Tax cuts and tax rises: do tax cuts pay for themselves?

It’s often claimed that tax cuts will “pay for themselves”. There’s good reason to believe that some historic tax cuts have done precisely this – what does that tell us about proposals for tax cuts today?

And what does history tell us about the potential to increase revenues by raising tax on the highest earners?

When tax cuts probably paid for themselves

Margaret Thatcher and Geoffrey Howe cut tax dramatically in 1979.

Thatcher inherited a top rate of income tax of 83% on “earned” income.¹Also, astonishingly, 98% on “unearned” income. I’ll focus on the 83% rate in this article. I would hesitate before applying the approach below to the 98% rate, because the numbers get very silly, and I’m doubtful many people ever paid the 98% rate (because: why would you?).

The 83% rate applied to incomes over £24,000; about five times average 1979 earnings, and twice the salary of a headmaster.²Average earning figures are here. I’ve used the figure for average male earnings; average female earnings were 40% lower, but significantly fewer women were in the workplace than today. In today’s money, around £120,000. It was a high income, but not exceptionally high.

In Howe’s first Budget, the rate was cut to 60%.

Wearing our 2024 spectacles, 83% to 60% isn’t a hugely generous tax cut. But think about what it means in cash terms. £10,000 taxed at 83% leaves you with £1,700. £10,000 taxed at 60% leaves you with £4,000. That’s a 135% increase in your after-tax income (“change in net of tax rate”, in the jargon).

This is a much more dramatic change than for the tax cuts we see discussed in 2024. There is literally no tax cut that could have this kind of impact today. Even cutting the top 45p tax rate all the way down to 1p would “only” increase after-tax income by 80%.

Intuitively, it feels plausible that more than doubling peoples’ after-tax income would have significant effects on peoples’ behaviour. But we can do better than “plausible” – let’s put some numbers on it.

A simple example

Economists talk about the “taxable income elasticity” – the TIE. That’s the degree to which people’s reported income increases as tax cuts leave them with more income after-tax. Why does it increase? Some mixture of incentive effects, reduced avoidance and reduced tax evasion.

Let’s say the TIE in 1979 for people paying the 83% rate was 1. This figure is almost certainly wrong, but it makes the maths easy, and we’ll come back to the true figure later.

And, whilst TIEs are usually applied to the aggregate tax base, i.e. the whole economy, let’s make our calculation simpler by assuming the economy consists of one taxpayer, who has £10k of earnings in the top tax band.³I’m ignoring another factor; Howe reduced the tax bands in real terms – that makes the tax cut even more effective than this simple model suggests.

Applying the hypothetical TIE of 1, then that Thatcher tax cut, with a 135% increase in after-tax income, would result in reported incomes increasing by 135%.

Instead of our one taxpayer earning £10k and paying £8,300 tax, they’d be earning £23,529. Perhaps they work more hours, perhaps they work harder, perhaps they stop avoiding tax or under-declaring income.⁴And in a real “whole economy” approach there would be other factors – increased net migration of high earners, deferred retirement, etc. And of course not all taxpayers paying the top rate of tax are the same – someone earning just a little more than £23,000 would have been very different from someone receiving millions. Either way, they are earning more, retaining more after-tax and paying more tax:

Everybody wins. It’s that rarest thing in economics – a free lunch.

You can download this example spreadsheet here. The “base case” is before the tax cut. The “static” column is with the tax cut, but ignoring elasticities. The “dynamic” column includes the TIE effect (but not other dynamic effects, e.g. economic growth – see below for that).

It’s important to stress that this calculation was purely illustrative – I pulled a taxable income elasticity of 1 out of the air, just because it made the calculation easier.

What would the TIE actually be?

A more realistic example

The problem is that estimating the TIE is hard. It varies between countries, changes over time, and is different for people earning different incomes, and even for people of different ages.⁵There’s a good discussion of these issues in this paper by Saez, Slemrod, and Giertz, see page 40.

There’s an even more important factor: the TIE varies depending on tax policy.⁶See the reference to “loopholes” on page 16 of Saez et al. Let’s say I can pay £50 for a tax avoidance scheme that magically reduces my tax rate from 83% to 60%. The TIE on the Howe tax cut would be enormously high, because all the people previously buying the scheme will now just declare their income.⁷This example is not that far away from some of the tax avoidance schemes that were common in the 1970s and early 1980s.

The TIE has to be inferred from natural experiments created by tax reforms and “kinks” in the tax system. For example, sometimes we see more taxpayers than expected “bunching” at a particular income point, just before a higher marginal rate kicks in (but estimating the TIE from these kind of effects is difficult).

