Round up the usual suspects

Much fun has been had with George Osborne's tale of his "shock" at discovering that the rich pay on average only 10% in tax on their income, with the Captain Renault clip from Casablanca being given an extensive airing. The suggestion is that the chancellor is a hypocrite, not only because he is well aware of the scale of tax avoidance but because he benefits from "tax planning" himself.

According to the Daily Telegraph, "Osborne is now determined that millionaires will have to pay tax of more than a third of their earnings". Coincidentally, Barack Obama has now come out in favour of the "Buffett rule", which will mean that US households earning over $1 million a year will pay at least 30% in tax. On the face of it, they appear to be heading in the same direction.

US median earners (the "middle class") pay an average of 16% in federal income tax. It's important to bear this in mind when considering Obama's call for a 30% minimum for millionaires. Also, the top 0.1% in the US pay an average of 26% in federal income tax. This is a massive drop from the 51% they paid in 1960, but it means that the Buffet rule is going to have only a limited impact on most of the rich. Their pips will not squeak. The real target are the minority of this minority (those earning over $100 million a year) who aggressively avoid tax and pay only 18%. It is this, combined with many millionaires paying the full top rate of 35%, that pushes the average down to 26%.

The historical trend in the US saw tax rates on the rich plummet after Reagan came to power, stabilise under George Bush senior, move back up under Clinton (but not too much), and then drop again under Bush junior. Obama's 30% target represents a Democrat concession that taxes on the rich will not return to pre-Reagan levels.

Despite this, there is little chance the Buffet rule will be implemented this side of the presidential election. It is a rhetorical commitment by Obama and marks the opening salvo of his head-to-head with Romney, the Republican candidate who has admitted to paying only 14% tax in 2010. The key point is that Obama wants the very rich to pay at least double the amount of federal income tax that median earners do. Romney will presumably argue to keep them where they are.

The UK figures are broadly comparable. Median households (earning about £26,000) pay 15% in income tax (after allowances) and those earning over £1 million a year pay about 36%. Given that the latter should have been paying income tax at 50% on most of their earnings, this average indicates a lot of avoidance. You'd have thought Osborne might have spotted this before now. UK national insurance contributions add roughly 7% for median earners, tapering off for higher earners.

In the above distribution, a near-vertical line indicates a highly progressive tax impact, a horizontal line a regressive impact - i.e. where the tax rate does not increase along with the quantum of income. While tax is largely progressive for most people, it becomes less progressive above median incomes. If you add in the impact of lower rates for capital gains and dividends, plus the regressive nature of VAT, the line becomes even flatter.

Osborne like Obama feels the rich should pay their fair share, but what is a "fair share"? The problem with 33% is that this looks unfair to the top rate payer, whose whole income is taxed via PAYE at up to 40% or 45%. Remember, in the Obama example, the discount for the rich playing by the rules is only 5%. The UK equivalent would be 7-12%. My suspicion is that we're being softened up for a top rate of tax close to 35% - i.e. the higher rate to be cut from 40% and the additional rate (now 45%) to be either reduced to 40% or abolished altogether.

The policy of the government, in cutting tax rates for the rich while attacking avoidance loopholes, is being sold as one of even-handedness. The cynical will note that the anti-avoidance campaign is focusing on issues that generate a lot of noise (e.g. capping charitable tax relief), rather than issues that might generate a lot of revenue (e.g. abolishing UK tax havens). A third degree reading is that we're seeing the resurfacing of the old dream of a flat tax regime.

No UK politician would dare to advocate this publicly (unlike in the US), so the appearance of a progressive system is maintained by the use of two rates, a basic rate and a top rate. The upper threshold for the basic rate is slowly decreased (it's going down from £35,000 to £34,370 this year) in line with the increase in the tax-free allowance. This pincer movement means that the range of income over which the basic rate applies will gradually shrink, and thus more median earners will find themselves paying the top rate.

While a lot of this will be paid for through cuts in public expenditure, the numbers will only add up if the total tax take doesn't shrink as the top rate goes down. This will not be the result of the Laffer Curve working its magic, but because more earners will be subject to the top rate, and because indirect taxes, notably VAT, will remain high as a proportion of household expenditure.

The ultimate strategy, for which the LibDems are as responsible as the Tories, is to divide the population into three classes: a bottom 25% who don't pay tax at all, 25% on the basic rate, and 50% on the top rate. Moving more median earners into the top rate band might appear counter-productive, but it means you are growing the potential support for cuts to the top rate. Reductions in the top rate are then sold as a quid pro quo for extending the bottom end of the band, though the greatest beneficiaries will obviously be the richest at the top end of the band.