How Rich is Rich?

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How Rich is Rich?

It is not only the rich who pay tax at more than basic rate, says MIKE TRUMAN. Are we sure that the right people are being targeted?

'THAT IS RIDICULOUS,' said the Paymaster General, Dawn Primarolo, in answer to a question from George Osborne on his first appearance at Treasury questions (Hansard, 14 October 2004 at column 406) in his new role as Shadow Chief Secretary. When a politician responds with scathing ridicule, it is normally an indication that a thrust has struck home and the speaker needs time to recover his or her poise. So what did Mr Osborne say to provoke this protestation?

He was putting forward an explanation of why 1.3 million more people are liable to higher-rate tax now, compared with 1997. The reason, he said, was that while average earnings have gone up by 39%, the higher-rate threshold (including the personal allowance) has only gone up by 29%.

The figure of 1.3 million had been given by the Paymaster General in response to a question from one of her own backbenchers, Gordon Prentice. But her explanation of the increase was straightforward:

In response to Mr Osborne she returns to the same theme:

So it's all down to the success of the Chancellor of the Exchequer's stewardship of the economy?

Well, there's some truth in that. Certainly if the economy had not been so robust there would not be so many high earners paying higher-rate tax. But Mr Osborne also has a point. Taxable incomes are governed largely by earnings. If earnings are going up faster than inflation, then increasing the higher-rate threshold only by the retail prices index (RPI) will result in more people becoming higher-rate taxpayers — the phenomenon of fiscal drag.

It's a drag

Jean-Baptiste Colbert, financial adviser to Louis XIV, said (as many readers will know) that the art of taxation 'consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing'. Fiscal drag is an excellent example of low-hiss revenue raising. Adding an extra penny in the pound onto the basic rate would provoke a cacophony; simply raising thresholds by inflation rather than earnings growth attracts little or no attention.

Indeed, a better argument for Ms Primarolo would have been to point to the actions of Conservative Chancellors, who froze the basic rate threshold from 1991-92 to 1994-95. The Institute of Fiscal Studies (IFS) Green Budget 2004, published earlier this year, showed that the number of higher-rate taxpayers rose from 1.7 million in 1990-91 to 2.1 million in 1996-97.

Future trends

Mr Prentice had referred to the IFS paper when asking a supplementary to his question. Was his right honourable friend aware, he asked, that the IFS was forecasting that there would be 4.4 million higher-rate taxpayers by the end of the next Parliament, and was the Government really happy with that?

In fact the IFS figures for 2009-10 are based on a specific assumption about tax policy — that the higher-rate threshold will continue to rise only in line with inflation, and that there is in addition a 2% real growth in incomes. If the threshold were increased in line with earnings, there would be 3.4 million higher-rate taxpayers in 2009-10, only 100,000 more than today. On the other hand, if the threshold were frozen, there would be 5.9 million. Basic-rate and starting-rate taxpayers stay fairly constant under all three assumptions, at around 22.5 million and 4.1 million respectively.

There would be no need for fiscal drag if there were no need for more tax. However, the IFS anticipates the need for a tax increase of around £13 billion by 2007-08, and the ITEM Club, sponsored by Ernst & Young, estimates that the Chancellor is going to be £6 billion short this year on his tax revenues.

The Chancellor has already ruled out increasing the basic or top rates of tax 'within the lifetime of this Parliament,' as the Paymaster General reminded the House in answer to Mr Prentice. He will be under pressure to do so again in the next manifesto, but it is to be hoped that he resists — if tax rates cannot go up, Chancellors just have to find inventive ways of raising taxes when they need more money and the system gets even more complex. But even if he does not bind himself (or his successor) to maintain rates, increasing them will always be a high-hiss strategy. So fiscal drag looks likely to continue, and the number of higher-rate taxpayers looks likely to increase.

Not only the rich

As a result, higher-rate taxpayers will not just be the rich. Mr Osborne mentioned deputy head teachers, police inspectors and warrant officers in the Army as examples of the new recruits to higher-rate taxpayer status. He might have added junior doctors — in recent years some have never been anything other than higher-rate taxpayers from the point they finished medical school, albeit only because they were being asked to work extremely long hours.

So what are the implications of a growing number of 'ordinary' taxpayers facing a marginal rate of 40% — or 41% if National Insurance is taken into account?

The first effect will surely be an increase in the number of people who have to complete tax returns. Our tax system is built on the assumption that the overwhelming majority of people pay tax at basic rate. We deduct tax from interest paid by banks and building societies at the rate paid by basic-rate taxpayers; the tax credit on dividends covers the liability at basic rate; we pay personal pension contributions and gift aid donations to charity net of basic-rate tax. For a basic-rate taxpayer, PAYE will collect the right amount of tax very efficiently, compared with the approximate systems used in many other countries. Higher-rate taxpayers, on the other hand, are unlikely to get their tax affairs right unless they complete a tax return. Good news for tax practitioners, bad news for forests.

