17 December 2020
Tax Changes
Roads to a better system.
By John Watson
Oink-splat; oink-splat; oink-splat? No, I have never really believed in the existence of flying pigs either but, for all that, they are less of a strain on the credulity than the statement at paragraph 4.1.2 of the final report of the Wealth Tax Commission that for a “one-off wealth tax” to be economically efficient:
“… the tax must be credibly one-off – individuals need to behave as though such a tax would not occur again. Otherwise, the tax would distort future behaviour in anticipation of it being repeated.”
Yes, you can see that they have to say that in a report which draws a line between a one-off wealth tax (payable by, say, five yearly instalments) as being an appropriate way of producing money to meet the cost of the Covid crisis, and regular wealth taxes as not being a good way of sharpening up the system generally, but what sort of an idiot really believes that politicians who find a new way of raising funds will not repeat it? Well, the authors of the report, it would seem.
To be fair the difficulty is acknowledged at paragraph 4.2.4 where the reasons for not spreading too far the period over which a single tax charge is payable include:
“Third, a one-off wealth tax is intended to respond to an exceptional crisis; the longer the payment period, the more likely it is that governments become structurally accustomed to the revenue even after the effects of the original crisis have dissipated.”
Quite so, but this understates the problem. Despite the examples of the one-off windfall taxes imposed by Margaret Thatcher and Gordon Brown on banks and utilities, which were, after all, designed to recapture specific windfalls, it seems inconceivable that any wealth tax would not quickly become annual. If, then, as the report suggests, the best way of permanently reallocating taxes is to reboot those we already have, that is where the energy should go.
As part of their research, the Wealth Tax Commission asked individuals what objectives were desirable in a wealth tax and presumably the answers would be applicable to any other form of taxation. The four key objectives identified were:
“1)The tax should raise substantial revenue; (2)it should do so efficiently; (3)it should also be fair; (4)the tax should be difficult to avoid”
to which the Commission themselves added a fifth to the effect that the tax should secure these objectives better than the alternatives.
Taken at face value, the list is disarmingly anodyne but actually there’s more to it than meets the eye. When the report talks about avoiding taxes it is using an economic and not a legal definition. That is to say that along with nefarious activities it includes taking perfectly legitimate actions, such as emigrating, which will have the effect of reducing tax liabilities. If a tax is not to be avoided it must not be escaped by widespread emigration. Similarly, in judging the fairness of a tax one has to take into account the ability of taxpayers to meet it (dealt with in the context of the one-off wealth tax under the head of “liquidity constraints”) and a tax is only efficient if it does not damage the economy. Each of these factors needs to be considered in redesigning the tax system and to illustrate this it is worth looking at how they might help shape the much-talked about reform of capital gains tax.
There are number of ways in which that particular tax could be reformulated in an attempt to increase the yield, but three stand out as candidates for specific consideration. They are:
- an increase in the maximum rate from the current level of 20% (28% on property or carried interest) which currently stands well below the 45% maximum rate of income tax;
- the abolition of the principal private residence exemption; and
- the replacement of the rebasing on death by some sort of the rollover.
Let’s begin with the most contentious one. The principal private residence exemption has been with us since the tax was introduced and now has a place in the nation’s heart equivalent to that of the National Health Service. Still, does it make sense? Why should people make enormous tax-free gains on property? Worse still it has been highly distortive. Misguided attempts to extract money from the retail property market by charging stamp duty land tax on sales have stopped empty nesters from trading down. So young couples with large families have too little accommodation whereas the older generation rattle around and wish they could afford to move to something smaller. What a complete mess!
So why is there a principal private residence at all? Looking past the hyperbole about an Englishman’s home being his castle, one is left with an essentially practical point. The main advantage of the exemption is to ensure that someone who sells a house which has risen in value is left with sufficient net proceeds to buy an equivalent but more suitable property elsewhere. If the state charged off with a large chunk of the proceeds from the first dwelling, someone who wished to move for, say, work reasons would not be able to do so without considerable downsizing. Similarly someone who would like to move to a house just a little less valuable than their existing one would find that they cannot afford do so and would have to move a long way down-market or remain where they are.
Yes, the exemption meets a specific need but are there other ways it could be covered. For example a rollover system under which, on the sale of a principal private residence, capital gains tax was only charged on the proportion of the gain not reinvested in the purchase of a replacement property within a period of, say, three years, the balance of the gain being carried forward until the replacement property or its successors was realised. Would that solve the problem in the cases we have discussed? Start with an executive who needs to move to a house of equivalent value in a different part of the country. All his proceeds would be reinvested in the new house so all his gains are rolled over. That seems fine. Then there is the elderly couple who move to a smaller house reinvesting 75% of the proceeds but retaining the rest. Why shouldn’t they pay tax on 25% of their gain? Of course there would have to be a revaluation to prevent historic gains being caught but going forward would this not be a better system?
