Why has the government considered scrapping the top rate of tax in recent months?

The government has spent a considerable amount of money in its fight against the coronavirus pandemic. From the furlough scheme to the cost of buying PPE and developing the Track and Trace system, the Treasury has had to shoulder a significant burden.

According to figures from the BBC, the government had to borrow more than £321 billion to cover the cost of these measures in the 2020/21 tax year. With this in mind, it might be surprising to hear that there have been proposals for significant tax cuts in the near future.

One unusual suggestion is to abolish the highest level of tax, as some economic theorists suggest this might be a useful way to boost both the economy and the Treasury’s coffers. Read on to find out why and what it would mean for you.

Cutting taxes may boost consumer spending, stimulating more economic growth

The cost of the government’s pandemic measures has far outstripped the Treasury’s ability to pay for them. Due to this, they have been forced to borrow large amounts to cover these expenses.

Of course, while this can be useful for meeting their short-term obligations, it isn’t a sustainable solution. For a start, the significant interest that the Treasury pays on these loans will pose an additional problem down the line.

Therefore, the government may have to think outside the box for new ways to stimulate the economy and in doing so raise their tax revenue. To accomplish this, cutting taxes might help.

The most obvious benefit of doing this would be that people have more money to spend. This rise in consumer spending could help companies to grow and hire more staff, increasing employment and generating even more economic activity.

As the economy becomes healthier, businesses see higher profits and workers enjoy better wages. This means that, in the long term, the government receives more tax revenue.

Of course, the economy is rarely as simple in practice as it is in theory, but this is the basic logic behind cutting taxes to stimulate growth.

However, there is also another reason why this can lead to more income for the Treasury and it explains why the government plans to cut the top rate of tax.

Supply-side economists argue that slashing taxes can actually boost government revenue

While it enables the government to provide important services, nobody likes having to pay tax. This is why one of the problems with raising rates is that it reduces people’s incentive to work, which can often lead to a fall in tax revenue.

This is the basis of the “supply-side economics” school of thought. One of its most famous proponents, the economist Arthur Laffer, argued that the relationship between tax rates and actual government revenue isn’t linear but rather curvilinear, as you can see on the simplified graph below.

Source: Investopedia

As you can see, when the tax rate is 0%, the government receives no income. Conversely, when it’s set at 100%, there is no incentive for people to work and so there will still be no revenue.

This economic theory argues that past a certain point (represented by the T* on the graph), increasing taxes is self-defeating, as doing so actually reduces people’s incentive to work.

This is why there have been suggestions that removing the additional rate could provide a major economic boost for the country. Not only would high-earners be able to spend more of their hard-earned money but cutting tax rates can also provide an incentive for greater economic production and activity.

If they did scrap the top rate of tax, the government may raise money through other means

If you earn more than £150,000 a year and the government chose to scrap the top rate of tax, the most obvious consequence would be that your tax bill would fall. However, while this may sound like good news, it’s important to remember that the move may affect you in other ways.

Even though the proposal would increase government revenue over time, in the short term it could lead to a large fall. Since further borrowing could be highly unpopular at a time when people are already being squeezed by the rising cost of living, they may have to raise money in other ways.

For example, the government may freeze more of their tax allowances. This would mean that as wages rise, the Treasury would see an increase in their revenue due to fiscal drag. As a result, even though you might save money on your Income Tax bill, your wealth would still be eroded in other ways.

If you want to avoid this happening, it’s important to be able to make informed decisions, which is where seeking professional advice can help.

Working with a planner can enable you to manage your wealth in a more effective way, allowing you to minimise the impact of any potential allowance freezes. This can help you to feel more confident that you’ll be able to meet your long-term financial goals.

Get in touch

If you’re concerned about the prospect of future allowance freezes eating into your wealth, we can help. Email enquiries@bowmorefp.com or call us on 01275 462 469.

Please note:

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

Bowmore Financial Planning Ltd is authorised and regulated by the FCA

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