Tax simplification

The GOM did quite a bit of work on simplifying taxes - cutting income tax and (more importantly) slashing customs duties and other such taxes.

We currently have a hugely complicated tax system in the UK; much of the complications are attributable to trying to address the deficiencies of Income Tax.

The problem with Income Tax is that it's only a tax on income and it assumes that income can be attributed to a particular point in time. That is, I get a payslip once a month and the income on that slip can be attributed to that month - and therefore taxed on that basis. This works well for people whose primary or sole source of income is a salary or wages from employment. It works much less well for people who earn money on a contract-to-contract basis, and starts to break down completely when we get to business owners and especially people with substantial capital assets.

Take the buy-to-let movement here in the UK. The core theory was that you could borrow money on a mortgage to buy a house, then the rental income from letting it would cover the interest aspect of the mortgage and that you could then sell the house and profit from the rise in prices.

If you treated the sale as income and the purchase as negative income (ie a tax deduction) then you get a nonsensical position where there is a huge tax liability at the end and much more deduction than you can usefully use at the purchase stage.  For example, you earn £50,000 a year and buy a BTL house for £100,000 - congratulations, you earned -£50,000 that year, but you can't pay negative tax on your negative income, so you just pay zero (saving you about £10,000 in tax).  A few years later, you sell the house for £110,000 and now you have to pay income tax at 40% on the £110,000, ie £44,000.  You can't go back and pick up that £50,000 loss from the past to offset against the tax, so your profit of £10,000 results in a net increase in tax of £34,000, or a net loss of £24,000.  So that doesn't work.

If you regard the change in capital values as not being income at all, then it's tax free.  But you have created an enormous tax loophole as it's pretty straightforward with investments to convert between income and capital gain¹.

So, of course, the Government creates another tax - Capital Gains Tax, which taxes the capital gain,  ie the difference between the purchase price and the sale price.  In the example from before you pay your standard £10,000 income tax on your £50,000 income each year, and you pay 25% CGT on the £10,000 profit when you sell, ie £2,500.

However, there's another "trick" to apply - if you don't sell, then you don't have to pay tax at all.  When you die, your inheritors get the house and don't have to pay the CGT going back to when you bought it.  But when they sell, the basis price (the purchase price) is the value that the house had when they acquired it, ie the capital gain that it underwent under your possession is tax-free.  So the government brings in Inheritance Tax.

And all three taxes are at different marginal rates, have different allowances, etc.  And I still haven't got into National Insurance Contributions - which are a tax on earned income but not on unearned income.  That is, people that work for a living pay more tax than someone who can live on a trust fund.  Is it just me that thinks that should be the other way around?

The USA has, for 2010 only, abolished Inheritance Tax².  However, they've actually increased the tax take (long-term) on estates of people who die in 2010. This is because the CGT basis is not reset on inheritance - ie if you inherit something in 2010 and sell it later, you pay CGT on the increase in capital value from when it was bought, instead of the increase since your inherited it. The CGT, because there are fewer exemptions, adds up to a much bigger tax bill - it's just going to be deferred until these assets are sold.  This was a result of a screw-up in 2001, but it's actually a pretty clever idea.  All they need to do is to make liquid assets (cash) acquired through inheritance taxable as income (only non-liquid assets can be taxed as capital gains later on) and you've got rid of one whole tax, and simplified everyone's life.  That's one swathe of tax planning lawyers and accountants out of jobs and able to do something more productive with their lives.

The next stage would be to merge CGT into income tax; not the stupid way I suggested above, but sensibly.  If you sell an asset, then you should count the capital gain on that asset as income³.  That would instantly remove the problem of income tax and CGT rates being different and also remove a whole swathe of tax planning and tax avoidance - if it doesn't matter whether it's income or capital gain, there's no point trying to convert one into the other.  Given that capital gains come in big lumps very occasionally, whereas income tends to be more even year-to-year, you should be able to use any unused income tax allowances from all the years that you owned the asset against the tax liability - and I'd treat paying a lower rate as a kind-of allowance, ie it enables you to pay only 20% on the first £37,400 of your income, so if your (taxable) income was £17,400, but there was a capital gain made during that period then you'd be able to reduce the tax rate on £20,000 of that capital gain from 40% to 20%.  Hopefully, you get the principle.  The unusued allowances and unused lower-rate entitlements would need to be index-linked until they get used up.

I hasten to point out that this would be a huge change to the tax system, which you could not bring in overnight - there would need to be a very careful study of the exact impacts, especially as this would be an effective big reduction in tax allowances (remember, I've just completely scrapped the personal annual CGT allowance).  Obviously there would have to be a compensatory increase in the income tax personal allowance, and probably a widening of the rate bands to prevent this being a tax increase.  The net effect would be a big shift in the emphasis of taxation to wealth and away from income, especially away from earned income.  That should provoke an increase in economic activity.

I'd like to study this idea in a lot more detail before even proposing it, but making taxes simpler by merging them together, and removing the incentives for accountants and lawyers to spend a lot of time and talent on shifting money from one place to another to minimise tax liabilities is something that I would hope any future Chancellor would spend a lot of time and Civil Service resources on.

¹ For example, take shares. Conventionally, the dividend is income and the change in share price is capital gain. But you can create an investment trust that purchases shares with the dividend. The trust would not itself pay tax (if structured properly) but the value of the shares in the trust (which pay no dividend) would rise with the values of the underlying assets.  That means that there is a capital gain in the trust which was income in the original dividend.  There are plenty of other such techniques; any good tax lawyer or accountant can show you several ways to convert income into capital gain and more to do the reverse.

² They call it Estate Tax, but it amounts to the same thing. It comes back in 2011.

³ You'd still have to keep track of the basis values, but it's still a whole lot simpler.