Making Tax Fairer

First published in January 2011

A friend recently opened a debate on Facebook by “asking his left-leaning friends, non-adversarially, why they think redistribution of wealth is a good idea.”

Good question. Another good question is whether redistribution of wealth is or has been government policy. The Labour Party’s Aims and Values adopted in 1918 read as follows:

To secure for the workers by hand or by brain the full fruits of their industry and the most equitable distribution thereof that may be possible upon the basis of the common ownership of the means of production, distribution and exchange, and the best obtainable system of popular administration and control of each industry or service.

The version drafted by Tony Blair and John Prescott in 1995 reads as follows:

The Labour Party is a democratic socialist party. It believes that by the strength of our common endeavour we achieve more than we achieve alone, so as to create for each of us the means to realise our true potential and for all of us a community in which power, wealth and opportunity are in the hands of the many, not the few, where the rights we enjoy reflect the duties we owe, and where we live together, freely, in a spirit of solidarity, tolerance and respect.

Neither of these explicitly make the redistribution of wealth an objective. Arguably wealth is the full fruits of someone’s industry, although it might just as well be based on good luck (winning the lottery or having control of a piece of land where mineral deposits were found) or exploitation of others.

Labour’s new Clause IV talks about wealth being in the hands of the many not the few, but Labour has been squeamish about actually redistributing wealth. An Independent article from 2001 is revealing: it claims that Ed Balls ‘admitted the Government is redistributing “income and opportunity” in an effort to ensure a substantial shift of wealth towards the poorest people of Britain’ but ‘Mr Brown and Tony Blair are reluctant to use the word “redistribution” publicly, fearing that to Middle Britain it means a “Robin Hood-style” strategy which soaks the rich to help the poor. But ministers talk more openly about redistribution to Labour Party audiences, who are concerned the Blair Government has not done enough to tackle poverty.’

The fact is that wealth confers a wide range of opportunities. Security. No need to pay extortionate interest rates for credit. The ability to engage in long term planning and make long term investments (the car or washing machine that will last rather than regular visits to the laundrette or the garage). Spreading the benefit is A Good Thing. The debate on higher education is a case in point: if I had faced paying fees of £27k to study at Oxford plus living costs, I don’t think I would have done it. That would have seemed a huge burden to take on. Yet having benefited from what Oxford had to offer, I contribute more than that in income tax and NICs every year. So for the Government, my education was an absolute bargain. For individuals like me under government proposals it will be an investment that the wealthy can make without a second thought but which others will see as a huge gamble.

The tax system has grown out of identifying easy opportunities to extract money from people: trade (primarily sales tax or VAT), income and property. In recent years there has been a recognition of the desirability of shifting the burden from activities which are desirable (wealth creation) to those which are not (e.g. carbon emissions). Given that all three main parties aspire to redistribute wealth, it seems obvious to me that we should seek to move the burden of taxation from wealth creation to wealth itself. Not at a rate which is punitive, but a rate which means they are paying their fair share towards the costs of society.

It is often argued that the wealthy do not require the services of government as much as the poor. But actually it would be more accurate to say that they benefit from different services. The very foundation of government – maintenance of law and order through the police and armed services are more important the more you have to lose. I’m not arguing for hypothecation as that has a range of unintended consequences. What I am saying is that in determining what everyone can afford to contribute, it would be fairer to base that assessment on wealth as much as on income. Given the massive loss of wealth which would have followed if economic collapse had followed the banking crisis, it is only right for the wealthy to pay the lion’s share of the cost of avoiding this.

So what did Labour achieve in Government while trying not to scare the middle classes? HMRC publish data with estimates of marketable personal wealth and its distribution. The most recent data is for 2005 and shows that wealth is pretty concentrated: the top 1% own 21% of wealth, while the top 10% own more than half.

The second graphic shows how the concentration of wealth amongst most wealthy percentages of the population has changed over time. Changes are negligible and may be susceptible to sampling error. The data series certainly doesn’t show any evidence of redistribution away from the most wealthy.

