I recently wrote about the Institute for Public Policy Research report, ‘Just tax: Reforming the taxation of income from wealth and work’. At first glance, at least, it was pretty revolutionary. Avid readers will recall that the report contained two main tax proposals:
- Capital gains should be taxed as income, with the annual exempt amount reduced to a de minimis £1,000 and most reliefs abolished, other than for principal private residences. The IPPR calculated that this could raise £65bn between 2021/22 and 2024/25, assuming no indexation allowance or rate of return allowance was built in.
All income (including dividend and savings income – and capital gains) should be taxed at the same rates. These rates should combine income tax and National Insurance contributions and rise gradually from 2 per cent at about £8,600 (replacing the personal allowance) to 50 per cent at £100,000. This structure would be revenue-neutral but would create 80 per cent winners and 20 per cent losers, with the crossover at about £45,000 of income.
Examining the IPPR proposals from the perspective of how we have arrived at the current UK tax system shines an interesting light on the IPPR’s radical ideas. Here’s our thinking at Technical Connection on what we consider to be the highlights, if you will, of the proposals:
Taxing capital gains at income tax rates
This idea has already been tried over a period of 20 years. When Nigel, now Lord, Lawson cut the top rate of income tax to 40 per cent in the Conservative government’s 1988 Budget, he replaced the traditional 30 per cent capital gains tax rate with income tax rates (then 25 per cent and 40 per cent), but left the indexation allowance in place. Gordon Brown supplemented the indexation allowance with taper relief in the late 1990s, while keeping tax rates matching those of income tax.
In 2008 another Labour chancellor chose to simplify what had become horrendous CGT calculations by scrapping both the indexation allowance and taper relief in favour of a single CGT rate of 18 per cent. Two years later George Osborne added a 28 per cent rate for higher and additional rate taxpayers, bringing back an indirect link to income tax levels. With various rate tweaks since, that basic structure has remained in being – we currently have 10 per cent for basic rate taxpayers and 20 per cent for higher and additional rate taxpayers but with those rates being 18 per cent and 28 per cent for gains on residential property and carried interest.
Removing the CGT exemption on death
The IPPR seems to have overlooked the fact that the Office of Tax Simplification examined just this option in the second part of its simplification review, published in July. The OTS stated: “The main potential disadvantage is that, assuming there were no changes to existing CGT allowances, many more people would be brought into a charge to tax on death than are currently subject to inheritance tax.”
Based on 2015/16 data, such a change would increase the number of estates paying tax from 24,500 (IHT) to 55,000 (CGT) and raise £1.3bn, assuming that principal private residence relief was applied. With the IPPR’s proposed £1,000 de minimis figure, reporting numbers and tax raised would both be higher.
Combining income tax and NICs
This is a proposal that has such obvious appeal that it is regularly floated. In 2001, Gordon Brown made a useful start by bringing the threshold for NICs into line with the personal allowance. However, this simplification only lasted until 2008.
From then on, the political spotlight fell on ‘taking people out of tax’ (but not NICs…), and the primary threshold and personal allowance drifted ever further apart. Today there is a gap of £3,868 between the two. By the time income tax bites, an employee will have already paid £464 of NICs.
Since 2008, the primary threshold for NICs and the personal allowance have drifted ever further apart
In his 2010 review of the UK tax system for the Institute for Fiscal Studies, economist Sir James Mirrlees said: “Maintaining separate systems yields little benefit… integration would underline the illogicality of most of the current differences between the two taxes.” In the following year’s Budget, George Osborne announced a consultation on a long-term merging of the two. Five years later the OTS published a paper on ‘The closer alignment of income tax and national insurance’. The seven recommendations the paper made remain just that, recommendations.
A merging of income tax and NICs raises many difficult issues. The IPPR solved one by saying the same rates would apply to all income, although it notably mentioned only savings and dividends as examples. The word ‘pension’ does not make it to the IPPR document, but it is one to which politicians, as opposed to thinktank members, would be extremely sensitive. In the 2017 Election, 77 per cent of those aged 60-69 and 84 per cent of those aged over 70 voted against a national average of 69 per cent.
There is another political aspect which harks back to the focus on the personal allowance: the Great British public has a poor understanding of NICs and generally does not see it for what it is, ie a form of earned income tax. This has allowed successive chancellors to play a smoke and mirrors game: income tax receipts rose by 82 per cent between 2000/01 and 2018/19, while NI receipts increased by 125 per cent.
Tax rates and bands
There can be very few informed people who would argue that the current system of tax bands and tapering or cliff-edge allowances represents a rational design. Today’s income tax structure is the result of various chancellors’ clever tweaks, often seemingly designed with obfuscation in mind and then left to fester. The tapering of the personal allowance is a classic example – the near doubling of the allowance since 2010 has expanded the size of the band in which a 60 per cent marginal rate can apply, from £12,950 to £25,000.
Few informed people who would argue that the current system of tax bands and allowances is a rational design
The IPPR solution is a system of incrementally increasing tax rates, although the proposed scale is not fully detailed. The IPPR argues this approach would avoid, “tax cliffs [which] can distort economic behaviour.” While there is some truth in this assertion, the tax cliff is more theoretical than real when considering earned income because of the matching of the upper earnings limit for NICs with the higher rate tax threshold, currently at £50,000.
The significant cliff edges are due to those chancellor tweaks, like the tapered personal allowance, high income child benefit charge and annual allowance taper. It is also noteworthy that all of these have no inbuilt indexation element, so potentially capture more taxpayers each year. Removing such distortions could be achieved without the introduction of 49 different rates of tax (2 per cent through to 50 per cent), which is what the IPPR is proposing.
It is not surprising that many of the IPPR’s proposals have already been considered and/or been tried out over the years. Nevertheless, there is a strong case for making the UK tax system more coherent. Given a blank sheet of paper, it is hard to imagine anyone would have designed today’s UK system.
Tony Wickenden is joint managing director of Technical Connection (a St James’s Place Wealth Management group company). You can find him tweeting @tecconn