How cuts to marginal income tax could boost the UK’s stagnant economic growth

The British prime minister recently claimed the UK economy has “turned a corner”. Rishi Sunak said inflation figures were encouraging, and proclaimed that 2024 would be the year Britain “bounces back”.

According to his chancellor, Jeremy Hunt, the latest GDP figures show the government’s plan is working. And it’s true that inflation is at its lowest rate for two years, which indicates some easing of the cost-of-living crisis. But prices are still rising, and average incomes have seen limited growth for nearly 20 years.

The broader UK numbers are not very encouraging either. GDP per person has grown by 5.6% since 2007, an annual increase of less than 0.4% a year. In comparison, for the 17 years before 2007, it had grown by 45%, an annual increase of 2.8%.

Growing the economy means more jobs, higher household incomes, and higher standards of living. The clear absence of growth for over a decade has been widely felt.

The median UK household has seen an increase of 9.6% in its disposable (after-tax) income since 2007, which works out at just 0.7% a year. For the lowest earners, this figure is less than 0.2%.

The global financial crisis, Brexit and COVID have all contributed to lower economic growth across most of the world, which results in weak growth in incomes and tax revenues.

So how can incomes for everyone be increased?

Marginal income tax rates

One area worthy of investigation is marginal income tax rates, and the effects they have on the economy. The UK has what’s known as a progressive income tax system, in which the rate you pay is divided into various bands.

When we talk about marginal tax rates, we mean the tax you pay on the next pound you earn. For example, if you earn £51,000, the tax you pay on the next pound earned is £0.40. This means you are paying a marginal tax rate of 40%. It’s different to the average tax paid across your income as a whole. (Rates are different for people living in Scotland.)

But in some circumstances, people whose income level causes them to lose valuable financial benefits, such as child benefit payments or their tax-free personal allowance, can be left facing marginal tax rates way beyond even the highest income tax bracket of 45%.

Research indicates that high marginal income tax rates reduce the financial incentive for people to work more or seek better-paid jobs. People often feel the extra effort or risk is not worth the smaller increase in take-home pay. They would be seeing a cut in their hourly rate, after all.

The higher the marginal tax rate, the stronger the effect. And it doesn’t just affect people moving towards salaries of £50,270 (where the “higher” tax rate of 40% starts) or £125,140 (threshold for the “additional” tax rate of 45%).

In the UK, high marginal income taxes affect even those who receive state benefits. People claiming universal credit see the amount they receive reduce dramatically for every pound they earn beyond their zero-tax personal allowance of £12,570. In some cases, by the time their universal credit payment has been tapered down, people can be hit with a marginal tax rate of over 70% on these earnings.

Similarly affected are people subject to the high-income child benefit charge, where parents or guardians earning more than £60,000 pay some of their child benefit back via a self-assessment tax return. Like universal credit, the amount is on a sliding scale depending on how much they earn (up to £80,000, when they effectively stop getting child benefit). These people can end up paying a marginal income tax rate of more than 50%, while anyone whose tax-free personal allowance is reduced due to their high income level can face a marginal income tax rate of 60%.

Examples like these create a disruptive economic effect, or “distortion”. Put simply, this means there is a significant difference between the cost of employing someone and what that employee actually receives. This difference affects incentives, reducing levels of employee effort and ultimately restricting economic growth.

In contrast, research indicates that “consumption taxes” – taxes on buying things, such as VAT – have a much lower impact on GDP than income taxes. So, one could argue that changes to these two types of taxation – an increase in VAT and a cut in marginal income tax rates – could be beneficial for disposable incomes and the wider economy.

Higher growth, higher incomes. Reducing marginal income tax rates could be the way to go. wk1003mike/Shutterstock

In growth we trust

But a further question then emerges. How is it good for the economy if your income increases, but at the same time consumption (buying stuff) becomes more expensive?

The answer lies in the fact that households can do one of two things with any income they receive. They either spend it or invest it.

The investment could be directly into business (for example, a sole trader could invest in machinery or equipment for their work) or indirectly through shares and bonds (in an ISA, for example). Or it could simply be by depositing money into a bank as savings, which can then be lent to other businesses.

A cut in VAT makes consumption cheaper, so households will spend more on buying things and less on investment and savings. This reduced investment makes the economy less productive in the longer term, which then means less growth and lower wages.

A cut in personal income taxes, on the other hand, increases incomes without affecting the relative price of consumption and investment. This means it does not make one option cheaper or more expensive relative to the other. So households spend more on both consumption and investment, and the latter again has a positive impact on wages and incomes over the longer term.

So, after years of stagnant growth, the government should consider reducing the UK’s high and distortionary marginal income tax rates to stimulate growth. This could be done through reducing the tapering rates applied to benefits (universal credit, child benefit and personal allowances), as these create the highest marginal tax rates. Generating more growth will in turn lead to higher incomes. And if additional tax revenue is needed, raising VAT is always an option.

This strategy might be politically controversial, but it makes no sense to deter people from earning more. Despite the recent talk of “bouncing back”, the UK’s economic situation still requires changes that are bold.