Are tax rates primarily determined by war?

A new book puts forward this controversial thesis—but the evidence doesn’t quite stack up

April 14, 2016
The City of London's skyline. ©Dominic Lipinski/PA Wire/Press Association Images
The City of London's skyline. ©Dominic Lipinski/PA Wire/Press Association Images
Taxing the Rich: A History of Fiscal Fairness in the United States and Europe, Kenneth Scheve and David Stasavage, Princeton University Press, £22.95 Thanks to Panama and its papers, the rich and the tax they do (or don’t) pay is back at the top of the news agenda. Even before the details of thousands of off-shore accounts, companies and investments emerged, the issue of what tax the rich should pay had recently returned to the centre of political debate for the first time since the 1980s.

Dealing with offshore tax havens is as much a matter for international cooperation as it is for domestic policy. But debate about them clearly influences how people view tax rates domestically—as the seamless transition from discussion of avoidance to discussion of inheritance tax proved this week.

In the UK we’ve seen a row about whether the top rate of tax should be 50 or 45 per cent generate more heat than any debate around much bigger tax rises or indeed cuts. While in the US, Bernie Sanders wants to see a return to top tax rates nearing 55 per cent at the same time as Ted Cruz (the “moderate” Republican extremist) argues for a flat rate of income tax set at just 10 per cent.

So this is a good time to discuss a new book­—subtly entitled “Taxing the Rich”—from Kenneth Scheve of Stanford and David Stasavage of New York University. Riding the Piketty trend of political economy books with levels of data more common in academic journals, the volume navigates two centuries to explore when and why countries have chosen to tax the rich. Importantly this is not a narrow tax policy book; it draws as much on history and political theory as it does on econometrics. John Stuart Mill and Ronald Dworkin are as central here as James Mirrlees.

So it’s a complex book—but one with a very simple conclusion: high rates of income (and inheritance) tax for the richest households seen across the middle part of the 20th century were not driven by the arrival of universal suffrage, left wing parties winning elections or rising inequality.

Instead they were the product of two World Wars that required mass mobilisations of populations to fight them, lending huge force to what Scheve and Stasavage call the “compensatory argument” for taxing the rich. This is the argument that tax policy should be used to compensate for less equal burden sharing or unjustified differences in outcomes between individuals for which the state bears responsibility. This strong manifestation of a compensatory argument was that, just as the state was requiring huge sacrifices of those conscripted to fight, so too the income and wealth of the nation should be conscripted to win the war and then in time to build the peace.

Figure one provides an illustration of this in relation to the UK and US. It shows top marginal income tax rates rising rapidly through the two world wars. The top rate in the UK was 8.33 per cent in 1914, but stood at 60 per cent in 1920—a level that was inconceivable pre-war. An even sharper jump from seven per cent to 77 per cent occurred in the United States, with most other active combatants that mobilised on a similar scale recording similar tax hikes.

The wars and their aftermath totally transformed politics and debates about what top tax rates should be. But they have not stayed there. The book goes on to note the significant decline in top tax rates world-wide since the 1970s.

In explaining this decline the authors argue it was less to do with Ronald Reagan or Margaret Thatcher’s political genius, or indeed globalisation, and more to do with the weakening over time of war-based arguments about equality of sacrifice. Those on the left in many advanced economies were stuck with woolly arguments about fairness which, lacking the power of strong compensatory arguments, were outgunned by the idea that people deserve to keep more of the reward for their hard work. The result was all marginal tax rates above 40 per cent being abolished in the UK in 1988, and similar reductions in the US.

We should note (and the book does) that there is a complex relationship between the top marginal rate of tax and whether the rich are actually paying less tax overall. In the UK, despite the big cuts in top tax rates over recent decades, the share of total tax (direct and indirect) accounted for by the richest ten per cent of households has been on a steady upward trajectory—from 20 per cent in 1977 to around 27 per cent today (see the blue line in figure two).

