The British Experience: Less Tax and More Income

During the global financial crisis, public pensions in Lithuania were cut to reduce further strain on the government budget. The Lithuanian government is now considering backpaying these pensions. Possible sources of public pension offset are mainly discussed in three ways: higher taxes, spending cuts, and privatization of state property.  

Shamelessly, another potential source is often ignored: tax cuts. We see this in the United Kingdom, which has successfully implemented new policy that ensures more revenue for the state budget.

Cut taxes – increase revenues

In 2010, the Labor-led government increased the upper personal income tax rate from 40 to 50 per cent. This rate applied to annual income above 150 thousand pounds (about 630 thousand litas) and more. The conservative-led government criticized excessive taxation and last year reduced the tax ceiling from 50 to 45 per cent. It then said the budget would lose about 100 million pounds (about 420 million litas).

The official forecasts on consequences of the tax cut did not materialize. The actual results were shocking, but not for the reasons anticipated. During the first year of tax reduction, the budget was supplemented by a stunning 9 billion pounds (about 38 billion dollars), rather than declining. Where did the money come from? The British tax payer. The total rose from 40 to 49 billion pounds, according to the highest progressive tax rate paid by the personal income tax (PIT) for the period of one year. Therefore, the PIT rate reduction of 5 per cent increased total tax income by 23 per cent – almost a quarter. Increased tax income allowed the crop on taxes for low wage earners as well.

How can tax cuts increase tax revenue?

The famous American economist Arthur Laffer examined the relationship between tax rates and tax revenue, and demonstrated his findings in a curve now named after him: the Laffer curve. It shows that there are cases when tax rises can increase tax revenues, but in the same way, tax increases can also reduce tax revenue.

How is this possible? As Laffer noted, a tax rate change always has two consequences: arithmetic and economic. Arithmetic consequences account for a reduction in tax revenue, which economic consequences take into account that a tax reduction creates more incentives for to work, produce, and employ more staff – actions which positively affect the whole economy. “The arithmetic effect always works in the opposite direction than economic,” Laffer said. “So, when aggregated arithmetic and economic consequences of changes in tax rate, the tax effect of changes in tax revenues are no longer so obvious.”

One of the most important things that determine the impact of taxation in the economy, and the revenue collected from tax, is a tax reduction of volume. If two different rates are deducted the same, the impact will be more pronounced at a higher rate reduction. It will mostly affect economic incentives to work and create wealth.

Lithuania rewarding a reduction in social insurance contributions

If we apply Laffer’s insights on Lithuanian tax system, what action would have the best outcome? Lithuania has one of the largest social insurance contributions – accounting for almost 31 per cent of earnings. Many try to avoid paying contributions by choosing to work illegally. As shown in a 2014 survey conducted by LFMI, a fifth of the labour market is in the shadow economy.

However, to talk about the budget of state social insurance contributions is unpopular when we have a deficit in this area. Some politicians even fear the imposition of social insurance contribution ceilings, while the Ministry of Social Security and Labour agree. The introduction of a so-called premium ceiling would make short losses for social insurance, but this will result in positive economic impact: an incentive to raise wages, create better-paid jobs, and boost foreign investment in Lithuania. It is estimated that the total loss of the budget would not be a dreaded billion, but rather, about 40 to 60 million litas.

Perhaps Georgia could inspire our politicians by their example. A decade ago they radically reduced social security contributions from 31 to 20 per cent. The result was an overwhelming success. In the first year of the reduction, revenue rose 45 per cent.

Lithuanian politicians fear that the positive results of a tax reduction may not be apparent immediately. Adverse short-term effects have to be dealt with here and now. This attitude is equivalent to the low-skilled workers fear that increasing his qualifications will result in a reduction in his income (although only temporarily) during the training period. This is also the case of the national budget. Without compromising, the shadow economy will remain strong and the country will suffer from poor incentives to work and create wealth. The United Kingdom, Georgia, and other countries have shown that reducing excessive taxation has tangible benefits. How long will it take for us to learn from these examples? The sooner we do, the sooner we will all benefit.