TaxJan 27 2021

Govt urged to sort out 'mess' of investment taxes

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Govt urged to sort out 'mess' of investment taxes
Credit: Chris Ratcliffe/Bloomberg

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.”

The IFS suggests an increase on the tax rates levied on the receipt of income from business, such as increasing rates on self-employed NICs to align with the overall rate of employee and employer NICs, to do so.

A “neutral” tax base would also need to be created, the IFS said, to remove disincentives to save and invest and scrap the distortions between different types of assets and finance.

Options to achieve this included a ‘cash-flow’ approach — giving 100 per cent up-front tax deductions for all savings and investments and then tax all incomes when they are received — or a ‘deferred-allowances’ set up, which would provide a stream of annual tax allowances for a risk-free return to money saved or invested.

The backdrop

The chancellor of the exchequer is looking at a £300bn hole in the public finances after spending soared last year as the government tried to save jobs and businesses amid the coronavirus crisis.

In July last year, Rishi Sunak commissioned a review into the structure of capital gains tax, asking the Office of Tax Simplification to consider the overall scope of the tax and the rates which apply as well as the reliefs, exemptions and allowances.

The OTS recommended an overhaul which would see capital gains rates more aligned with income tax, their annual allowance reduced and the ‘uplift on death’ removed. Such a move would bring in an estimated £14bn of extra revenue to the exchequer.

imogen.tew@ft.com

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