But, before we all start worrying about a stealth squeeze on the top, Figure two also shows that this increase has been driven almost entirely by the fact that the top ten per cent have also accounted for an increasing share of income. Indeed, as the red line shows, the importance of the richest ten per cent to the Exchequer has increased even as the tax burden they face has actually fallen slightly to a fairly consistent 35 per cent over the past 20 years.

In its big picture argument the book is convincing: on both the correlation and nature of causality between wars that required the mass of working people to sacrifice not just their labour but also their lives; and on the imposition of higher tax rates on the rich in the 20th century.

But just as the strength of its argument comes from that big picture focus across the last century, so it leaves something to be desired for those of us trying to understand what is happening right now. Unless you’re expecting World War III, the book doesn’t focus on what might drive more incremental changes in the tax that is paid by different groups in society today. And in the end those incremental changes are the main bread and butter of political debate, as the 50p tax debate in the UK has shown.

For example the book rather discounts the impact of the 1909 People’s Budget which introduced graduated supertax (a tax in addition to the basic rate), with tax on the richest rising from five per cent to 8 per cent. Such a 60 per cent rise is a very big deal, and it followed big increases in inheritance tax in 1907. Understanding what leads to changes of that sort even in the absence of war is more directly relevant to the debates we face today.

Indeed the focus on the big picture of what leads to huge increases in top tax rates also leaves the book slightly understating what has occurred in recent years in the aftermath of the financial crisis, at least here in the UK. The authors are sceptical that similar structured arguments about equality of sacrifice can be used today because only a small fraction of the wealthy directly benefitted from state bail outs—arguing that “it is not clear why Silicon Valley should be taxed just because Wall Street was bailed out.”

They are clearly right that we are not in a situation remotely analogous to a major war, but they do understate the use of compensatory arguments today and prevalence of the anti-elite mood post-recession. Remember the political centrality of “we’re all in it together,” the huge fall in living standards experienced since 2008 and the widespread view even before the Panama papers that the rich operate by another set of rules to the rest of us.

It also does not quite match the experience in the UK of recent years. Yes some taxes have gone up that affect lower income families since 2008, especially VAT in 2011, but the balance of arguments and actually implemented tax rises has focused on taxes that affect the very richest. Not just a higher 50p top rate of tax (brought in in 2009, later repealed), but big reductions in pensions tax relief for top earners, removal of personal allowances for those earning over £100,000, and a (now partially reversed) increase in capital gains tax.

As Figure three shows, in contrast to the picture for the top ten per cent of households, the tax burden (focusing just on income tax this time) faced by the top one per cent of individual taxpayers has risen since the financial crisis in the UK. A flat effective tax rate of just under 35 per cent pre-crisis underwent a steep change with the introduction of the 50p rate, with a subsequent partial reversal following the reduction to 45p. As a result, the top one per cent’s contribution to total income tax revenue continued rising post-crisis, even as their share of gross income fell slightly.

But before we conclude that the British state has suddenly become very progressive, remember that while the tax rises may have disproportionately affected the very richest, tax cuts are overwhelmingly benefitting the top half of households. At the same time, significant benefit cuts are taking billions away from those on low and middle incomes. It’s definitely not progressive—but it probably feels like it is if you’re in the top one per cent.

Looking to the future, the big question is whether the tide is already turning on the forces that led to the incremental increase in taxes on the very richest in recent years. You might think the move from a 50p to 45p top rate shows this has already happened, but a strong counter argument is that we still have a 45p rate despite a clear wish by the party of government to cut it to 40p.

Thankfully, we’re not talking about a return to income tax rates of over 90 per cent anytime soon. But don’t be surprised to see more developments in this area—particularly in relation to wealth. Property taxes are already rising up the political agenda. In the Scottish elections currently underway, plans from all major parties to slightly increase taxes on more expensive homes are centre stage. The UK government has also opened the door via higher stamp duty rates on expensive homes. There’s also a strong case for reversing cuts to capital gains tax in the recent Budget—a call that would rally fiscal policy wonks and tax fairness campaigners alike.

Even in the absence of war, arguments about the rich paying their fair share in the aftermath of the great recession don’t quite seem done and dusted.