Taxing capital

Proponents of big government commonly complain that capital is horribly under-taxed in the major developed economies. A prominent current example is French economist Thomas Piketty, whose new book ‘Capital in the Twenty First Century’ has revived demands to increase the tax burden on capital. But the reality is that capital gains tax, corporation tax and income tax on dividends all add up to a punishing tax burden.    

In 2009, Liberal Democrat MP Vince Cable wrote that “payment in shares which appreciate in value generate a capital gain taxable at 18 percent instead of the 40, then 50 percent, paid on earned income over £150,000.” He subsequently became a senior member of the coalition government and used his position to extract an increase in capital gains tax from 18 percent to 28 percent for high earners.

In Britain, the total top marginal tax rate on income earned, saved, invested in a company and passed on to children can, over time, reach more than 90 percent – and that is before taxes on consumption, such as value added tax. No wonder people find every way they can to minimize their tax bills. The “scandals” are the result of a simple mistake: only counting one of the taxes on capital income.

Share prices rise and shareholders enjoy a capital gain. They pay capital gains tax. Those shares rise in price because of an increase in expected returns. Those returns are depressed by corporation tax and they are worth less to shareholders thanks to the income tax that they have to pay when they receive the dividends. The capital gain is less than it would be thanks to those other taxes and capital gains tax is really an unfair double tax on top of all the other taxes paid on corporate income. It all adds up to a punishing tax burden but one shrouded in a veil of complexity.

The same thing happens with labor income, which is subject to both income taxes and payroll taxes. In Britain, the real rates of income tax aren’t the headline rates of 20 percent, 40 percent and 45 percent. Including employers’ and employees’ National Insurance contributions, the real combined marginal tax rates on labor income are closer to 40 percent, 45 percent and 50 percent.

All of that complexity and opacity has two consequences. First, many people are not aware of just how much they are paying and, second, it is easier for politicians to sell ruinous tax rates.

Thankfully though, despite all the confusion over the rates, most people are sufficiently aware of how much they’re being ripped-off that lower taxes in general are still an election-winner.

The deeper problem is that, because it is more or less impossible for one person to know what others pay in tax, it is easy for one to suspect that everyone else is getting a great deal, or not playing by the rules. Politicians are able to play on those suspicions, inventing one cartoon villain after another: the private equity executive; the foreign owner of an apartment in a nice part of town; the business that has made a loss in a prior year or enjoys some other tax relief voted into place by our representatives one moment and then condemned the next.

Of course, the higher taxes just mean more pressure for people to find ways to limit their exposure to the tax system. Even if politicians give up on the rule of law and introduce draconian rules such as a General Anti-Avoidance Rule (GAAR), they cannot compel people to work or invest in their country. There is always the avoidance strategy of last resort: leave. Or don’t come in the first place.

We can and should try to educate people about how much tax everyone is paying. We should make everyone more aware of how – for example – in Britain the highest earning one percent of taxpayers, who earn about 11 percent of all income, pay about 24 percent of all income tax. It won’t be enough though. Our tax system is too complex for anyone really to understand and it is too tempting to blame a faceless, fortunate ‘other’ for the economic woes created by profligate governments.

If we want to avoid a vicious cycle in which higher and higher tax rates extract less and less money from a declining economy, the answer has to be tax reform. Not just any tax reform though. We need a tax system that is more efficient and encourages people to work, save and invest and put their talents to the most productive use possible. We need a tax system that is simpler and does not bury firms or individuals in paperwork. We need a tax system that is fairer and does not, for example, take someone’s death as an excuse to pick their family’s pockets. But, more than anything, we need a tax system that is more open and honest.

Of course, that is easier said than done. The TaxPayers’ Alliance and the Institute of Directors worked together to look at how tax reform could be achieved in practice through a major joint project called the 2020 Tax Commission. That report set out the case for a single, proportionate income tax – including payroll taxes – in order that everyone would know how much tax they were paying on their labor income.

Just as importantly, the report also set out how the same simplicity might be achieved for capital income. If you are interested in the details, the report is available online, but the crucial thing is that we need to stop taxing capital gains and corporate profits and instead tax net distributions. That way we would end the discrimination in favor of debt over equity, we would massively simplify the system and – by abolishing the extra taxes – we would also improve competitiveness.

It should not matter whether someone receives their income through wages or dividends or through a share buyback. Unfortunately, the over-complicated tax system we have today leads people to think that simple principle is best achieved by setting the capital gains tax or corporation tax rate at the same rate as income tax, but in reality that would just exacerbate the existing unfair, repeated taxation of capital earnings. The truth is the opposite: to achieve a competitive single rate, we need to get rid of the extra taxes.

All of this might sound like dreaming, but the pressure is on for politicians to do something about the endless tax scandals. They are even starting to get caught up in those scandals themselves. At the last election for London mayor, the candidates were forced to disclose their tax affairs – a rare event in Britain. Ironically, “Red” Ken Livingstone became embroiled in a scandal which seriously hurt his chances. In the last U.S. presidential election, reports about his tax affairs hurt the Republican candidate, Mitt Romney.

All that the left offers people outraged at the dysfunction of failing tax policy is synthetic outrage and demands for ever more stringent crackdowns. We can be successful if we offer a simple principle instead: low, simple and honest taxes, so everyone can rest assured that they play by the same rules.

A number of smaller economies have already shown that it is possible to secure enormous economic advantages by reforming taxes and offering a competitive environment to international investors.

The race is on for the first major economy to stop thinking about what they need to do to get by in the next quarter, and start thinking about what it will take to construct a new tax system fit for the next quarter century.
 

 

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Matthew Sinclair

Matthew Sinclair is a Senior Consultant at Europe Economics, having joined in January 2014. He studied Economics and Economic History for a BSc and MSc from the London School of Economics.  Previously Matthew worked at the Tax Payers' Alliance (TPA), most recently as Chief Executive. His responsibilities included:  lead editor of the 2020 Tax Commission; a major joint project on tax policy with the Institute of Directors; authoring two books; 'How to Cut Public Spending' and 'Let Them Eat Carbon'; and representing the TPA in the national and international media and parliamentary hearings. 
 

Matthew Sinclair
Senior Consultant
Europe Economics
London
 

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