The Current Tax System of the UK - Essay Example

The current tax system of UK is very complex. It does not treat all the taxpayers equally. This paper analyses the proposals made by the Mirrlees review to reform this system so that it can achieve fiscal neutrality. Currently, income tax is levied on owner-occupied housings, for cash and shares held in ISAs, and on National Insurance Contributions. Withdrawals and returns are exempt from tax (Mirrlees et al., 2011). However, there is a limit on cash investments but equity investments are completely included in this treatment. Conversely, pensions are taxed upon withdrawal but fund income is exempt (EET system). Further, 25% lump sum can be withdrawn from pension funds tax free (Lymer & Oats, 2013). Due to these treatments, most of the savings in the UK are made in pensions, housings and ISAs. They discourage savings in all other forms and put limitations on economic activity. Further, the current tax laws are complex. According to the current system, neutrality can neither be achieved over time nor across assets. It discourages people from saving because the present value of their income increases. They become better off spending their income now than later. Also, this system does not take inflation into account. The returns on savings are taxed on nominal returns. Therefore, tax on returns on savings actually increases with a rise in inflation rate. Further, the phenomenon of compound interest reduces the effective rate of return and its reducing effect is directly proportional to the passage of time (Mirrlees et al., 2011). Adam Smith (1776) proposed four canons of taxation for an optimal tax system. These canons are: ‘Equity, Certainty, Convenience and efficiency’ (Lymer & Oats, 2013, p.43). Economic efficiency relates to fiscal neutrality which refers to an ideal tax condition which does not ‘distort the economic and commercial decisions made by individuals’ (Lymer & Oats, 2013, p61). The concept of neutrality demands that people’s choices should not be distorted. However, in standard income tax, neutrality is foregone both over time and across assets. The current system makes people prefer investing in pension funds and ISAs but discourages saving through other opportunities as it taxes them at a higher rate. Further, it actually subsidises investing in a pension fund as it allows a tax free withdrawal of a lump sum. This discourages people from taking risks and limits economic activity. It also defeats the prospects of achieving neutrality over time. This system treats capital gains differently than accruing gains. They are taxed upon realization than on accrual. Since capital gains are held for several years and they also increase in value, taxation upon realization implies that the tax payment on these assets is deferred. The effective tax rate is reduced and gets further reduced with the passage of time. Since this advantage swells with time, there is an incentive to hold on to these assets much longer. This is also known as the ‘lock-in’ effect (Mirrlees et al., 2011). Tax smoothing is also very important to consider in the context of neutrality as the tax rates, earnings, and spending are not constant all the time. In a system where a particular group gets penalized due to their variable income or spending, it is advisable to make them able to choose the system according to which they want to be taxed. Income tax penalizes those who postpone consumption, whether they choose to do so, or because their earnings occur early in life (Bradford, 2000). Every household should be able to make a choice about the taxation system. The concept of Life Cycle Hypothesis also falls in line with this suggestion. According to this concept, individuals seek to even out their consumption throughout their lifetime in the best possible manner. Neither do they spend extravagantly today and suffer tomorrow, nor do they save thriftily today and spend furiously tomorrow. This concept involves the role of speculation to a great degree. Of course, there can be many unexpected changes and contingent events that can easily disturb the overall plan. This is why this concept works best when income and consumption are assumed to remain constant, or change at certain expected levels (Modigliani, 1966). However, everyone cannot be expected to have the required foresight and the financial sophistication to smooth their tax payments perfectly (Mirrlees et al., 2011). They can still end up paying more even if they are able to choose their own system. There are three phases in taxation i.e. first, ‘when the income is actually received’; second, ‘when returns on savings accrue’; and third, ‘when the funds are withdrawn from an account or an asset is sold’. The stages that are taxed are denoted by (T) and the stages which are exempt from tax are denoted by (E). Based on these concepts, the Mirreless review (2011) proposed three routes to achievement of neutrality in taxation of savings because of the comprehensive income (TTE) cannot achieve neutrality (the three proposals as follows): A ‘cash flow expenditure tax’ in which income is tax as it is spent—EET; A ‘labour earnings tax’ in which savings are taxed when first made but all income from savings is exempt from tax—TEE; An ‘income tax with a rate-of-return allowance’ (RRA) in which labour earnings and supernormal returns to savings are taxed—TtE. Here ‘t’ denotes that only normal returns are exempted (Mirrlees et al., 2011). Since the normal returns on savings are untaxed in all of these approaches, people are neither encouraged nor discouraged to save. However, there is a crucial difference when supernormal returns come into play. Both TEE and TtE systems bring such returns into the tax base unlike EET. Leaving investment income untaxed by TEE may be inappropriate because no matter how high is this income, it goes untaxed. TEE also makes a distinction between investment income and earned income, with the investment income being exempt altogether. These approaches also deal with borrowings in different manners. TEE ignores borrowing just like it ignores savings. EET adds loans to the taxable income in years in which they are taken out and then deducts the payments of interest and principal. TTE also allows deductions on interest payments. But it does not allow the payment of principal as deduction, nor does it include borrowings to taxable income. TtE allows deductibility of