Make it simple

KEY POINTS

• Tax is too complicated.
• Effect on the economy.
• A single income tax.
• Special treatment for pensions.

Anyone wishing to measure the complexity of the UK’s tax system could do worse than count the number of pages in Tolley’s Yellow and Orange Tax Handbooks, which, in between 1997 and 2011, tripled in size to 17,795 pages.

The complexity implied by those numbers imposes considerable costs on businesses and individuals in the UK.

Alleviating the mammoth burden which that complexity places on the British economy was a core objective of the 2020 Tax Commission, an 18-month joint project between the TaxPayers’ Alliance and the Institute of Directors.

Our final report, The Single Income Tax, launched in May, proposes a radical yet necessary change to how the government raises taxes, aimed at making the system cheaper, fairer and legitimate.

The cost of complexity goes beyond the need to employ more expertise to be familiar with more rules and conditions, although the cost of in-house and external tax advice for taxpayers, as well as additional HMRC officials, is significant and growing.

Tax specialists do important work for individuals and businesses, navigating the tax system so that their clients do not pay more than they are required to.

But a large and sustained rise in the number of advisers is surely a symptom of an over-complicated and worsening tax code as much as of an industry becoming more successful in promoting the benefits it offers.

Membership of the Chartered Institute of Taxation has grown every year from 10,115 in 1996 to 15,400 in 2011.

Fear of the impenetrable

The perception of almost impenetrable complexity means opportunities are not exploited because people do not know the extent of tax rules beyond the knowledge that they are complicated.

People price in the risks associated with their ignorance on tax matters when contemplating potential projects.

In addition, complexity has led to the tax system having lost legitimacy as many people do not really understand how much tax they should pay with respect to their own financial affairs, let alone how much others should pay.

That opacity, a direct consequence of complexity, inevitably leads many to suspect others of not paying their fair share. This has manifested itself in the popularity of groups such as UK Uncut and the often misguided media attention on the tax affairs of companies such as Barclays Bank.

In 2011, The Guardian reported that Barclays paid tax of ‘just 1% of its 2009 profits’. Subsequent analysis showed that the pre-tax profit figure used was that of the global Barclays Group rather than the bank’s UK operations, which was compared against UK corporation tax paid.

It was also inflated by including the sale of Barclays Global Investors, a type of gain exempted from corporation tax to avoid tax distorting restructuring decisions.

Once these two mistakes alone are corrected, an effective tax rate of more than 23% emerges, much closer to the then headline rate of 28%. However, by the time the correct information had been released, the damage to the legitimacy of the system had already been done.

Neutral but radical

The more evidence the 2020 Tax Commission heard and the more research and modelling of the system we did, the more we came to realise that tax neutrality had to be the key mechanism to achieve the radical simplification we desired.

Income is now taxed at different stages and at different rates depending on irrelevant factors concerning how it is received by the beneficiary. But how an individual earns his income should not affect his liability for tax on that income.

One hundred pounds should be worth the same to the payee whether it is received in a salary, dividends or an interest payment. The total income of an individual determines his ability to bear the burden of tax, not whether that income is labelled as ‘salary’, ‘dividends’ or anything else.

Taxes should be as neutral as possible. That is why the single income tax proposes to abolish eight that do little more than complicate the system and add confusion as to who actually ends up paying the bill.

Both employer’s and employee’s National Insurance are almost indistinguishable from income tax in their impact on the labour market and their function: to raise revenue.

The ‘insurance’ function implied in the name has steadily been eroded away to meaninglessness under successive reforms.

Meanwhile, capital gains tax is little more than an additional income tax on dividends, albeit one bafflingly levied on the difference in the expected future values between the times of purchase and sale of an asset.

The murkiest of all is corporation tax, which effectively penalises some combination of labour and capital based on the economic efficiency of the company concerned.

The academic literature is mixed on the question of how much of the burden of corporation tax is passed through to labour in the form of lower wages and how much is borne by capital in the form of lower returns on investments, but either way the burden falls on the employee or investor in proportion to how efficient the company is, not the individual’s ability to pay.

