Tax System and Inequality-UK

THE TAX SYSTEM IS MAKING THE UK MORE UNEQUAL

Changes in the UK tax system since the 1970s have contributed to a 30% rise in inequality – but this trend is reversible. That is the central conclusion of research by Keshab Bhattarai, presented at the Royal Economic Society’s 2013 annual conference.

The study looks at the Gini coefficient for after-tax income in the UK – a measure of distribution ranging from from 0 (perfectly equal) to 1 (all income in the hands of one person). It finds that in the 1960s, the UK was one of the most equal countries in the world with a score of 0.25. Now, the score is as high as 0.38 after a series of reforms to the tax system since the 1970s aimed at making the UK economy more dynamic.

The research then seeks to understand the effects of different policies on income inequality in the UK and forecasts what might happen if the direction of taxes and government spending were to change. It argues that:

  • Very high rates of income tax are harmful for growth and actually make the income distribution more unequal.
  • More equal distribution does not necessarily lead to higher welfare if the cost of more equality is lower economic growth.
  • Excess public spending is harmful for growth, but more public investment in production raises the productivity of capital in the private sector.
  • Lump-sum taxes of household income are more efficient than taxes on inputs in production.

The study concludes that with the right changes to the tax system it would be possible to generate sustainable growth and bring the Gini coefficient down to 0.29. The author comments:

‘It is ironic that the UK is turning into an economy with more unequal distribution of income after a series of reforms in the tax and transfer system that started in the late 1970s.

‘These reforms intended to correct distortions and to send right signals through relative prices to all consumers, producers or traders to make UK economy more flexible, efficient and dynamic.

‘But they turned out to have unintended consequences leading to greater disparity of income among households’.

More…

The UK was one of the most egalitarian countries in the world in 1960 with the Gini coefficient of post-tax income at 25.1%. This was a cumulative outcome of reforms in the tax transfer system that had its roots in the peak phase of industrialisation when the UK was leading the global economy.

It is ironic that the UK is turning into an economy with more unequal distribution of income with Gini coefficient as high as 38.3% after a series of reforms in the tax and transfer system started in late 1970s. These reforms intended to correct distortions and to send right signals through relative prices to all consumers, producers or traders to make UK economy more flexible, efficient and dynamic. But they turned out to have unintended consequences leading to greater disparity of income among households.

Despite a large body of research assessing the impacts of the tax and transfer system on the choices and welfare of households and firms and on the patterns of growth and inequality in the UK economy, very few studies are based on results of a fully specified dynamic general equilibrium model of the UK economy where the intertemporal choices of those households and firms are influenced by the sequence of the tax transfer distorted relative price system.

Heterogeneity in households and firms are not found in sufficient details in the applied dynamic macroeconomic or macroeconomic models available in literature needed to evaluate patterns of growth by sectors and the distribution of income and consumption simultaneously based on the optimal choices of households and firms who follow the signals of the relative price system in allocating their scarce time and resources.

By studying the evolution of the whole economy with these details, it is possible to evaluate the long-run consequences of various policy alternatives to find the most efficient path to make UK one of the most dynamic, egalitarian and fair economy in the world in the next century as it was in 1960s as the dynamic price based mechanism connects optimal paths of consumption, saving, leisure and labour-supply to the optimal size and space of investment, technological progress and the accumulation capital stock across various sectors of the economy.

A large scale dynamic general equilibrium model calibrated to the micro-consistent dataset contained in the input-output table of the UK economy for 2009 provides a great picture of the equilibrium process in all commodity and factor markets and is very helpful to study the emerging structure and the path of the distribution of income and consumption in the next century with the time-series of Gini-coefficients from model solutions which take account of current and anticipated policy choices to come.

The idea of size and proportions of the various sectors in the evolving economy generates quantitative intuitions that are crucial in forming the long run vision about the economy and are helpful in designing price based mechanism to promote the welfare of households with revenue neutral or other reforms of the tax transfer system.

Very high rates of the labour and capital income taxes are harmful for growth and make distribution worse. More equal distribution does not necessarily lead to higher welfare when the economy does not grow. Excess public consumption is harmful for growth but greater amount of public investment in production enhances productivity of capital in the private sector.

Lump-sum taxes of household income are more efficient than taxes on inputs in production. It is possible to generate sustainable growth and bring the Gini coefficient down to 29% by a careful choice of direct and indirect taxes.

ENDS


Contact:

Keshab Bhattarai: 01482 463207, 07932 854651 (K.R.Bhattarai@hull.ac.uk)

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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