During the last couple of weeks there have been conflicting assessments of the priorities for income tax cuts in the UK. A group of economists argued for scrapping the 50p top rate on the grounds that it is undermining national competitiveness and growth prospects. Others, including many Liberal Democrats, have argued for reducing the incidence of basic rate taxation through raising the income threshold at which the 20p tax rate kicks in. Here are three simple arguments in favour of prioritizing lower effective tax rates for low income groups:
1. The ongoing austerity measures intended to eliminate the structural budget deficit by 2015 are inevitably regressive given that low income groups are more dependent on state provided services. Prioritizing tax cuts towards the lower end of the income distribution would help offset this.
2. In response to the sluggish performance of the UK economy, partly linked to the conservativeness of fiscal policy, monetary policy has been extremely lax and has taken the form of bank rate at an effective lower bound for an extended period and asset purchases financed via quantitative easing. Although these measures have no doubt helped to achieve some rebalancing from public to private demand, they have not compensated for the increase in inequality due to fiscal policy. Instead, they have exacerbated such trends. The historic lows in interest rates have transferred billions from savers such as pensioners to wealthier homeowners that maintain a leveraged asset portfolio. The Bank of England's asset purchases have raised the profitability of large corporations and benefited those that have a stake in them via equity ownership or employment, but have not filtered through to those with lower down the wealth and income scales. Prioritizing tax cuts seems appropriate compensation.
3. The bleak outlook for GDP growth is partly due to a less positive outlook for equilibrium output following supply-side shocks, but also due to weaker than anticipated convergence on equilibrium due to deficient demand. Concentrating tax cuts on low income groups is an effective strategy for boosting effective demand given the much higher consumption propensity amongst this group. Through improving the GDP outlook, this kind of tax cut may well improve the budget position through a reverse paradox of thrift.