A TIE of 1 is extremely high.⁸Note that I am talking here solely about tax on income – elasticities for some other taxes can be much higher. Stamp duty land tax is an extreme example, given that a person’s decision whether or not to buy a house will in some cases be entirely affected by SDLT. We tend to see elasticities like that only for people on very high incomes – think the top 1% – and in very exceptional circumstances.⁹There’s a good introductory Harvard lecture series on this – see here and here. It is possible that those circumstances applied to the UK 83% rate – I don’t know (and I’m not aware of any evidence on this).

We do, however, have some recent evidence from the UK’s more recent introduction and then repeal of the 50p top rate.¹⁰There is an outstanding House of Commons Library briefing paper on the history of the 50p top rate. HMRC used the resulting data to estimate a TIE of 0.48, but others have come to very different conclusions. ¹¹One might think the UK’s brief 50% top rate was a beautiful natural experiment, but the brevity of the rate means that income effects are dominated by people accelerating their income to before the rate went up, and then deferring it until after the rate went down – the linked IFS paper goes into detail on the attempts to reverse-out these effects.

Here’s a table from the Scottish Fiscal Commission showing the TIE they expect at different income levels, based on the HMRC 50p data and a review of the literature:

So, given we can’t be sure what elasticity applied in 1979, let’s ask the question the other way round. What elasticity would be needed for the Thatcher tax cut to pay for itself, on our modelled £10k of income?¹²Obviously a different and much, much, easier question than “did the Thatcher tax cut pay for itself overall”.

A TIE of only 0.28.

I should stress again that modelling one taxpayer in this way is an extremely simplified approach, but that the numbers are so stark that we can still say it looks very plausible that the Thatcher top-rate tax cuts paid for themselves.

This was, however, an exceptional case for two reasons. First, the effect of the tax cut was very significant (with that dramatic 135% increase in after-tax income). Second, the tax rate, even after the cut, was very high – so a good chunk of the additional income that the tax cut incentivised into existence would itself be paid in tax.

When tax cuts won’t pay for themselves

What if the UK scraps its current 45p top rate?

This would have a much less dramatic effect than Thatcher’s tax cut. A tax cut from 45p to 40p is the difference between retaining £55,000 and £60,000 from a £100k slice of gross income above £125k.¹³Important to remember that 45p is the marginal rate on this slice of income. The overall rate is much less – but it’s marginal rates that matter for incentives, and therefore for tax elasticity calculations. That’s not nothing, but it’s only a 9.1% increase in after-tax income.

We therefore need an exceptionally high elasticity for this tax cut to “pay for itself”. Even an (unrealistic) elasticity of 1 doesn’t cut it:¹⁴Although it comes quite close! See below re. Scotland.

Let’s do something more exciting. What if we adopted a “flat tax”, with everyone paying a 20p rate? So the marginal rate on a £100k slice of gross income above £125k drops from 45p all the way to 20p.

Again, let’s assume an unrealistic elasticity of 1:

The flat tax isn’t even close to paying for itself. Why is that, given the sizeable 45% change in after tax income?

Partly because 45% is still a lot less than 135%. But also because that £45,000 of new income we’ve incentivised into existence is only taxed at 20%. It’s much, much harder for this tax cut to pay for itself than when the rate, even after the tax cut, was 60%.

I should repeat the caveat that it’s woefully simplistic to think of the economy as just one taxpayer but (as before) the numbers are clear enough to make the point.

So the depressing conclusion from this is that what was plausibly true in the 70s and early 80s probably isn’t true today – we shouldn’t expect income tax cuts to pay for themselves in the short/medium term.

There’s no free lunch in 2024.

Is the answer different in the long term?

Perhaps. Whether tax cuts pay for themselves in the long term is a different question, and one that’s highly contested.

Some economists believe the evidence shows that tax cuts in the US led to higher GDP and lower unemployment, with faster effects when the tax cuts benefit those on high incomes. Other economists have found no evidence that tax cuts for those on high income increases growth; conversely, others have found that tax cuts targeted at people on low income can increase growth.

There is also a view that funded and carefully implemented tax cuts may create growth, but unfunded/deficit-funded tax cuts will not.

