The UK Business Tax System for Small Business - Research Paper Example

The UK Business Tax System for Small Business The last few years have seen an outpouring οf proposals for radical reform οf the nation's tax system. These reforms have been motivated by a wide variety οf goals--improved economic efficiency, a fairer distribution οf tax burdens, and, perhaps most οf all, the desire to simplify the operation, compliance, and administration οf the tax system. A common element οf many such proposals is to eliminate end-of-year tax return filing requirements for some or all taxpayers. In a "no-return" tax system, revenues would be collected through some combination οf withholding and end-of-year reconciliation by the tax agency; individual taxpayers would not file annual returns. No-return systems are clearly feasible: thirty-six countries--including Germany, Japan, the United Kingdom, and several other industrialized nations--use some form οf no-return system for at least some οf their taxpayers (U.S. General Accounting Office [GAO], 1996). Moving to a no-return system, however, has implications for both the administrative and structural features οf the tax system. Our goal in this paper is to identify and provide information on some οf the major trade-offs involved. The next two sections describe different types οf no-return systems and summarize features οf the British system. We then provide estimates οf how many U.S. individual income tax returns could be eliminated under various sets οf changes in the tax code. The last section provides some concluding remarks. No-Return Systems There are, broadly speaking, two types οf no-return systems--exact withholding and tax agency reconciliation--with many possible variations on each prototype. Exact Withholding In exact withholding systems, the tax agency makes every effort to withhold the exact amount οf taxes so that no end-of-year filing, payment, or refund is needed. Thirty-four countries operate exact withholding systems. These systems require taxpayers to report some minimal, nonfinancial information to either employers or the tax authorities. (In the United States, this would likely consist οf items such as name, address, social security number, filing status, name and social security number οf spouse and dependents.) The proportion οf taxpayers who have to file varies by country. About 90 percent οf taxpayers eligible for final withholding in the United Kingdom did not have to file in 1991. In Germany in 1986 and in Japan in 1988-90, the corresponding figures were 46 and 63 percent, respectively. Moreover, even among wage earners, exact withholding can be difficult to apply accurately to everyone. Withholding errors can occur when earnings come from more than one source or when the taxpayer changes jobs, retires, marries, divorces, or has a child. These issues indicate the important interaction between tax structure and tax administration. If these tax systems had been set up to tax only wages, and to tax at a flat rate with no allowances, deductions, exemptions, or credits, exact withholding would work accurately for virtually everyone. Tax Agency Reconciliation Taxpayers may be relieved οf the burden οf filing even in systems that do not generate exact withholding. In tax agency reconciliation (TAR) systems, taxpayers can elect to have the tax agency prepare their return. Under a TAR system, tax filing occurs in four steps. Interested taxpayers provide basic information to the tax authority. Because withholding does not have to be exact, TAR systems may not place as great a burden on employers and other payers as exact withholding systems. Moreover, it may be easier in a TAR system to apply a progressive tax rate structure to a combination οf income derived from different sources. But TAR systems are not costless to either payers or to the tax authorities. In order to ensure timely payment οf both refunds (to the taxpayers) and balances due (to the tax authorities), payers must report payments to the tax authorities as close to the end οf the tax year as possible, while the tax authorities must absorb, process, and match millions οf information returns more quickly than under current law. Only Denmark and Sweden--both relatively small countries--operate TAR systems. About 85 percent οf Denmark's taxpayers and 74 percent οf Sweden's taxpayers had their returns filled out by the tax authorities in 1994. Neither an exact withholding or TAR system provides an easy way to handle capital gains, itemized deductions, business income, employee business expenses, moving expenses, or individual retirement accounts, although some accommodation is possible. A key issue in either system is who would bear responsibility for mistakes on the tax form prepared by the tax authority or mistakes in exact withholding made by either the tax authority or the employer/ payer. One major difference between the systems is where the burden οf tax preparation is placed, with the tax authority facing much οf the additional burden in a TAR and employers and other payers in an exact withholding system. The British System Some perspective on no-return systems can be gleaned from the British tax system. Exact withholding was established in Britain in the 1940s, when the financing requirements οf World War II led to a 150 percent increase in the number οf taxpayers over a two-year period. The unit οf taxation is the individual, although joint filing was permitted before 1990. The personal allowance was £3,765 in tax year 1996-7 (which ended in April 1997). Married couples receive an additional allowance οf £1,790 that can be allocated arbitrarily across spouses. Taxpayers who are blind, recent widows, or elderly receive additional allowances. Taxable income includes wages, interest, dividends, some capital gains, royalties, business income, and other items. The marginal tax rate was 20 percent on the first £3,900 οf taxable income, 24 percent--the "basic rate"--on additional income up to £25,500, and 40 percent on higher levels οf income. About 64 percent οf taxpayers are in the basic rate bracket. Having a large number οf taxpayers withheld at the same rate makes it easier to administer a no-return system. Coupled with PAYE, a number οf features οf the tax system enhance the possibility οf not having to file a return. Taxes on interest, dividends, and royalties are withheld at the source at the basic rate. Capital gains on owner-occupied housing are completely exempt from