interest payments to the extent to which they exceed a ‘normal’ rate of interest (Mirrlees et al., 2011). These systems deal with cash income and capital gains to almost similar effect. Further, they do not require any indexation for inflation. In EET, tax is simply paid upon withdrawal of savings. In RRA, a certain percentage of the initial investment is carried forward and any interest or capital gains are set against this allowance in the future; otherwise, the unused allowance is carried forward. The unused allowance increases at the normal rate of return. Hence, normal returns are not taxed; tax is imposed only on the supernormal returns. A tax system must achieve neutrality so that the taxpayers’ choices are not distorted (Lymer & Oats, 2013). EET system is an automatic failure in achieving neutrality as it clearly discourages saving. If TEE taxation is made the standard system of taxing savings at all levels, it would increase economic activity manifold as people would not be reluctant in investing in opportunities other than pension funds or ISAs. They would look to take more risks and the only thing driving their decisions would be their profit motive. However, it can also lead to people making investments in unnecessarily ‘high risk-high reward’ opportunities which might take a turn for the worse. If TtE system is brought in as the standard treatment, it would also be very beneficial in increasing economic activity just like the TEE system. In addition, it would also take away the danger of abuse of tax exemption as only the normal returns on savings would be taxable but supernormal returns would be charged. This would make people avoid making risky investments. TtE system would bring only high earning savers into the tax bracket. Also, equal treatment of different assets would help achieve neutrality across assets. The benefits of assets and saving should be availed by many, not few (Paxton, 2003). This system also eliminates the effects of inflation and compound interest to a great degree. However, investment in human capital still leaves a huge question mark as the taxation of this benefit seems to be unfair. Also, this question involves such elements which are almost impossible to be considered in monetary terms. Further, reforming the whole system would naturally create a lot of winners and losers. The losers are likely to create problems for the Government. TEE system is likely to penalize those people who have variable income because they are taxed at a higher rate when the income is high and are taxed at a lower rate when the income is low. They end up paying more tax than people who have similar average but constant income. EET system penalizes those who have variable spending (Mirrlees et al., 2011). It also penalizes households that save in order to support their children in the future. EET system is likely to penalize people who plan to consume later but big corporate companies can thrive in this system as they can make the choice of using their savings at such a time when the rate of tax is low. The reverse is true for companies to some extent in a TEE system. When tax smoothing comes into play, it is recommended that taxpayers should be able to choose the system of their liking. But this can fail because astute taxpayers would end up making the most out of the tax laws and people having limited knowledge are likely to pay more. In contrast, companies have whole teams of experts that provide them with helpful advice hence making them pay less. People who currently enjoy lenient tax treatment on capital gains and employer pension contributions would have to face increased taxation. With the removal of tax free lump-sum, the subsidisation of pension would be eliminated hence creating a disincentive for saving in a pension. Also, people who are lucky or are astute in the stock market would also have to pay extra tax as the RRA system would tax their earnings above the normal returns. However, people who rely on cash savings would benefit under this system through reduced tax rates. Also, people having investments outside ISAs would also benefit as they have to pay at higher tax rates under the current system. The neutralisation of tax on savings would reduce tax rates for such people. Overall, the proposed system seems to be capable of achieving neutrality at a greater level than the current system. It is recommended that the rate structure of income tax should be simplified. NIC should be merged with income tax. The current system has multiplicity of benefits which can be replaced by a single integrated benefit. Also, the rates for dividends and capital gains on shares should be reduced so that they reflect corporation tax already paid. Equalisation of marginal tax rates would reduce distortions between different economic activities and opportunities for avoidance. The work incentives should be strengthened so that overall employment and aggregate earnings can increase. But there is a difficulty in achieving neutrality between financial and human capital investments. A person who invests in human capital e.g. education, gets taxed when he actually obtains a gain from this investment. Such costs should also be deductible. In order to balance it out, it might be a good idea to tax normal returns from savings to some extent. But it should be progressive and low income groups should be exempted. The current tax system requires a huge change and significant reforms. While bringing a change, the toughest part is to unfreeze from the existing system. Once this step is taken, moving and refreezing become very easy. Bringing radical changes to the system can be received poorly. The Government can opt to bring these changes gradually and educate the taxpayers as to what is better for them. This way, the whole system can be reformed successfully. References： Bradford, DF. 2000. Taxation, Wealth, and Saving. Massachusetts Institute of Technology, USA. Lymer, A & Oats, L 2013, Taxation: Policy and Practice 2013/14, Fiscal Publications, UK. Mirrlees, J et al., 2011, Tax by Design: The Mirrlees Review, Oxford University Press, UK. Modigliani, F. 1966. The Life Cycle Hypothesis of Saving, the Demand for Wealth and the Supply of Capital, Social Research, ProQuest Information and Learning Company, US. Paxton, W. 2003, Equal Shares?: Building a Progressive and Coherent Asset-based Welfare Policy. Institute for Public Policy Research (IPPR), UK. Read More