Incentive to work vs revenue from a higher rate

The last government introduced a 50% income tax rate on taxable earnings over £150,000. The aim was to raise more tax revenue by making the rich pay more.

This is a well established principle of progressive taxation. However the trend has been to reduce direct tax rates because of the disincentive effect this has on workers.

The 'Laffer curve' describes how as tax rates rise the government gains a higher tax revenue. As tax raises, however, some people begin to think that working is no longer worthwhile and start to reduce their working hours. Eventually this effect becomes so strong that raising the tax rate even more leads to lower government revenue. The increased tax rates add less to government revenue, due to the higher proportion of income being paid tax, than the loss of revenue due to people opting to work less.

It is very difficult to find the tax rate where the government maximises its revenue but also keeps the labour supply sufficiently high for the economy to grow.

Many people are making a lot a of noise about the "temporary" 50% tax rate and saying that it is already holding back growth. Their argument is basically that the disincentive effect has already kicked in.

The counter argument is, of course, equity. The less well off would have to pay an unfair proportion of the cost of the collapse of the banks and the resulting deficit. Further many might say that having the chance to pay 50% tax is quite a good position to be in!

The Guardian covers the story here