taxes. Other capital gains are taxed on an inflation-adjusted basis, and only realized gains in excess οf £6,300 per person are subject to taxation. Indexing, however, cannot be used to turn a gain into a loss or to increase a loss. Not surprisingly, very few people pay capital gains taxes in the United Kingdom. The first £3,250 οf rental income on rooms in the renter's home is exempted from taxation. Tax-preferred saving is incorporated via payroll deductions for pensions and "back-loaded" saving incentive plans, in which contributions are not deductible but earnings and withdrawals are not taxed. Tax adjustments for mortgage interest are provided, but not on the individual returns. Interest relief is provided at the source at a 15 percent rate. For example, a taxpayer with a 10 percent mortgage would pay 8.5 percent interest, and the lender would collect the remaining 1.5 percent interest (on the first £30,000 οf the loan) from the government. A limited amount οf charitable contributions can be made through a payroll deduction plan, and taxpayers can also "covenant" income earmarking the income to charity for four or more years. The taxpayer deducts the basic rate from the donation, and the charity recovers this amount from Inland Revenue (the British tax agency). Very few employee business expenses are deductible, nor are general medical expenses (but οf course the structure οf health expenditures is quite different in the United Kingdom than in the United States). There are no deductions for local taxes. The British experience suggests that operating a no-return system may have implications for both the structural and administrative features οf tax policy. On the structural side, the British system--and other no-return systems--is marked by systematically different choices than the U.S. system. The system has fewer rates, fewer itemized deductions, fewer attempts to run social policy through the tax code, more withholding, and more compromises in favour οf simplicity and against trying to measure income or ability to pay exactly right. In the last category, we note the exemption οf a large amount οf capital gains, the cap on deductions at the basic rate for charity and 15 percent for mortgages regardless οf the taxpayer's actual marginal tax rate, and the limit on the mortgage interest deduction to the first £30,000 οf the loan (well below the median house price in Britain). There are no dependent allowances or earned income tax credits (EITCs); spending programs mimic these tax programs. There is also no alternative minimum tax (AMT), no income-based phase-out οf allowances, no income-based cap on deductions, no child tax credit, etc. It is also noteworthy that the basic rate is substantially higher than the 15 percent rate faced by most U.S. taxpayers. Thus, although the debate on no-return systems typically focuses on administrative issues, there may be additional gains or costs, depending on one's perspective, from the ways that no-return systems may constrain the structural features οf tax systems. On the administrative side, no-return systems are often thought to provide large savings. The British experience may be somewhat surprising. While Inland Revenue (cited in James and Wallschutzsky, 1994) compares the system to "... a vintage Rolls Royce which the Revenue laboriously if not lovingly maintains... and in which the taxpayer rides in reasonable comfort and for free," Kay and King (1990) note that "Two characteristics οf the British tax administration can be given objective description. Few people understand it, and it is very expensive." That few people understand the system is not surprising, because they have no need to learn the details. That the system is thought to be expensive is more surprising, but may be misleading. Kay and King (1990)cite Inland Revenue administrative costs οf about two percent οf revenue collected. This is about four times the figure for the IRS relative to total U.S. revenues. However, the net impact on other participants is ambiguous. Because so few individual forms are filed in Britain, individuals' compliance costs seem much more likely to be higher in the United States (see, for example, Blumenthal and Slemrod, 1992). The administrative costs to employers and other payers may be higher in Britain. In any case, complaints about the complexity and administrability οf the British tax system cannot be ignored. At least in the 1970s, the British taxpayer was in contact with Inland Revenue about four times as frequently as the typical American taxpayer was in contact with the IRS (Barr, James, and Prest, 1977). Recent events suggest the British are moving toward a self-assessment system more like the U.S. system (Johnston, 1996). Kay and King (1990) claim the British system is expensive due to the lack οf use οf computers, because the absence οf an end-of-year tax form constrains the solution to many withholding problems, and because it is cheaper to have the individual income tax forms be the primary source οf information (as in the United States) than to have the tax authorities collect the information. They conclude that "... the experience οf many countries suggests very clearly that it is more expensive to maintain the apparatus required to achieve exact withholding than to accept lower standards οf withholding and process an annual return from every taxpayer". Works Cited Barr, N. A., S. R. James, and A. R. Prest. Self-Assessment for Income Tax. London: Heinemann, 1977. Blumenthal, Marsha, and Joel Slemrod. "The Compliance Cost οf the U.S. Individual Income Tax System: A Second Look After Tax Reform." National Tax Journal 45 No. 2 (June, 1992): 185-202. James, Simon, and Ian G. Wallschutzsky. "Should Australia Adopt a Cumulative Withholding Tax System?" Australian Tax Forum 11 No. 3 (1994): 311-35. Johnston, David Cay. "British to Adopt American-Style Tax Filing." New York Times (February 15, 1996): D6. Kay, John A., and Mervyn A. King. The British Tax System. 5th ed. Oxford: Oxford University Press, 1990. U.S. Department οf the Treasury. Internal Revenue Service. Current Feasibility οf a Return-Free System. Washington, D.C., October, 1987. U.S. General Accounting Office. Alternative Filing Systems. GAO/GGD-97-6, Washington, D.C., October, 1996. van der Heeden, Koenraad. "The Pay-As-You-Earn Tax on Wages--Options for Developing Countries and Countries in Transition." IMF Working Paper No. 94/105. Washington, D.C.: International Monetary Fund, 1994. Read More