Transaction taxes have little relation to the ability of individuals to pay. It is not entirely clear why someone ought to pay tax because he sells his house or shares.

The effect of stamp duties is to slow down markets for surprisingly little benefit to the Treasury: the government expects to collect just £3bn from stamp taxes on shares this year out of total revenues of around £570bn, and just £6.4bn from stamp duty land tax.

Those figures do not account for other tax revenues lost from discouraging share trading in the UK.

At a time when London’s international competitiveness as a financial centre is under question, we can ill afford to harm it with illogical taxes that either do not exist or are much lower in competing financial centres.

While stamp duty land tax is probably less economically destructive, the rates are high and look especially eye-watering compared to the deposit, which for most people is the only bigger cost involved in buying a home. It is also arguably more unfair and comes at a particularly bad time for those who have to pay for it.

Finally, inheritance tax hits families again on the same money they have already paid tax on, just because someone has died.

Cost of a single tax

Instead of that plethora of specific taxes, we have proposed that the burden individuals bear for the cost of running the government should be in proportion to their income, however it is received.

Abolishing all those taxes as well as air passenger duty and cutting fuel duty by 5p would have revenue implications.

Our modelling suggests that for taxes to raise 33% of national income (the share we recommend, approximately the same as Australia’s) a single income tax rate of 30% would be required, after a personal allowance of £10,000, based on 2011/12 prices.

The cornerstone on which so many of the benefits of the single income tax rest is the single rate of 30%. One rate of tax across all income types and levels allows for huge distortions in economic decision-making to be ironed out of the tax system entirely.

It would no longer offer small businessmen a tax advantage to pay themselves through a company in dividends.

Similarly, there would be no reason to try to disguise their income as a family member’s to benefit from a lower rate, beyond the effect of the personal allowance.

Controversies such the question prior to the London mayoral election of whether Ken Livingstone received his income through a company would be rendered meaningless and irrelevant.

Reforms to other taxes

These neutrality advantages are further augmented by our proposals for capital taxes reform: abolishing corporation tax and capital gains tax and introducing a system of tax on income from capital that deducts the entire liability, made up of net distributions to holders of capital, at source.

Doing away with corporation tax would eliminate the inherent bias in favour of corporate debt that has plagued economies with classical tax systems and above-the-line deductions for interest.

Heavily indebted companies would not directly lose out, but they would no longer be advantaged by an artificially low weighted average cost of capital.

Getting rid of capital gains tax would eliminate the distortion in favour of the status quo in ownership of assets.

Capital gains tax often means that people who would otherwise sell assets to buyers who might be in a better position to make use of them, instead keep them because the extra tax outweighs the advantages.

For instance, a business that has grown too large for its founder to manage well might be retained to avoid having to pay tax on the sale proceeds, rather than sold to another businessman with skills better suited to running a larger business.

Without capital gains tax, these decisions would no longer be affected by tax planning considerations.

Perhaps the single most radical element of the single income tax, however, is the tax on income from capital. The idea is that UK companies will be liable for tax on net distributions of capital to shareholders and lenders.

This would in effect be dividends and interest payments less dividends and interest received. In addition, subscriptions to new shares, share buybacks and loan principal amounts would also be taxed or eligible for a credit against tax, depending on which way the cash flows.

This would ensure that only returns to capital are taxed, not the return of the capital itself, while closing off opportunities for tax avoidance by distributing cash through share buybacks.

When these transactions are between two UK companies (such as between a controlled company and its parent), they could be disregarded for tax purposes on both sides of the transaction.

However, to account for new capital coming into UK companies and to handle other transactions where it cannot be certain that all parties are UK companies (such as dividend payments by public companies), we propose that a system of transferrable credits against tax is established.

Transferability is important because it would eliminate artificial incumbency advantages by ensuring that tax becomes a negligible concern for investors who prefer to extract cash from one company to reinvest it in another.

