Should we squeeze the rich or leave them alone?

Before we address the heated question of tax policy and the super rich, let is start with a question......

In fiscal year 2010-11 how many people in Britain earned more than £1 million a year? Before you answer, here are three background facts. First, there are 31.5 million income tax payers in the UK. Second, their total tax liability was £159 billion. Third, the average nnual payment for all tax payers was £5,220.

So what is your answer? Well, according to the Office of National Statistics, the number is just 13,000. Their tax liability, on the other hand, was a little more impressive. Again, in 2011, it amounted to little over £12 billion. A tidy little sum, but still only a fraction of the total economy-wide income tax liability.

What does this tell us about tax policy? Should the Chancellor squeeze these big earners with a higher income tax rate? Or should we leave them alone?

It is this group that the leftists have in mind when they proffer a “soak the rich” alternative to austerity. The argument is by taxing this miniscule minority of super rich, we can pay for a first-class health service, a generous benefit system and ample subsidies for climate friendly start ups. The Right, on the other hand, counter that these are the wealth creators. If the rich are overtaxed, incentives are blunted, and ultimately economic growth is diminished. If the tax rate is really punitive, the super rich will pack up and go, leaving Chelsea and Kensington to be reclaimed by Chavs.

Neither of these arguments are terribly convincing. Even if the rich were taxed at the rate of 100 percent, the UK would still have an unpleasantly large fiscal deficit. While the rich earn telephone number salaries, there aren't enough of them to cover the difference between government expenditure and tax revenues.

As for the incentives argument, the vast majority of these super earners are working in the financial sector. The staggering growth of the banks and other financial institutions certainly contributed generously to UK GDP prior to 2007. Once the crash was underway, the costs of the bail out and the repression have meant that the UK economy gave back everything it gained from finance during the heady days before Northern Rock and Lehman. Moreover, the household and corporate sectors are now deleveraging massively. As the financial sector shrinks, consumption and investment will be constrained. The financial sector will impose a terrible burden that could weigh upon GDP growth prospects for at least a decade.

So, taxing the rich will not solve our problems, but neither will it make them any worse. The UK's fiscal difficulties are much more intractable. Rather than start with unhelpful rhetoric about the rich, it is more useful to think about the size of government. Currently, government expenditure is almost half of GDP. Taxation also claims a fearful amount of national output, but it's more in the region of 40 percent of GDP. In other words, public expenditure is massive, the tax burden is oppressive, and we still can't balance the books.

Prior to the crisis, the headline numbers didn't look quite so bad. However, dig into the details and we quickly find some deeply disturbing trends.

On the expenditure side, health and education spending were growing alarmingly. On the tax side, revenues became heavily dependent on financial services, asset price growth, and housing transactions. This vulnerability became painfully evident as soon as the financial crisis began. From the autumn of 2007 onwards, tax revenues fell down a dark hole. That tax revenue model isn't coming back any time soon.

Does the UK public want a government that spends half of national output? Overall, it appears that they do, especially when one considers that it was health care, pensions, and education that drove the public expenditure to GDP ratio upwards to 50 percent. Is the public prepared to allocate 50 percent of national income to taxation? Unfortunately, the answer seems to be no. We want the services but we don't want to pay for them.

This is why discussions about tax policy have homed in on the 50 percent tax rate for the rich. If the rate goes up or down or stays where it is, it won't seriously affect fiscal outcomes. It is a phony war; a largely irrelevant discussion that neatly avoids addressing the deeper and more painful issues. What should be the optimal size of government? And are we really serious about paying for public services in a sustainable way?