Where wealth resides: Canary Wharf in London © Bloomberg

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With an end to the pandemic in sight, policymakers’ minds are turning to replenishing Covid-depleted government coffers. That will be no small undertaking. In the UK Budget this year, the government said its borrowing in 2020-21 would be £355bn — the highest since wartime.

So where is the money going to come from? The rich have had a “good pandemic”. Many ultra-wealthy people saw their fortunes grow considerably in 2020 and the professional classes who have held on to their jobs have suffered comparatively little in financial terms (they may even have improved their own balance sheets because they are spending less).

Talk of tax rises is common — and there is a growing appetite for taxing the wealthy, which has been out of favour since the 1970s. In the US, the Democrats control all three branches of the federal government for the first time since the early Obama years. The Biden administration is planning the first major tax hike since 1993, which will include higher taxes on higher earners. Meanwhile, Argentina has already passed a one-off levy on the wealthy.

But this raises a wider question — what level of tax of is “right”? Income tax rates in both the UK and the US are at historically low levels. The key period is the 1980s when, under Reagan and Thatcher, the top US and UK rates fell precipitously, although they have since increased. The average top income tax rate for OECD member countries fell from 62 per cent in 1981 to 35 per cent in 2015, according to an IMF blog.

Of course, higher-rate income tax is not the only tax that targets the rich. There is also capital gains tax, some property taxes, luxury taxes and so on. Finally, there is talk of a wealth tax.

In December a group of UK academics known as the “Wealth Tax Commission” proposed a one-off tax on total assets. One figure bandied about was 5 per cent on everything over £500,000 for an individual (or £1m for a couple) to be paid over five years. Rishi Sunak, the UK finance minister, has said repeatedly that this will not happen. But even if it does not, there is a good chance tax rises that affect the better-off will.

The arguments against progressive taxes on wealthier people are well-known: tax people less and you incentivise wealth creation. You prevent wealthy people from becoming tax exiles and stop money fleeing offshore; if you give the rich more, they spend more and everyone is richer.

The Reagan era was characterised by low taxation © AP

This thinking, as espoused by the economist Arthur Laffer, was popularised under Reagan and has proved remarkably persistent, despite considerable evidence that tax cuts do not work this way.

The latest such evidence comes from the London School of Economics. In December it released a study looking at 50 years of tax cuts across 18 OECD countries. The conclusion was that cuts did not lead to significant increases in competitiveness or GDP. Rather, the main thing they led to was greater inequality because the top 1 per cent captured nearly all of the gains.

“Our research shows that the economic case for keeping taxes on the rich low is weak,” said one of the authors.

Those who advocate higher taxes note that countries such as Sweden do not seem to suffer from a lack of dynamism, and that the postwar decades were high-tax, high-growth.

And higher tax rates rarely result in mass exoduses. When the UK briefly raised the top rate to 50 per cent a decade ago, some wealthy people, such as the financier Guy Hands moved. But many stayed put, perhaps deciding it was worth paying a bit extra to live in London rather than Guernsey.

In fact, the level at which marginal tax rates become an overall negative may be remarkably high. In 2012, two economists, Peter Diamond at MIT and Emmanuel Saez at Berkeley produced a paper arguing that the ideal top rate for society as a whole was 73 per cent.

As for the rest, the idea that cuts for the rich produce more economic activity than those for the poor (who almost certainly will spend them) is questionable at best. Here it is worth remembering that the term “trickle-down”, which is widely used to describe supply-side economics, was (probably) coined by the humorist Will Rogers in a 1932 newspaper column on the shortcomings of President Hoover.

A related issue is the idea, popular in conservative libertarian circles, that philanthropy from the (lightly taxed) rich can replace some of the work of taxation. Exhibit A here is often the Gates Foundation, which has given away more than $50bn since its inception. Yet, although many charities do fine work, philanthropy as a substitute for government spending brings problems of its own.

Bill Gates’ foundation has given away more than $50bn, but philanthropy as a substitute for government spending throws up ethical problems © AFP via Getty Images

One is that billionaires can pick and choose their causes in a way that governments cannot.

You may be very happy with the Gates’s charity work. But you may be less keen on philanthropists who fund causes such as climate-change scepticism. More generally, philanthropy tends to benefit charismatic causes such as the arts and the environment over less charismatic ones such as alleviating poverty and poor health.

A further problem here is that allowing philanthropy to take over from taxation is another way of ceding power from the state to the wealthy whose influence is already cause for concern. The comedian Henning Wehn summed this up neatly in 2019 when he said: “We don’t do charity in Germany. We pay taxes.”

This article is part of FT Wealth, a section providing in-depth coverage of philanthropy, entrepreneurs, family offices, as well as alternative and impact investment

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