished, as was the additional personal allowance that had provided comparable support to unmarried people with children. However, means-tested benefits and tax credits continued to use couples' joint income, partially reversing the individualizing effect of independent income taxation.

Q: How do workers respond to changes in earnings taxation?

The number of hours worked by someone already holding a job appears to respond little to the level of taxation. The decision to enter employment can be more responsive, especially for single mothers, women with working partners, lower-skilled and less-educated people, and mothers whose children are of school age. Employment also responds around education and retirement ages.

Q: What is the revenue-maximizing top income tax rate?

A study prepared for the Mirrlees Review tentatively estimated that the revenue-maximizing income tax rate for the top 1% was around 40%, using evidence from top-income responses to tax-rate reductions during the 1980s. The estimate was extremely uncertain. The authors assigned about a two-thirds chance that the rate was somewhere between 33% and 57%, subject to their assumptions.

Q: Why might a government choose a rate above or below the revenue-maximizing rate?

A government need not focus exclusively on maximizing revenue. If it values the additional benefit that high earners receive from keeping more income, the revenue-maximizing rate may be too high. If reducing inequality is considered valuable in itself, the government might choose a rate above the revenue-maximizing level, even when doing so makes high earners worse off without raising additional revenue.

Q: Why do tax credits create conflicting work incentives?

Working tax credits can strengthen the incentive to enter employment because eligibility requires someone to be in work. Once the credit is means-tested, however, its withdrawal as earnings rise can weaken the incentive to earn more. Because means testing uses couples' joint income, support may encourage a family to have one earner while discouraging additional earnings or a second earner from entering work.

Summary & Key Takeaways

• The population and labor market have changed substantially, with more single-person and single-parent households, greater employment among women and mothers, fewer working men at older ages, longer participation in education, wider wage inequality, and a shift among couples from the traditional single-earner model toward more zero-earner and two-earner households.

• Tax policy has also changed. Basic and top income tax rates fell, tax thresholds lagged behind earnings, and the number of higher-rate taxpayers increased fivefold. Independent taxation replaced largely joint taxation, while National Insurance, indirect taxes, tax credits, and benefit withdrawals became increasingly important components of the effective tax burden on earnings.

• Behavioral evidence suggests that hours worked respond little to taxation, but decisions about entering employment can respond more strongly for specific groups. At high incomes, taxable income can change through several behaviors. Policymakers therefore face uncertain revenue estimates and difficult trade-offs between employment, additional earnings, distributional goals, and support for families.