The madness of the tax system

Inland RevenueThree years ago, Guy Hands, the founder of Terra Firma buy-out group, packed up and moved from UK to Guernsey to escape the new 50 per cent tax rate slapped on Britain's highest earners -- that is, those with incomes of £150,000 or more. Unfortunately, it's not possible for all Fools to follow big Guy's example and up stakes to the tax haven because A) there's not enough room on the island and B) not many of us have enough wealth to qualify.

So we stay and pay our taxes. Although Hands is in the super-tax category, even those with income of £35,000 to £150,000 pay 40 per cent on every quid earned in that bracket. And obviously the amount of income tax we pay has a big influence on how much is left to invest.

Here's the thing -- the UK government takes £4 in every £10 earned in the economy, according to a study by the Institute for Fiscal Studies. So clearly any tax system that big should be responsible, rational and highly efficient -- except that it's not and hasn't been for decades. The more tax the government extracts from earners' pockets, the worse job it tends to do.

Titanic Tolley's
This can be measured in the size of Tolley's income tax guide, the bible of tax legislation. According to the Taxpayers' Alliance, these days it's up to 1,801 pages, more than twice as long as it was in 2000. And that's just the income tax guide. There's also the Tolley's capital gains tax guide at 1,463 pages (70 per cent longer than in 2000), Tolley's inheritance tax guide at 958 pages (63 per cent longer) and Tolley's corporation tax guide at 1,897 pages (185 per cent longer).

In short, the tax system continues to become more and more complicated, confusing and opaque. And it does so at a much faster rate than is justified by changes in our economic behaviour.

As Paul Johnson, director of the institute, points out: "The current set of taxes is complex and often incoherent and they impose a much greater cost on the economy than need be." And by implication, on wealth-creating investment.

Discouragement and distortion
Rescue may be at hand though in the form of the institute's Mirrlees report, a heavyweight study of the tax system chaired by Sir James Mirrlees, Nobel prize winner and world authority on optimal tax systems. As Sir James says, among other failings the system "discourages saving and investment, and distorts the form that they take". The overall conclusion is that a radical overhaul is called for.

Because the report is nearly as long as the Tolley's income tax guide, it's only possible to pluck a few gems from its page:

  • Wildly irrational tax rates distort our decisions on savings and investment by forcing us to seek tax-avoiding assets.
  • Investment returns on higher risk but economically important assets are penalised.
  • The varying rates of taxation on capital gains and income make little sense.
  • The corporate tax system encourages the use of debt over equity finance, with highly destabilising effects.
  • By world standards, the system is "exceptionally centralised", with Westminster grabbing 95 per cent of all tax revenues.
  • Capital gains tax has been something of a shambles over the years. Before 1982, it was charged at 30 per cent without allowance for inflation. In 1998, capital gains it was tapered for longer-held assets. In 2008 tapering and indexation were abolished and a flat 18 per cent rate introduced. In short, a major upheaval every few years. And we haven't even got on to the continuing saga of inheritance tax.

Tax rates of 98 per cent
True, there have been reforms over the years, mainly in the shape of progressive cuts in income and corporate taxes. Imagine paying 98 per cent on unearned income or 83 per cent on earnings, the top rates back in 1978? At that time, an investor good enough to achieve a return that the tax authorities deemed excessive by the tax inspectors was slugged with "an investment income surcharge" of 15 per cent, thus producing the maximum rate of 98 per cent. This swingeing rate wasn't abolished until 1980. No wonder Sean Connery moved to Spain.

Your government needs Fools
The main lesson we learn from the institute's analysis of the tax system is that the government crucially depends on successful investors and earners for its income. In 1978, the percentage of highest-rate taxpayers was a measly three per cent. Today, it's well into double figures and rising. What's more, over half of all income tax is paid by the wealthy and around a quarter is paid by the wealthiest -- that is, the top one per cent of all earners.

So, despite progressive reductions in income tax rate over the years, the government bags more and more revenue from wealthy earners and investors. Put another way, the more tax Whitehall gives away, the more it gets. The lesson is simple: the tax system should encourage the creation of wealth because the government and, through it, the people win.

But don't wait up. It took decades for governments to understand that 98 per cent tax rates didn't work.

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