Peculiarities of Taxation Policy - Essay Example

TAXATION BY COLLEGE PRESENTED TO Taxation There are two significant taxes that have a huge implication in savings and investment onassets in UK. These are the capital gain and the income taxes. However, the national insurance and VAT are equally important taxes charged to both the employed and self-employed individuals. All the same, there are other types of taxes such as the inheritance tax and pensions. However, very few individuals pay the inheritance tax annually considering only a few assets are moved for probation and that the tax has been easy to evade over the years (OECD 2007, 13). This leaves the income tax and capital gains taxes as the two most important taxes to any household in UK, with huge implications on the consumption and investment patterns in the country. However, the taxation policy in the country does not observe neutrality in that it may discourage deferment of consumption and investment by taxing savings and returns on investments more into the future than now. The income tax is paid per any tax unit that is beyond the personal tax free allowance. The tax is charged from diverse types of savings and is charged at a basic rate of 25% or a higher rate of about 40% (OECD 2007, 13). On the other hand, capital tax operates much similar to the income tax above; there lacks a clear distinction between income and capital gains tax in UK. Any investor with a capital gain of £5800 or below per annum is exempted from this tax. However, any income above this level is taxed based on the gains at marginal rate of the income tax. In U.K, today, any transaction on savings is treated differently under the taxation policy; the mode of taxing any savings is a vital feature of the UK tax base and leads to an understanding of the comprehensive income tax. In most cases, the comprehensive income tax refers to a case where the income from savings, the labour tax and any other elements that make up the tax base are taxed equally. On the other hand, in expenditure tax, the returns from taxes are not taxed until the individual uses the savings for consumption, at which the tax is known as an expenditure tax or consumption tax (Mirrlees, 283). The major difference between the two taxes is in the treatment of savings. Taxation of savings has an impact on the investment and consumption choices of individuals and companies in UK today. According to Mirrlees report, several effects were identified resulting from the taxation of savings. One, there is an attempt to design a carefully leveled taxation system that seeks to equalize the tax burden of the taxpayers with the same income era in their lifetimes, but with different patterns of calculating this income. Moreover, the mode of taxing savings greatly affects how small firms and the self-employed react to the taxation system and how capital is allocated to large corporations. In addition, taxation of savings has an effect on the total amount of money saved in an economy and how the savings are distributed to different investments, which affects the distribution of capital and the efficiency of investing such capital. More important, today, taxation of savings has a huge implication on individuals saving behaviors about how much to save, when to save, and the risks to be taken when distributing these savings to different areas. This suggests that the taxation on savings has a great impact on individuals when unemployed or after retirement when such individuals would like to benefit from their accumulated savings. However, the main difference between consumption and comprehensive tax is that while consumption tax does not result in any distortion at consumption, comprehensive tax will result in distortions (Mirrlees, 284). As Mirrlees report explained, the main reason behind this is that a comprehensive tax system will decrease the after tax rate of return compared to the pre-tax rate of return. Considering the rate of return that an individual enjoys depends more on the future versus present prices of products to be consumed, the best option would be to avoid distorting the consumption of the largest population in their consumption choices and patterns. This can only be achieved by having a taxation regime that would be neutral over the time of consumption to prevent individuals from postponing or consuming their savings now with the tax system as the main determinant. The neutrality system thus seeks to level the grounds in taxation of all savings despite the time of consumption of the savings. A neutrality system A neutral taxation system has to observe two critical aspects. One of these involves the timing of the saving. When dealing with a neutral taxation system, people do not have to consider the taxation system in deciding when to consume their incomes (Mirrlees 286). In other words, consuming the income now and consuming it in the future should not be affected by the taxation policy in place. Secondly, a neutral taxation system has no effect on making a decision on the types of assets in which people invest. Such a system should have no effect on the assets that people have to choose to save their incomes as a way to evade high deductions at present or in the future. This suggests that a neutral tax system should not affect people’s decisions on when to consume and the assets they choose to invest in now or the future. Whether a person consumes today or invests in any asset that they choose to should not affect the tax payable. This suggests that a neutral tax system has to allow people the liberty to choose when to save and consume without the fear of high taxes on returns. As such, any tax system that taxes the normal return on savings cannot be considered a neutral system. In other words, those who decide to save their incomes and consume later in life will end up paying more than those who consumed their incomes earlier. Consequently, such a tax system will affect decisions based on time of saving and consumption, which a neutral system does not affect. Moreover, the proposal to have different tax rates at different consumption rates would amount to taxing some consumption goods more than others, which affects the decision on how and when to consume. Ideally, the tax is meant to redistribute resources from those who have more to those who do not have. As such, people should be taxed according to their