How many higher-rate taxpayers are going to be reporting relatively small amounts of bank interest as the only income that has been insufficiently taxed? And is this therefore the right time to be reducing the amount that you can put into a cash ISA to £1,000 a year? Wouldn't a better policy aim be to try and devise a set of rules that lets a taxpayer nominate one account with a ceiling of, say, £10,000 on which interest could be paid tax-free, thus allowing people to have a reasonable, but fluctuating, level of savings without a liability, but not to go on accumulating more cash tax-free year after year?

How many taxpayers keep a record of the amounts that they put into charity envelopes where they tick the gift aid box? Not many. So most higher-rate taxpayers probably underclaim higher rate relief on their gift aid payments. Why should the Treasury benefit from that failure? If it is acceptable for taxpayers to self-certify that they have paid enough tax to frank their gift aid payments, why is it not acceptable for them to self-certify that they are higher-rate taxpayers, and let the charity pick up 67% of the net payment from the Chancellor? There could be a fairly low limit on the amounts that could be self-certified, so that it was used only for occasional and not regular donations.

Is this a sneaky solution to the pensions crisis? A net cost of 60% is bound to be more attractive to a worker than a net cost of 78% — perhaps fiscal drag will increase contributions? But on the other hand, if the current levels of drag continue it won't be too long before a significant number of pensioners are paying higher-rate tax.

Pensioners' margins

For some pensioners, a marginal rate of 40% would be a blessing. For the Liberal Democrats, Dr Vincent Cable pointed out that two-fifths of pensioners are already facing a marginal rate of tax and benefit reduction of more than 50%, and a quarter lose 75% or more of their marginal income. These figures, following the introduction of Pension Credit, are at least better than those which applied before it, but they are still not attractive.

Of course pensioners (or those aged 65 and over, which is not necessarily the same thing) get extra help from the tax system. One area where there has been the reverse of fiscal drag is the level of age allowance. The gap between the age allowance and the personal allowance has steadily widened. Age allowance now stands at £6,830, more than £2,000 higher than the personal allowance of £4,745. However, once income exceeds £18,900 it starts to be reduced, with a resultant marginal rate of 30% or more. Presumably the assumption is that 'richer' pensioners should not benefit from this increased allowance, but does an income of £19,000 or so make you rich — particularly if most of the income of a pensioner couple comes from the occupational pension of one of them?

Indeed, any idea that the UK only has three marginal rates, the starting rate, basic rate and higher rate, is wholly illusory. A personal pension contribution paid by a higher-rate taxpayer with dividend income to cover it will receive 44.5% tax relief, as the 22% basic rate is supplemented by a saving of 22.5% on the dividend. On the other hand, the junior doctor mentioned above probably faces a higher rate of deduction than 41%, because an increase in marginal income means an increase in student loan repayment.

Large numbers of one-earner families are caught in the 70% marginal rates that result from tax credit being withdrawn (see Example). The impact of this seems not to have yet percolated down into the national psyche, but when it does it could have a significant impact on the readiness of the people concerned to take on extra work. There are 2.3 million families where at least one adult is in work, and where a claim is being made for either or both of Working Tax Credit (WTC) or Child Tax Credit (CTC) in excess of the family element.

The adults in these families are the ones facing the 70% marginal rate, but they may not have realised it yet. It is only when the full cycle of provisional award, renewal and amended award has worked its way through that recipients will start asking why they are working overtime if they only keep three pounds in every ten that they earn? Indeed, why are they working full time when they could work part time for not a lot less money? When workers start to draw the logical conclusions from the system they are working under, the rush to part-time work may become unstoppable.

Mr Dependable

As complexity piles on complexity, it's comforting to return to Hansard and see that one Member of Parliament can at least be depended on to make his argument without any regard for his party, his chances of promotion, his audience or, indeed, his own pocket. Step forward the 'Beast of Bolsover', Mr Dennis Skinner:

'If we added on another 2% tax for higher-rate taxpayers, such as MPs, Cabinet ministers, directors and the rest of them, we would be able to pay a pension of £150 to every pensioner. That's another way of looking at it.'

It is indeed…

Example

Family claiming CTC at more than the family element, main earner is liable to basic rate tax and is below the NI upper limit, and has the opportunity to earn £100 gross by working ten more hours a week:

Gross pay for extra hours £100

Less:

Tax 22

NI 11

Reduction in CTC* 37 70

Net increase £30

Effective marginal rate 70%

*The increase in income of more than £2,000 p.a. will trigger a recalculation of the provisional award for the current year at renewal.

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