Tax Increases Cost You Less Than You Think

Many British taxpayers expect to pay more – often a lot more – when income tax and VAT rates increase than they actually do. That is the central finding of new research by Professors Norman Gemmell and Oliver Morrissey and Dr Abuzer Pinar, published in the February issue of the Economic Journal. More importantly perhaps, when people are asked which tax-raising option they prefer, mistakes in their tax-cost calculations make it more likely that the ''wrong'' – more costly – tax option will be preferred.

The research looks at answers to questions on tax perceptions and tax preferences in the British Social Attitudes Survey (BSAS) to examine how accurately people assess how much any increase in tax rates would cost them, and whether this affects the taxes they would prefer the Chancellor to increase.

The research reveals that:
· People are more likely to overestimate how much a tax increase will cost them than they are to underestimate the cost – and the majority get their estimates wrong.
· Less than a third of taxpayers accurately guess how much an increase in VAT will cost them (to within £50 a year). But more than half overestimate the cost and less than 20% underestimate.
· People''s perceptions of the cost of tax increases are more accurate for income tax than for VAT: more than 40% are correct in estimating how much an increase in income tax will cost them. Nevertheless, almost 40% overestimate the cost of an increase in income tax and only 15% underestimate.
· Given the choice between a one percentage point increase in VAT, 1p in the pound on the basic rate of income tax and 5p on the top rate, a clear majority of people – 59% – favour the last option. A VAT increase is the least favoured option (chosen by 10%), while 30% choose the basic rate rise.
· People who overestimate their income tax liabilities are more likely to prefer a VAT increase to the 5p income tax increase. Equally, correctly identifying that you would have a higher liability under the income tax rise makes it more likely that you would prefer VAT. For example, those on higher incomes show a clear tendency to prefer the VAT increase to the increase in the higher rate of income tax.
· Though many seem to make mistakes in their tax calculations, Labour voters or those who say they favour redistribution, at least seem capable of identifying correctly that VAT is the least likely tax option to achieve that, while the 5p income tax option is most likely to deliver.

What might explain people''s widespread misperceptions of the impact of tax rises? If you were asked how much a one percentage point increase in VAT would cost you, you would probably guess about 1% of what you spend. But
some of the items you buy are not subject to VAT and you may forget to deduct any savings.

And while people seem to have a better understanding of the costs of income tax, it appears that the complexities of the system cause a significant proportion to overestimate the cost. As with VAT, the immediate way to guess the cost of an extra 1p in the pound on the basic rate would be to guess 1% of income, but this would lead to overestimates.

Do these misperceptions matter? Quite possibly if they influence people''s tax preferences, especially at a time when with large recent rises in government borrowing, commentators are increasingly asking whether the Chancellor will soon have to raise tax rates and, if so, which taxes he will choose. The research indicates that people are less likely to express a preference for a tax if they overestimate the cost. But this is only one factor influencing
preferences, and probably not the major one. Income is very important: those on higher incomes are more likely to favour an increase in VAT than in income tax because they believe (correctly) that it would cost them less.

Working in the other way, preferences for redistribution strongly affect tax preferences – so people are more likely to prefer increasing the top rate of income tax rather than increasing either the basic rate or VAT. This is consistent with self-interested preferences as the majority of people are not liable to the top rate of income tax.

In simple terms, people prefer increases in those taxes that they do not pay or, if they are liable, those taxes that they believe are less costly to them. An increase in VAT or the basic rate of income tax would elicit more opposition from the public than it should, because people tend to overestimate the cost to them of these tax increases, and because what they prefer is for higher rate taxpayers to bear the burden.

''Tax Perceptions and Preferences over Tax Structure in the UK'' by Norman Gemmell, Oliver Morrissey and Abuzer Pinar is published in the February 2004 issue of the Economic Journal. Professors Gemmell and Morrissey are in the School of Economics at the University of Nottingham, University Park, Nottingham NG7 2RD; Dr Pinar is at Ankara University.

Norman Gemmell

chief economist at New Zealand Treasury