The government should tax income from all sources under the same rate to tackle the “unfair” and “problematic” bias within the UK’s tax system, according to the Institute of Fiscal Studies.
In a new 160-page report on the UK’s tax system, the IFS said the parts of the structure that dictated how different forms of income were taxed were “not fit for purpose” and created a “large, unjustified and problematic bias” against employment and labour incomes.
The IFS said: “The tax treatment of returns to investment is a mess: incentives vary depending on the asset type, source of finance and legal structure involved and range from large subsidies to large penalties.
“And this is just the start; the list of problems is long. Some problems are high profile and periodically subject to tinkering. Others are so baked into the system that they are generally overlooked, yet are no less problematic.”
Reasons for reform
The report, entitled ‘Taxing work and investment across legal forms: pathways to well-designed taxes’, concludes that taxing income differently depending on “legal form” — different types of workers — creates a range of problems: unfairness, economic inefficiency, lost revenue and administrative burden.
Under the current structure, people generating the same overall level of income can attract very different tax bills, according to the legal form in which they work.
Although often discussed in the context of low-income self-employed workers, the IFS said income from business and the tax benefits that come with it — such as capital gains, dividends and partnership income — accrued disproportionately to the top 1 per cent of taxpayers.
It said: “For example, the average income of a partner working in the financial services industry is £308,000, and that income will attract £20,000 less in each tax year than if the same job were performed by an employee.”
The IFS also argued that by distorting a range of decisions, by encouraging people to make decisions based on tax benefits, the system reduced society’s aggregate output and well-being.
Such decisions included the move to become self-employed alongside a consumer’s levels of investment and risk-taking.
According to the report, government revenues are reduced substantially by providing reduced tax rates for business owners, relative to that which would be levied if they were employees — to the tune of £15bn a year.
And the current system produces extra administrative burden on the taxpayer and the taxman, the IFS said, as boundaries in the structure create the need to devise, administer, comply with and police rules to distinguish the different legal forms.
Road to fixing it
The IFS argued the two goals of tax policy — taxing all income the same and not discouraging saving and investment — can be achieved by taxing income from all sources under the same overall marginal rate schedule and reforming the tax base.
It said: “It is aligning overall rates – including all layers of tax – that matters.
“There are many combinations of rate changes that could achieve this and, overall, tax rates could be levelled up to current employment tax rates, levelled down to current capital tax rates, or set somewhere in between.”