earnings, which implies they should be taxed according to their consumption abilities. However, the actual earnings or expenditures of an individual are usually used to calculate these taxes. The result is that taxing people as per their earning capacity discourages them from earning or spending their earnings to the best extent that they would prefer (Mirrlees 293). To avoid such taxes, people change their behavior with respect to choosing their leisure time. To collect this imbalance, taxing the normal return on savings may only be accurate when targeting the high earning individuals (Mirrlees 293). However, it might be impossible to measure the ability of individuals accurately. In some other cases, people perceive taxing savings as the best way to redistribute resources. This is due to the belief that those who save must have a better income in their lives compared to those who do not save. This is a wrong notion considering that a person with savings might not be any better compared to the one without any savings; in fact, the two people might be earning the same over their lifetimes, but at different times (Mirrlees 294). As such, taxing the returns on savings is disadvantageous to those who defer their consumption. Therefore, savings may not be a reliable way to isolate those who earn more from the rest, but it pinpoints those who prefer spending tomorrow than today. Consequently, taxing savings is not the right approach in targeting the rich in redistributing resources. Another problem occurs when taxing assets. In this case, neutrality is altered when the assets are taxed differently. However, this does not affect pensions, which are treated with more generosity in encouraging people to save for their retirement period, as a way of reducing poverty at advanced ages. All the same, the tax system should not be the basis on which an individual has to choose the assets in which to invest. Consequently, the standard taxation system would not achieve neutrality considering it makes any future consumption more expensive than the current consumption. The fact that standard taxation policy affects savings and assets discourages investments (Mirrlees 295). In other words, the value of income is greater when used today than when differed to the future, which affects people’s decisions regarding the types of assets to invest. The unpredictability of inflation rates affects the neutrality of taxation policies and makes future consumption more expensive than today’s consumption. There are possibilities of having higher inflation rates into the future, which suggests that interest rates would be higher. Therefore, investing one’s income or saving for future consumption will certainly attract higher interest rates and discourage people from saving their incomes. This problem is compounded by the difficulty in creating a system where income tax is taxed at realization and with some adjustments that would have a realization based tax at the same level with tax on accruing gains One way to achieve neutrality in taxation would be to recognize the fact that capital gains are returns to savings, similar to interest on dividends. When dealing with a comprehensive tax policy, income on capital goods should be taxed as it accrues, which suggests that any capital gain tax has to be taxed at a similar rate with other streams of income. Adopting this policy may ensure neutrality in taxation policies, though the policy has not been adopted in U.K. Therefore, in capital gains, there is a need to design a tax policy that necessitates taxation on accruals only and not on realization. As such, when an investor holds on assets that appreciate in value for some time before disposing them, the tax payment on accrued capital has to be deferred for some time. Another approach to ensure neutrality in taxation would be to have a tax policy, which taxes on realization, but with the same benefits as taxation on accruals. However, such a tax policy requires a change in the asset’s tax based on an amount equivalent to the rate of return since the owner purchased the item (Mirrlees 296). Another incentive on savings and investments would be delaying taxation. In this case, the government treats the tax payable as an interest free loan to the taxpayer from the time the value of an asset increases to its disposal. However, the government will suffer loss of income as this will reduce the overall tax rate on capital gains especially for assets held for long periods before disposal. As such, this form of taxation policy favors those whose income from assets is in the form of capital gain compared to those receiving returns in form of cash streams. Consequently, such a taxation policy would encourage investments on the long term as individuals invest in assets that generate capital gains over others. All the same, this method may force some individuals to pay taxes on accruals when they do not have the financial muscle to do so. Taxation on household savings and investment on assets in UK fails to meet the neutrality standards. This is because; the used taxation policies encourage consumption today rather than saving due the tendency to tax ones savings more in the future than today. This is despite the fact that two people may have the same level of income distributed differently in their life time. All the same, to ensure a taxation policy that attains the neutrality measure, Mirrlees offered some suggestions for taxation policy on savings to encourage savings other than consumption. These suggestions include taxing only the income used for consumption at the time when it is spent. In addition, it would be possible to have a neutral taxation policy by creating a labor earnings tax. This is a policy that excludes all savings from being taxed, but does not exempt the savings when they are first made. Lastly, there should be an income tax that has a rate of retention on allowance. In other words, as the Mirrlees’ report indicated, such a tax policy targets labor earnings and any rate on earnings that would be considered supernormal and exempts the normal returns from taxation. List of References Mirrlees Review Chapter 13. The Taxation of Household Savings. [http://www.ifs.org.uk/mirrleesreview/design/ch13.pdf] March 15, 2014. OECD. 2007. OECD Tax Policy Studies Encouraging Savings through Tax-Preferred Accounts. Danvers, MA: OECD Publishing. Read More