The second series published by HMRC (third graphic) focuses on the rest of the population, showing percentages of Population with less than various amounts. Of course inflation explains much of the downward trend in this graph – but the fact that the trend ceases to fall and even starts to rise shows the percentage of the population with minimal wealth increased during Labour’s time in office.

Percentages of Population with less than...

So what are the aspirations of the Coalition Government?

The Liberal Democrats said in their manifesto that “No tax system should try to create total equality of income – but it can and should help redistribute wealth and power, to alleviate the worst excesses of inequality.” They said they would:

  • Make the first £10,000 you earn tax-free
  • Give tax relief on pensions only at the basic rate, so that everyone gets the same tax relief on their pension contributions.
  • Tax capital gains at the same rates as income, so that all the money you make is taxed in the same way.
  • Tackle tax avoidance and evasion, with new powers for HM Revenue & Customs and a law to ensure properties can’t avoid stamp duty if they are put into an offshore trust.
  • Introduce a Mansion Tax at a rate of 1 per cent on properties worth over £2 million, paid on the value of the property above that level

The Conservatives said in their manifesto that their economic vision is founded on a “determination that wealth and opportunity must be more fairly distributed”.

A Simple Idea – Tax Wealth

Based on HMRC’s estimates of personal wealth, taxing the wealth held by individuals over £250,000 2% each year would generate almost £117bn per year – enough to abolish income tax and national insurance for most of the population. In contrast Government income from VAT is £80bn and today’s increase to 20% is forecast to raise a further £13bn a year by the end of the parliament.

I think it is difficult to argue that a 2% tax on wealth would be punitive or unfair. The 10% of the population who would be liable to pay the new tax would certainly have an incentive to secure an income if they want to keep their wealth, but the long term average rate of return on shares is over 10%, so wealth will still accumulate if invested wisely, even taking account of inflation.

Taking things down to a personal level, consider the individual who is earning £35k and has total wealth of £800k. This is slightly more than median full-time weekly earnings in London and significantly more than the median for all employee jobs in the UK (£21k). This person’s employer is paying £4,212 in national insurance contributions, while £5,705 is deducted from their pay packet for income tax and £3,619 in national insurance. So the overall tax on employment amounts to £11k or 32% of the total cost of employing them. Under the wealth tax proposed above, this burden would shift from the employment to the wealth. Someone with less assets (that’s 99% of us in case you are wondering) would benefit more.

A number of “what if” questions arise. The possibility of a significant proportion of wealth would be transferred overseas needs to be considered: the number of people willing to rebuild their mansions brick by brick in a foreign country is fairly limited but what about other assets? Asking wealthy individuals to declare their property holdings (including overseas) as a condition of citizenship doesn’t sound unreasonable to me – the US Government requires the same from its citizens in relation to income. People certainly resent the taxes imposed on income, capital gains and inheritance. Part of the problem is that these are one off – and therefore create distortions and incentives to find a way round them. A steady rate of taxation on the ownership of assets needn’t generate the same behaviour. If you deliberately fail to declare an asset it could be confiscated – would you risk that for 2% of its value? And because assets don’t change hands that much, the work required for the tax authorities to keep up with the almost 5 million individuals liable for the wealth tax shouldn’t be too onerous.

On the other hand it would be prudent to introduce a Wealth Tax at a significantly lower level – say 1% and continue to rely on income tax until it has proved itself as a source of revenue. Given the need to find new revenues to tackle the structural deficit, now would be an ideal time to introduce such a measure as it wouldn’t have the adverse impact that other tax rises and public spending cuts are likely to have.

Council Tax

The one tax on property which is levied year in year out is Council Tax. But this is a fundamentally unfair tax as shown by the fourth graphic. As can be seen, the wealthy pay a much smaller percentage of the cost of their dwelling than the poor – and all properties valued over £320,000 in 1991 (worth about £650,000 in late 2010) pay the same rate. The red line is proportionate and a sharper line would be required to be redistributive.

Not only is the maximum paid pegged at £650,000 (except Wales where there is one further band), second homes get a discount when a redistributive system would be to charge more.