I’m not an economist and so don’t have a position on these questions. However I would tentatively suggest that the lesson of the Truss/Kwarteng mini-Budget is that either the bond markets don’t believe unfunded tax cuts deliver growth, or they’re not patient enough to wait.¹⁵The outcome of the Truss/Kwarteng Budget tells us nothing about funded tax cuts, but it’s a rare politician these days who proposes to fund tax cuts with either other tax rises, or public spending cuts. Thatcher, by contrast, did fund her income tax cuts. Whilst the cut in the highest rate of income tax probably paid for itself, other income tax cuts (for example cutting the basic rate from 33% to 30%), did not – and they were much more expensive. So Howe’s Budget raised the rate of VAT from 8% to 15%; later tax cuts were partly funded by revenues from oil and gas taxation.

What does the TIE tell us about raising taxes?

The simple spreadsheets above show the position for hypothetical individual taxpayers. They don’t attempt to model the impact across all taxpayers.

You can, however, use the TIE in a more sophisticated calculation to find the “revenue maximising tax rate” – the top income tax rate that will raise the highest amount of tax, based upon assumptions as to the shape of the income distribution.¹⁶If we assume income is flat, the revenue-maximising rate is simply 1 / (1 + TIE), but we shouldn’t assume income is flat.

So, let’s forget tax cuts for the moment, and answer a different question: can we raise more revenue by increasing tax on those on the highest incomes?

One influential paper estimated that, if the TIE is 0.46, then the revenue-maximising tax rate on the highest earners would be 56.5% (see page 102).

An employed¹⁷Employer’s national insurance means the marginal rate is much higher for an employee than someone who is genuinely self-employed, or an investor. high earner in England today pays a top income tax rate of 45%, plus 2% employee national insurance – and their gross wages are subject to 15% employer national insurance.¹⁸That’s relevant because, in the long term, the burden of employer national insurance falls on employees. That’s a total effective rate of 55% – rather close to the revenue-maximising rate.¹⁹One might think the current effective rate is 62% (45% + 2% + 15%) but the employer NI is a % of the gross salary, and income tax and employee NI is a % of the same gross salary number. As an example: imagine a highly paid employee receiving a £100 pay rise. Employer national insurance applies at 15%. There is then 45% income tax and 2% employee national insurance – so employee taxes of £47. So the total tax is £62 (£47 plus £15) out of a total of £115 paid by the employer – a rate of 53.9%. (Apologies for the error in the original version of this article, which said the rate was 54.95%). More if we take indirect tax into account.²⁰Whether we should do that, and how we should do that, isn’t clear to me. Brewer et al uses a 52.7% figure (on page 91) that includes indirect tax, but doesn’t explain where it comes from.

There are a large number of uncertainties – the TIE itself, as well as the assumed shape of the income distribution. So the 56.5% figure should not be taken as a policy absolute – but it does suggest that we should be cautious about assuming that increasing the 45p rate will raise more tax.

The Scottish experiment

The Scottish government is kindly conducting an experiment into what happens if you do go higher than 45p.

In this year’s Scottish Budget, the top rate went up to 48p (from 47p). Here’s the Scottish Fiscal Commission’s figures on how much that will raise:²¹See figure 4.12

Almost all (85%) of the potential revenue from the 48p rate vanishes in “behavioural responses”. This is an extremely inefficient tax increase.

There is still a positive revenue yield from the 48p rate, based on reasonable assumed tax elasticities. But, given how close this is to the break-even point, it wouldn’t take much for the behavioural response to exceed the static revenue. We may well find that elasticities that are reasonable for the UK as a whole are not appropriate for Scotland. Scottish taxpayers have a magical tax planning solution available to them that UK taxpayers don’t. They can leave Scotland, or not return, or not arrive in the first place. ²²These effects will be small, but they are real, and across an economy small effects can matter. And migration is a particularly bad effect for a tax rise to have, because you’re not just losing some marginal amount of a taxpayer’s income – you’re losing all of it. So, as the IFS says, the Scottish top rate of tax may reduce revenue.²³Disclosure: I’m a member of the Scottish Government’s Tax Advisory Group, but we were not involved in the decision to raise the top rate.

We should know the result of the Scottish experiment in a few years’ time.

Is it just about the numbers?

Of course some people believe high taxes on those on high incomes are justified for reasons other than tax revenue – for example to reduce inequality by reducing the after-tax incomes of people on high incomes.²⁴There is also a deeply counter-intuitive view that higher taxes can encourage entrepreneurship. Others believe that we shouldn’t be trying to maximise tax revenues, but rather maximise economic growth²⁵i.e. because when we are the Scottish point of extremely diminishing returns, some of the tax revenues “lost” to behavioural effects represent real lost economic growth or welfare. Some believe that high taxes are not very effective at reducing inequality. And of course some believe that high taxes are immoral per se.