Now let’s move to the current system for revaluing assets of death. That is there because it is considered unfair that families should suffer capital gains tax and inheritance tax on the same event. Quite understandable but why give up the prospect of tax on the gain altogether? The double hit could equally be avoided by a system under which those inheriting assets took them with the base cost of the deceased. Then the capital gains tax charge would arise but not until the assets were actually realised.
The observant reader will have noticed a theme emerging here. By introducing more rollovers it should be possible to achieve a long-term increase in the capital gains tax base while ensuring that a charge only arises when the taxpayer has the cash to pay it. Redesigning the tax in this way respects the great principle laid down by Jean Baptiste Colbert, finance minister to Louis XIV, that
“the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
Taxpayers are less likely to hiss if they only pay tax when they have the money.
Actually there are other areas where rollovers could be used to improve the design of the tax. Gifts, of course, are an obvious one but there would also be some sense in introducing a rollover on a reinvestment of the proceeds of realisation of stock exchange investments. Economists will tell you that it is a good thing generally if investors change their portfolios to reflect their predictions for the economy but here, surprisingly, a dichotomy arises. If an investor sells shares held direct and reinvests the proceeds he or she will pay tax on the gain realised, a clear inhibition on the efficiency of the market. If, on the other hand, those shares are held through a unit trust, no capital gains tax is charged until money is extracted by the investor by cashing in units. How can that possibly make sense? Have successive governments been in a conspiracy with unit trust managers? Clearly the sensible and efficient course is to allow roll over on reinvestment within the personal portfolio.
Alas, there is a fly in the ointment. However much a rollover on portfolio investments might improve the structure of the tax system, it is likely to defer revenues, not something which we can afford at present. For the moment, then, the obvious use of rollovers is to replace the private residence exemption and the up valuing on death, with rollovers on the exchange of investments being left to more prosperous times.
It is impossible to discuss tax without giving some thought to the rate. The 20% top level of capital gains tax (leaving aside the 28% special rates on land and carried interest) is lower than the top rate of income tax, in part to compensate for the fact that there is currently no relief for inflation. From a tax collector’s point of view the trick is simply to set the rate at the highest level which will not result in an unacceptable level of avoidance. Put the top rate at 45% and investors will find emigration attractive. Put it too low and you waste yield. Finding the right rate is a matter of judgement but the “right rate” depends on how fair the tax is as a whole. A tax which is not paid unless the taxpayer has money available can be charged at a higher rate than one which involves a forced realisation of assets to meet the bill.
As the government scratches round for revenue, its thoughts will not be confined to capital gains tax. There are other low hanging fruit which could be visited. For example:
It would be possible to reintroduce the special rate of tax for development gains. This was tried in the 70s but failed because the rates were too high and the tax became a major block to development. Approached more modestly this could be a useful source of funds.
Also there is the question of taxing international businesses which make use of the UK marketplace. Considerable progress has been made on this with the Digital Services Tax in the UK and the work done by the OECD. Still, there is no reason why this should not be exploited as a cash cow in much the same way as the government exploited North Sea Oil. The companies providing the services are overseas-based so there is no political angle limiting how much can be raised. It is just a question of taking what one can without killing the goose.
No modern budget is complete without claptrap about raising funds by cutting down on nefarious avoidance. Generally it is nonsense, not because anyone likes that sort of thing but because the attempts by HMRC to close it down have already been very successful. Perhaps though the time has come to change the angle of attack and to convert an individual’s obligation to pay tax from an irksome liability to an opportunity to make a contribution to the communal coffers. This may sound like a big undertaking, and indeed it is, but that is no reason why a start should not be made. Perhaps then the Treasury should ask itself what might make the payment of tax more palatable to the individual. Here are a number of suggestions.
First, those who pay large amounts should have their contributions acknowledged. If membership of the House of Lords is supposed to recognise a contribution to the nation, perhaps the top 10 taxpayers in each year should be given some form of temporary life peerage. If that is too much, then they could be invited to some well-publicised junket. It wouldn’t matter too much what it was. The point is that paying a lot of tax should become something to boast about and, human beings being competitive animals, something to emulate.
Second, the system should be made fairer. I have already suggested how this might be done in the context of capital gains tax but other taxes need looking at too. To pay a fair tax may be admirable. To pay an unfair one looks like being taken for a mug, not an image which the payer particularly appreciates.
Thirdly, care needs to be taken over the way taxpayers are handled. In the old days HMRC were more heavily manned than they are now and that allowed for a much more personal relationship between taxpayers and the fisc. It is understandable that in these days of computerisation that has gone, but there is a price to pay for it. If HMRC want compliant taxpayers those taxpayers need to feel that they can discuss their affairs in a friendly manner. That means more inspectors of taxes.
One effect of Covid is that many economic changes which have long been due are being squeezed into an uncomfortably short time period. This applies to the system of taxation as well and it would be a great pity if in the need to raise immediate revenue the opportunity to consider how the system could be made more effective and fair was missed.
