Estimating the size and nature of responses to changes in income tax rates on top incomes in the UK: a panel analysis

In April 2010 the UK's marginal rate of income tax above £150,000 was increased from 40% to 50%, affecting the highest-income 0.66% of the adult population (and 1% of income taxpayers). This would seem an ideal opportunity to obtain an estimate of the taxable income elasticity, but identification is impeded by forestalling (individuals bringing forward income to the year before the tax rate was increased) resulting from the reform being announced more than a year in advance. In this paper we use panel data methods in an attempt to strip out the impact of forestalling, and estimate the underlying taxable income elasticity of those affected by the 50% tax rate, and thus the revenue-effect of the reform. In particular, we develop a new method of correcting for forestalling by averaging income over the (three year) period during which forestalling is likely to have taken place. This approach yields an estimate of the taxable income elasticity of 0.31, lower than earlier estimates by HMRC (2012) based on the same reform (but a different method), and consistent with the 50% tax raising around £1 billion a year (relative to the current 45% rate). Three things are worth noting, however. First, is that estimated elasticities are very sensitive to changes in specification, and to the inclusion or exclusion of a small number of individuals with extremely high (and volatile) incomes. Second, at the same time the 50% rate was introduced, restrictions were placed on the amount of pension contributions some taxpayers could deduct from their taxable incomes (in advance of more general restrictions in place from 2011–12). Those forced to reduce their pension contributions (or unable to increase them) would have higher taxable income than they would have if these restrictions were not put in place: this may downwardly bias our estimate of the taxable income elasticity. Indeed, our estimates of the elasticity of broad income (before personal pension contributions are deducted) are higher – 0.71 using the same method. Finally, it is worth noting that the panel approach adopted here, by focusing on individuals who are observed both pre- and post- reform, excludes some forms of response (such as migration). Taken together, these three issues imply that higher figures for the taxable income elasticity (including those in HMRC, 2012) are plausible. Thus it is also plausible that the re-introduction of the 50% could reduce revenues somewhat: an elasticity of 0.71 would imply a reduction of around £1.75 billion if none of the lost income tax or NICs revenues were recouped from other tax bases or in other time periods. We also explore in more detail the nature of the response to the 50% tax rate. Two findings stand out. First, when we restrict our sample to those just around the £150,000 threshold, we consistently estimate the taxable income elasticity to be between 0.1 and 0.2, implying that behavioural response to the higher tax rate is concentrated among those with the very highest incomes. Second, we find little evidence that individuals responded to the higher tax rate by increasing use of tax deductions. However, this must be a tentative conclusion as not all deductable items are recorded on the tax return data available. Particularly relevant in this context is the possibility that owners of closely-held incorporated businesses chose to respond to the 50% tax rate by retaining income in their business, for extraction at a later date (perhaps in the form of capital gains rather than dividends). Analysis of such responses would require the linking of personal and corporate income tax returns, which is a subject for future research.