Wednesday, October 17, 2007

Simplify tax regime with common rate on all (capital) income

An earlier version of this blog appeared as a Letter to the Editor in the Financial Times of 18 October 2007.

Of course the UK Chancellor of the Exchequer is being attacked for abolishing taper relief (a capital gains tax rate of 10 percent on an arbitrary selection of capital gains and on other capital income items masquerading as capital gains) and setting a uniform capital gains tax rate of 18 percent. Those who complain are those who stand to lose. Special pleading always masquerades as the defence of the common good: the losers want us to believe that their loss is not only painful to them, but also unfair and damaging to the UK economy. The Chancellor should not listen. Taper relief has no more justification on grounds of efficiency or fairness than would tape worm relief. Further reform of the CGT is required, integrating it fully with the taxation of other forms of capital income, and indeed with the taxation of labour income. The main reasons are tax administration and the preservation of the tax bases for capital income and labour income.

Through trivially simple financial engineering (varying dividend pay outs, borrowing and share repurchases) listed companies can seamlessly transform dividends into interest or capital gains. The same can be achieved by unlisted companies when their owners sell the business. This means that, for simple tax administration reasons and to preserve the capital income tax base, only a common tax rate for all capital income, dividends, capital gains and interest, makes sense. Sector, holding period, type of capital, nature of ownership, size of firm, corporate form are all irrelevant.

That only leaves the common tax rate on all forms of capital income to be decided. Efficiency dictates that you tax things at a higher rate the lower its elasticity of demand or supply. In the long run, capital is in infinitely elastic supply. This suggests a zero marginal tax rate on capital income is optimal. In the short run, capital is given – a zero supply elasticity. This suggests confiscatory taxation is optimal. Are we in the short run or in the long run? You take your pick.

Furthermore, most labour income in the UK is in fact capital income, the return on risky investment in human capital – education, training and other skills acquisition. Therefore, to avoid distortions, labour income and all capital income should be taxed in the same way. There also is a tax administration and income tax base preservation argument for taxing labour income and capital income the same way. In small enterprises, where the same persons are both shareholders and workers, income can be transformed seamlessly from wages into dividends and vice versa.

Both efficiency and fairness would be served by taxing all labour income and all capital income the same way. There is no case, of course, for a separate corporation tax. Only natural persons – the beneficial owners of capital should be taxed. There may be a tax administration case for collecting some of the personal capital income tax at the level of the company, as a withholding tax, but there should be full offset of such withholdings.

So, to preserve capital income and/or labour income as a tax base, it is necessary to add together each person’s wages, dividends, interest income and capital gains and to apply a single tax schedule to the total. The highest marginal tax rate on capital gains would therefore be 40 percent, the same as it is for wages and dividends.

A final benefit of my proposed simplification of the capital taxation regime is that it would lift the burden of guilt of engaging in privately profitable but socially unproductive labour from tens of thousands of tax lawyers, tax accountants and other tax efficiency experts and free them for socially productive labour.


Anonymous said...

Nice theory. Have a uniform tax rate on everything in the interests of “efficiency and fairness”.

Unfortunately, we live in the real world and you are completely missing the point about the current situation relating to the proposed removal of taper relief.

In April 1998, Gordon Brown, as Chancellor, “introduced Capital Gains Tax (CGT) taper relief in order to create incentives for investment in assets generating sustained growth, with particular support for entrepreneurial investment…”

The labour party manifesto in 2005 stated “We want a tax regime that supports British business.That is why we have cut corporation tax to its lowest ever level, introduced the best regime of capital gains tax in any industrialised country, and introduced a new Research and Development tax credit. It also stated that there was an increase of 300,000 in the number of businesses between 1997 ands 2005.

Since 1998, hundreds of thousands of entrepreneurs took the availability of CGT taper relief into account when considering the risk/reward balance of starting up and/or investing in new businesses.

The Sainsbury Review, “The Race to the Top. A Review of Government’s Science and Innovation Policies” published on 5 October 2007 indicates that taper relief has been instrumental in creating a favourable environment for investment in new firms.

The availability of the relief was a compensation for high risk and “sweat equity” put in at the start of most businesses. Withdrawal of the relief has been viewed by those involved with SMEs as a complete betrayal of trust by the government. It also strongly suggests that the government does not understand innovation, business or wealth creation.

You say “The Chancellor should not listen” to complaints about the loss of taper relief. According to some news reports, the Chancellor is already in a mode where he has not listened to the advice of several of his own government colleagues and advisors. There is a wave of anger against the removal of taper relief. Five of Darling’s own enterprise advisers have spoken out against the tax rise. The CBI, the British Chambers of Commerce, the Federation of Small Businesses and the Institute of Directors have been prompted by the huge and angry response of their members to join forces to seek talks with Chancellor Alistair Darling. More than 11,000 signatures have now been added to a petition against the removal of taper relief

On reflection, it is not surprising that the government does not understand wealth creation as few of the professional politicians in important cabinet roles have ever had a job in business. The least that we can expect of our politicians however is that they should consult people who do understand an area in which the politicians themselves do not have expertise. On this occasion Darling and Brown do not appear to have done so; the result is a broad coalition against the change. They would do well to remember Denis Healy’s First Law of Holes: “if you are in one, stop digging”.

Tim Worstall said...

"This suggests a zero marginal tax rate on capital income is optimal. In the short run, capital is given – a zero supply elasticity. This suggests confiscatory taxation is optimal. Are we in the short run or in the long run?"

Err, wasn't that what taper relief was trying to exploit?