The converse argument which is sometimes made is that council tax is unfair because it does not relate to ability to pay. It is true that marketable wealth is not always immediately marketable and moving the elderly from their homes to pay bills lacks compassion. On the other hand, our housing shortage would be reduced considerably if single people and couples living in large houses could be persuaded to move to smaller accommodation. I think the appropriate balance could be achieved through equity release schemes: either the Government or a private equity firm takes a stake in your home in exchange for settling the tax liability.

Obviously a Wealth Tax would need to replace Council Tax – but total revenues from Council Tax amount to £25bn compared to the £116bn which would be generated by the Wealth Tax scheme proposed above (2% with £250k threshold) so this could be accommodated within the proposal. It would be appropriate to identify an alternative mechanism for linking local council spending decisions with what local people have to pay (e.g. local income tax).

Income Tax Thresholds

The Coalition Government’s proposals for benefits recognise the problems caused by the poverty trap. In the early 90s it was common place for benefit claimants to lose money if they went into work. This has been ameliorated somewhat by Tax Credits – but the system is complicated. When mistakes are made, families have to repay the overpayment – leaving them feeling that they would have been better off not working at all.

The Government’s  proposals for benefit reform involve combining benefits and introducing a single Marginal Deduction Rate of 65% (so for every pound you earn you lose 65p in benefits) and for basic rate tax payers 76% (so you lose 76p). It is worth pausing for a moment on reflecting on this: since the 1980s there has been a consensus across parties that the top rate of tax should be 40% and this has only changed to 50% in light of the financial crisis. So why should the poor face a marginal rate so much higher?

In fact the marginal rates we pay are significantly higher than the headline rates as a result of national insurance contributions – only some of which are revealed in our pay packets, but all of which need to be considered by an employer in calculating the total cost of employment. And although marginal rates are important (how much of an extra £100 I get to keep), in terms of equity and redistribution, the more important question is how much of everyone’s income goes to the Government.

Of course there are considerable advantages to those with higher incomes in setting themselves up as a company. This provides them with a preferential tax rate (at the top end of the range shown here, an overall tax rate of 40% and a marginal rate of 50%) and to offset some of their living expenses as business expenditure so as to further their tax bill.

Avoiding Wealth Tax

Of course some of the wealthy will be willing to pay significant sums to accountants to minimise their tax bill. Since charitable trusts and businesses are not part of this proposal, a millionaire might prefer to transfer his country estate to a charitable trust or to a limited company he owns.

It seems to me that the key to closing tax loopholes is to use the following tests:

  • If complex financial arrangements appear to be aimed at minimising the tax burden, let the tax authorities recalculate the tax bill on the basis that would apply if these arrangements had not been made.
  • If a company trading in Britain is making a profit but this is being reported within the accounts of an overseas parent company (conveniently located in a tax haven), tax the company’s activities in Britain as if it was based here.
  • If someone wishes to offload their tax liabilities by transferring their wealth, the test should be who benefits. If this is a genuine transfer, the answer will be the new owner. If not, they continue to be liable.

If this means that a millionaire is able to divide their wealth between four children and therefore escape liability, fair enough – in the same way as inheritance tax is avoided. But such arrangements would need to be scrutinised carefully. If assets are transferred to a limited company, the value of that company will rise accordingly (and legislation would need to provide for resolving disputes about the real value of an asset).

Transferring an asset to a charitable trust is another loophole which some might look for. The key would be ensuring that the test of who benefits is applied rigorously: transferring a forest to a charitable trust for the benefit of local people and then denying public access would suggest that the original owner is continuing to enjoy the benefit – but a gift to a genuinely independent organisation working on nature conservation would be a good thing and would avoid liability.

These and other issues would need careful scrutiny and to be resolved in legislation. But none of them are insurmountable. Some of the solutions which property owners might apply could of course be in line with the objectives of the policy, even if they reduce the tax paid: an owner of a business might transfer a share of the business to employees. But in transferring wealth and opportunity from the few to the many he (or she) would be fulfilling the ambition that all three main parties have been arguing for.

What do you think?

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