The claim

“We say it will raise revenue, it will raise a substantial amount of revenue.”
Ed Balls, 27 January 2014

The background

The shadow chancellor, Ed Balls, has denied he is “anti-business” after pledging to bring back the 50p top rate of tax if Labour wins the next election.

The announcement prompted a chorus of disapproval from the business world, with 24 business leaders writing to the Telegraph to damn the move as “a backwards step”.

But Mr Balls says returning to the 50p rate for those who earn more than £150,000 would represent “a fair approach to deficit reduction”, adding: “Those with the broadest shoulders need to bear their share of the burden.”

Leaving the issue of fairness aside, the big question is how much money the move would bring in to the exchequer. Nobody seems to know for sure, but numbers flying around today have ranged from £100m to nearly £10bn. How can these sums be so dramatically different?

The analysis

In April 2010 Labour raised the tax rate for people earning more than £150,000 from 40p in the pound to 50p. The coalition kept the additional rate system, but cut it to 45p from last April.

According to the latest numbers from the taxman, only 287,000 people earned more than £150,000 in 2013/14, almost exactly 1 per cent of all taxpayers.

The top earning 1 per cent currently contribute just under 29.8 per cent of the total tax paid, up from 20.8 per cent ten years ago. Over the same period the bottom earning 1 per cent have contributed a flat 0.1 per cent of all tax.

That’s not necessarily proof that the tax system is getting more progressive. In part it simply reflects that the richest 1 per cent’s share of total income has gone up too (from 11 per cent to 13.7 per cent over the last decade).

But it does demonstrate the fact that the nation’s top earners are a massively important source of revenue for any chancellor, and tinkering with the way they are taxed carries a risk.

The wealthiest people also happen to be able to afford the best financial advice, and economists tend to assume that a big hike in taxes will lead to a change in behaviour among the intended targets.

This can range from people simply choosing to work less so that their declared income falls short of the tax threshold to people deciding to leave the country.

Then there are legal ways of avoiding tax like shifting income into different tax years to avoid paying a higher rate.

This is exactly what HMRC think many high earners did when Alistair Darling announced he was going to increase the top rate of tax from 40 to 50 per cent from 2010.

We would have expected incomes among top earners to fall in 2009/10 as the recession continued: but they shot up. Then income declared to the taxman crashes suspiciously when the 50p rate comes in.

In a 2012 analysis, HMRC concluded: “Between £16 billion and £18 billion of income is estimated to have been brought forward to 2009-10 to avoid the additional rate of tax. This behavioural response is entirely legitimate, and difficult to prevent using anti-avoidance legislation.”

The result was that the Exchequer scooped significantly less extra tax than the £6.5bn Labour predicted would come in.

The taxman has calculated how much tax was actually paid in 2010/11, based on about 95 per cent of self assessment returns, but of course that number doesn’t tell us how much people would have paid if rate had been 40p.

TIE fighters

The only thing you can do is come up with a theoretical estimate of how much people’s behaviour changes in response to tax hikes, then work out how much you would have got if you had left the rate untouched.

Economists do enormous amounts of analysis on this, then handily turn it into a single number representing Taxable Income Elasticity or TIE. The higher the number, the better people are at avoiding tax.

HMRC suggest a reasonable TIE value in this scenario is 0.45.

This is significantly higher than the last Labour government’s estimate of 0.35, which is a simple explanation of why a lot less tax was raised by the tax hike than Mr Darling was expecting.

The independent Institute for Fiscal Studies and the Office for Budget Responsibility both use TIE values similar to the one favoured by HMRC, suggesting Labour deliberately used an unlikely number to overestimate the expected windfall.

It’s no surprise then the IFS is cautiously supportive of HMRC’s estimate of how much tax will be raised if Labour brings back the 50 per cent additional rate: as little as £100m a year.

David Phillips from the Institute of Fiscal Studies told us: “It’s a sensible estimate. It’s a reasonable estimate. There is a lot of uncertainty around it though.”

So volatile are the mathematics of TIE that a slight variation in the number means amount of tax revenue could vary wildly, from an annual loss of £700m to a windfall of £600m.

Of course, none of these numbers will make a significant dent in the nation’s budget deficit, currently running at about £110bn.

What about Labour’s £9.5bn?

Labour has produced some figures that suggest HMRC’s 2012 analysis is out of date, saying that more recent updates suggest people earning more than £150,000 paid £9.5 billion more in tax than previously thought over the three years of the 50p rate.

But the IFS may have sunk this theory today, saying the research done last year would actually have used figures almost identical to the ones Labour say are new.

David Phillips and Paul Johnson say: “There is little additional evidence to suggest that a 50p rate would raise more than was estimated by HMRC back in 2012.”

They add: “At the moment, the best evidence we have still suggests that raising the top rate of tax would raise little revenue and make, at best, a marginal contribution to reducing the budget deficit an incoming government would face after the next election.”

Mr Phillips told us Mr Balls’ insistence that a return to 50p would only be a temporary measure could also encourage top taxpayers to postpone declaring income until after the measure has lapsed – making it even less likely to rake in significant amounts of cash.

The verdict

It’s not just business leaders who don’t like Labour’s latest idea. The IFS is broadly on the side of the government on this one, although all economists stress the deep uncertainty which underlies this educated guesswork.

The think tank has also put a hole in Labour’s theory that more recent numbers suggest an increased rake for the taxman in the 50p years. Mr Phillips diplomatically puts this down to a “misunderstanding” of the research.