For instance, a company that receives £100 start-up capital from an individual would receive a credit exempting £100 of distributions from tax. That credit could then be traded and, if tax is set at 30%, it should be worth up to £42.85 (because £100 equates to 70% of £142.85).

So a shareholder should be able to extract cash from a company and invest it in another without suffering a tax disadvantage compared to leaving the money for the first company to reinvest.

Safeguards

Five key principles would ensure a robust system. Credits should:

• never result in a cash payment out by HMRC;
• only be used to reduce a tax liability;
• not be issued until after a corresponding tax liability has been settled;
• be divisible at the request of the taxpayer with the corresponding liability; and
• only be issued when the corresponding taxpayer confirms the details of the credit.

To ensure that companies do not pay tax twice on foreign incomes, credit should also be given in respect of tax already paid. For example, if a company receives dividend income of £90 from a foreign country which has a tax rate of 10%, the dividend without tax would be £100.

However, the UK tax would be £30, so an additional £20 would be due. A credit against tax would be issued for £23.33, i.e. ((10/30) x £100) – (£100 – £90), so that only £66.67 of the £90 received would be taxable when it is distributed.

Transitional matters

The recommendations are unashamedly radical. Nonetheless, we believe they are also achievable, realistic and necessary.

They would considerably shrink the size and complexity of the UK’s tax legislation, but there are two important transitional issues which a government implementing the single income tax must address.

The first is the mechanism for abolishing National Insurance. The government’s state pension proposals will remove all but a relatively tiny link in the benefits system with National Insurance.

The remaining contributory benefits can easily be reformed. Some of those losing out will be eligible for non-contributory benefits, while benefits for the others could either be abolished or linked to tax payments instead.

A key issue is to inform employed taxpayers that they already pay employer’s National Insurance. This would require the reform to be phased in two steps.

An initial step would compel employers to state employer’s National Insurance on payslips, add a line called ‘total salary’ that included employer’s National Insurance, and rename it ‘income tax (payroll charge)’.

Only when the effects of that reform have informed the public debate should the charge be fully merged into income tax in a later step.

Pensions

The second transitional issue relates to pensions. While pension funds in general would benefit enormously from the much simplified and reduced burden of tax on capital, those in defined benefit schemes and pensioners whose plans have already been annuitised may risk facing a higher burden of tax without a carefully considered transition.

Two main options exist to ensure pensioners are protected. The first would be to mandate that annuities are increased to offset the new 30% rate compared with the existing basic rate of 20%.

This could be funded by the likely substantial increase in funds’ asset values arising from the abolition of corporation tax, capital gains tax and transaction taxes.

Discarding stamp duty on shares alone would increase the value of the FTSE All Share index by approximately £150bn.

However, such an increase might have to be as large as almost 10% to ensure that every pensioner would benefit, and therefore detailed technical study would have to be conducted to investigate whether it would be affordable.

The second option would be to retain a special exemption for those with already annuitised pensions and perhaps those above a certain age, to include people whose funds are primarily invested in asset types unlikely to increase in value as a result of the changes.

This option might also be necessary to cover income from other sources, such as royalties and self-employment, that currently receive considerable tax advantages.

While some might question the fairness of some groups receiving special advantages over others, it would be especially unfair to increase tax on people who rely on fixed incomes, have planned their affairs under the existing system and who have limited or no ability to alter their plans.

Tax cuts

History has shown that major tax reform must be part of a tax cutting programme. Revenue neutral or tax-raising reforms rarely succeed, as the Chancellor’s recent difficulties with pasties and caravans have demonstrated.

If ordinary families get a tax cut, however, the complexity that has gradually built up in the system over decades can be substantially reduced without being politically derailed by the disgruntled.

The radical neutrality of the single income tax proposals would transform Britain’s tax environment into one of the world’s most competitive: unleashing enterprise and prosperity to revitalise the economy.

That prize, along with the chance to hack the size of our Tolley’s guides back down to size, is too important to lose.

Issue: 4358 / Categories: Comment & Analysis , simplification , Admin , Income Tax