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Canary Wharf: Piketty's proposals to tax the rich would actually increase wealth and income inequality by squeezing low-earners (credit: Ray Wewerka)

Most readers of Standpoint will by now be aware of Professor Thomas Piketty and his best-selling book, Capital in the Twenty-First Century.

His thesis is that the long run return on capital is always higher than the growth in output (r>g). The wealthy are able to save and accumulate wealth faster than others earn wages, in proportion to r-g, and the result is a spiral of inevitable inequality. The belief that free markets spread wealth more fairly is exposed as a myth inspired by misunderstanding the destruction of assets in the wars of the 20th century. Although inequality is not quite at pre-1914 levels, it soon will be thanks to high executive salaries that will found the next generation of mega-fortunes. The only way to save capitalism from itself, says Piketty, is to reintroduce punitive income tax and a new global wealth tax. This analysis is backed by 500 pages of charts, tables and relatively engaging prose.

Let us put Piketty's proposals to the test. William is chief executive of Norton Corp. He is paid £350,000, which at present is taxed thus:

Headline salary: £350,000
£32,000 @ 20 per cent tax: (£6,400)
£118,000 @ 40 per cent tax: (£47,200)
£200,000 @ 45 per cent tax: (£90,000)
Take-home pay: £206,400
Effective tax rate: 41.0 per cent

(Income bands have been rounded, and national insurance contributions ignored, for simplicity. As someone earning above £150,000 William is not entitled to a personal allowance.)

Norton Corp is discussing a salary increase for William to £500,000. If the UK tax system were unchanged that would leave him in the following position:

Headline salary: £500,000
£32,000 @ 20 per cent tax: (£6,400)
£118,000 @ 40 per cent tax: (£47,200)
£350,000 @ 45 per cent tax: (£157,500)
Take-home pay: £288,900
Effective tax rate: 42.2 per cent

This doesn't capture the full picture. Norton Corp, as his employer, can claim William's salary as a deductible business expense, reducing the profits liable to corporation tax. So the extra £67,500 tax paid by William would be offset by a saving for the company of 20 per cent on the salary increase. But it still leaves the Exchequer better off by £37,500.

There, in a nutshell, is the justification for moderate income tax rates: it encourages value to move from being taxed in companies at 20 per cent to being taxed in the hands of individuals at 40 per cent/45 per cent. This is associated with the Laffer Curve, the thesis that there is an optimal tax rate which maximises revenue because a higher rate encourages avoidance and a lower rate raises less. According to taste this can be buttressed by arguments that people like William merit high pay as a reward, or need to be encouraged to work harder, but the foundation is all about cash-flow for the state.

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