My take is that, if you want to raise more tax from people on high incomes, you should not do so by raising the top rate of income tax, but focus on the base – for example capital gains tax. And if we want tax cuts, we have to fund them.

Photo by Levan Ramishvili, identified as public domain.

• 1
  Also, astonishingly, 98% on “unearned” income. I’ll focus on the 83% rate in this article. I would hesitate before applying the approach below to the 98% rate, because the numbers get very silly, and I’m doubtful many people ever paid the 98% rate (because: why would you?).
• 2
  Average earning figures are here. I’ve used the figure for average male earnings; average female earnings were 40% lower, but significantly fewer women were in the workplace than today.
• 3
  I’m ignoring another factor; Howe reduced the tax bands in real terms – that makes the tax cut even more effective than this simple model suggests.
• 4
  And in a real “whole economy” approach there would be other factors – increased net migration of high earners, deferred retirement, etc. And of course not all taxpayers paying the top rate of tax are the same – someone earning just a little more than £23,000 would have been very different from someone receiving millions.
• 5
  There’s a good discussion of these issues in this paper by Saez, Slemrod, and Giertz, see page 40.
• 6
  See the reference to “loopholes” on page 16 of Saez et al.
• 7
  This example is not that far away from some of the tax avoidance schemes that were common in the 1970s and early 1980s.
• 8
  Note that I am talking here solely about tax on income – elasticities for some other taxes can be much higher. Stamp duty land tax is an extreme example, given that a person’s decision whether or not to buy a house will in some cases be entirely affected by SDLT.
• 9
  There’s a good introductory Harvard lecture series on this – see here and here.
• 10
  There is an outstanding House of Commons Library briefing paper on the history of the 50p top rate.
• 11
  One might think the UK’s brief 50% top rate was a beautiful natural experiment, but the brevity of the rate means that income effects are dominated by people accelerating their income to before the rate went up, and then deferring it until after the rate went down – the linked IFS paper goes into detail on the attempts to reverse-out these effects.
• 12
  Obviously a different and much, much, easier question than “did the Thatcher tax cut pay for itself overall”.
• 13
  Important to remember that 45p is the marginal rate on this slice of income. The overall rate is much less – but it’s marginal rates that matter for incentives, and therefore for tax elasticity calculations.
• 14
  Although it comes quite close! See below re. Scotland.
• 15
  The outcome of the Truss/Kwarteng Budget tells us nothing about funded tax cuts, but it’s a rare politician these days who proposes to fund tax cuts with either other tax rises, or public spending cuts. Thatcher, by contrast, did fund her income tax cuts. Whilst the cut in the highest rate of income tax probably paid for itself, other income tax cuts (for example cutting the basic rate from 33% to 30%), did not – and they were much more expensive. So Howe’s Budget raised the rate of VAT from 8% to 15%; later tax cuts were partly funded by revenues from oil and gas taxation.
• 16
  If we assume income is flat, the revenue-maximising rate is simply 1 / (1 + TIE), but we shouldn’t assume income is flat.
• 17
  Employer’s national insurance means the marginal rate is much higher for an employee than someone who is genuinely self-employed, or an investor.
• 18
  That’s relevant because, in the long term, the burden of employer national insurance falls on employees.
• 19
  One might think the current effective rate is 62% (45% + 2% + 15%) but the employer NI is a % of the gross salary, and income tax and employee NI is a % of the same gross salary number. As an example: imagine a highly paid employee receiving a £100 pay rise. Employer national insurance applies at 15%. There is then 45% income tax and 2% employee national insurance – so employee taxes of £47. So the total tax is £62 (£47 plus £15) out of a total of £115 paid by the employer – a rate of 53.9%. (Apologies for the error in the original version of this article, which said the rate was 54.95%).
• 20
  Whether we should do that, and how we should do that, isn’t clear to me. Brewer et al uses a 52.7% figure (on page 91) that includes indirect tax, but doesn’t explain where it comes from.
• 21
  See figure 4.12
• 22
  These effects will be small, but they are real, and across an economy small effects can matter. And migration is a particularly bad effect for a tax rise to have, because you’re not just losing some marginal amount of a taxpayer’s income – you’re losing all of it.
• 23
  Disclosure: I’m a member of the Scottish Government’s Tax Advisory Group, but we were not involved in the decision to raise the top rate.
• 24
  There is also a deeply counter-intuitive view that higher taxes can encourage entrepreneurship.
• 25
  i.e. because when we are the Scottish point of extremely diminishing returns, some of the tax revenues “lost” to behavioural effects represent real lost economic growth