Dynamic Benefits Therefore, the task is to find the MTR schedule that maximises social welfare, however defined. Before doing so, we will illustrate some simple examples. E.2.2 Earnings-only elasticity: illustrations assuming flat taxes To illustrate the interaction between tax rates and behaviour under the Mirrlees assumptions, we will demonstrate how the tax take can be maximised using a flat tax rate. The following graph shows the different tax takes (on the Y-axis) that would result from different levels of flat taxes (X-axis), given different earnings elasticity assumptions (also assuming for the moment that the decision to become employed in the first place is unaffected by the tax rate). A flat tax is a simple model as it gives a constant marginal tax rate. For each elasticity assumption, there is a flat marginal tax rate that would maximise the overall tax take.2 Figure E.2 Tax Take for different flat tax rates – ‘Earnings-Only’
Tax revenue
Laffer Curves £900,000
Earnings Elasticity of 0.05
£800,000
Earnings Elasticity of 0.2 Increasing elasticity
£700,000 £600,000 £500,000 £400,000 £300,000 £200,000 £100,000 £0
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‘Flat’ tax rate
Given the range of earnings elasticities that have been observed in the UK labour market, we find that: Up to a point, the higher the tax rate, the lower the post-tax earnings, but the greater the tax take. (The maximal tax-take is represented by the high point of each line.) The greater the elasticities, the lower the marginal tax rate at which tax take is maximised, and the lower the overall available tax take. However we must consider a world of varying MTRs across earnings. E.2.3 Earnings-only elasticity: variable tax schedules When tax rates can vary across earnings, there are a number of further effects:
2
330
Based on a population of 1,000 households with earnings of £1,000 when there is no tax.