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THE CURRENT CHANCELLOR of the Exchequer is keen on 10% tax rates. He often suggests that the top rate of capital gains tax on the disposal of business assets is 10% (actually, it is 40% although 75% taper relief might be available). The Chancellor also introduced a 10% starting rate of corporation tax in FA 1999 (with effect from April 2000) in what later led to the non-corporate distribution rate fiasco. This article, however, focuses solely on the 10% income tax starting rate, which was also introduced in FA 1999.
Why a 10% rate?
Superficially, the attraction of having a 10% rate band is that it provides a gentle introduction to taxation for individuals on low incomes, so that the marginal tax cost of earning an additional £1 is initially just 10p. Therefore, taxpayers on low incomes can feel that they are being given some rebate (or discount from the basic rate) to reflect the fact that they are less well off than most. The 10% rate also sits comfortably with the rate of tax payable on dividend income although there is no real need for these two rates to be aligned.
Furthermore, the calculation of the 10% rate does not give rise to too many complexities. Whilst it does add a line or two to a computation, most tax advisers (even in the absence of a computer) would probably not complain about a system that has just three main rates of tax.
Who benefits from a 10% rate?
It would be natural to assume that the 10% starting rate is therefore designed to be of principal benefit to individuals on lower incomes. However, in fact, the opposite is true.
Of course, all individuals with income in excess of the personal allowance are financially better off for paying 10% tax on their surplus income (or the first £2,150 of their surplus income, if their income is sufficiently high), rather than going straight into the 22% rate band (or, for the sake of completeness, paying tax at 20% if this income is non-dividend savings income).
However, an individual with just £1 of income above the personal allowance is saving just 12p (or 10p) whereas anyone whose income takes them into the basic rate band or beyond will find that the starting rate band is worth at least £215 and, in many cases, £258 (ignoring those cases where a person's income is principally from dividends). In other words, the higher a person's income, the more he benefits from the starting rate band.
Is 10% really the first rate of tax?
Furthermore, to talk about a gentle introduction to tax is a little disingenuous. Many taxpayers on low incomes are also in receipt of earned income and (ignoring timing issues) National Insurance contributions will be payable on the same income amounts. Therefore, the headline first rate of tax of 10% is, in reality, very often 21%. If the Chancellor wanted to give low earners a gentle step into the world of tax, removing the link between the National Insurance thresholds and the personal allowance would be much more effective as that would allow an initial effective tax rate of 10% or 11%, depending on whether it was the personal allowance or NIC threshold that was increased.
An unnecessary complexity
Advisers who regularly deal with individuals on low incomes will also be aware of a real practical difficulty caused by the 10% rate band. Pensioners often find that they have modest amounts of savings income (bank and building society interest) over and above their pensions. In many cases, it is this savings income which takes their total income over their personal allowance. Because of this taxable income, they are unable to request that interest be paid gross. Therefore, tax has to be deducted at 20% and, if the individual can negotiate the paperwork, the excess can then be reclaimed by the taxpayer at the end of the tax year.
HMRC have previously publicised a 'Taxback' campaign — it still exists officially — to encourage people to reclaim the amounts deducted by their banks and building societies. Whilst the abolition of a 10% rate would not eliminate the cases of taxpayers overpaying tax on interest income (and not reclaiming it later), it would certainly go some way to reducing the problem.
What is the alternative?
A Chancellor (especially one who is hoping to lead his party at the next general election) would not want to be seen to remove a tax break without offering some form of alternative, especially where the alleged tax break appears to be aimed at those on lower incomes. Therefore, I will now suppose that rather than simply scrapping the 10% band, the Chancellor were to increase the personal allowances.
Suppose, for the sake of simplicity, that to be totally revenue neutral, personal allowances were then able to rise by £1,000. The basic-rate band would therefore now be £32,300 (i.e. £1,000 narrower than at present). Ignoring savings and dividend rates, this would mean that individuals currently in the basic-rate and higher-rate bands would save 10p tax on £1,000, but would pay an additional 12p on £1,150 — a net tax rise of £38. However, an individual on lower income would actually be better off. For example, an individual who currently pays tax on £1,000 of taxable income would gain by £100.
I accept that these savings/tax costs are wholly dependent on the level of increase that is necessary to ensure that any change is revenue neutral. However, they do illustrate the fact that the 10% band is currently being subsidised by individuals on low incomes for the benefit of those on higher incomes.
Personal allowances
Arguably, much of what I have said applies equally to personal allowances themselves, which can be thought of as a nil-rate band (of variable width for different taxpayers). However, the personal allowance system does have the attractions of removing some of the friction in the tax system by keeping individuals with very low incomes out of the system. Furthermore, the fact that the personal allowances system is not perfect does not justify the retention of a 10% band which serves no useful purpose.
Welcome to the tax club!
Despite what I have said above, the 10% band does serve some purpose. Unfortunately, the beneficiaries are the politicians who retain the myth that the 10% band is of benefit to taxpayers and boast of having introduced the lowest headline tax rate in recent times.
Furthermore, the 10% rate also means that more people are paying tax than necessary as a commensurate increase in the personal allowances would take some individuals outside the club of taxpayers. That would be commendable; however, twenty-first century politicians are aware that if you remove people from a particular system, they cease to be interested in matters relating to that system.
For example, if 10,000 people were to be taken out of the 'tax club' because of an increase in the personal allowance, that would mean up to 10,000 people (most of whom are voters) might become both disinterested and uninterested in other fiscal initiatives (such as changes to the ISA rules) that might be announced by the Chancellor.
Summary
I recognise that the public might view the abolition of the 10% rate as a tax hike (as the first headline rate of tax would then be 22%). To adapt a famous cliché, it is not sufficient for a tax break to be given; it must be seen to be given.
However, the 10% rate introduces unnecessary complexity into the tax system. If it is meant to cushion the first imposition of tax, I would suggest that this can be more effectively achieved using the National Insurance rates (my arguments for the abolition of NIC will have to wait for another day). Furthermore, to the extent that the 10% rate does benefit taxpayers, it benefits those with higher incomes more than those on lower incomes.
A Chancellor with a desire to simplify the system and to benefit those on lower incomes would be well advised to consider scrapping the 10% rate band.
Keith Gordon MA (Oxon), FCA, CTA, is a barrister, chartered accountant and tax adviser. He practises from Atlas Chambers (020 7269 7980, www.atlaschambers.com) where he provides tax advice and litigation support for accountants, tax advisers and lawyers. Keith can be contacted by e-mail at keith@keithmgordon.co.uk.
