The overall tax rates levied on employment income are higher, and sometimes significantly higher, than the overall (personal and corporate) tax rates levied on income from running a business, including dividend income, self-employment profits and capital gains (see chart below).
Levying lower tax rates on the self-employed cannot be justified by differences in publicly funded benefits or in employment rights, and are not well targeted at promoting entrepreneurship. And varying rates across different types of income creates a range of problems, including unfairness because people generating similar overall income from doing similar things can face very different tax rates.
There are often calls to apply the same overall tax rates to income from business as to income from employment – that is, to make all of the bars in the chart above the same height. However, increasing tax rates on business income would discourage some saving and investment. It would also worsen a range of other problems that are created by the design of the tax base (the definition of what is taxed).
Policymaking has been hampered by this perceived tension in setting capital taxes: aligning capital tax rates with labour tax rates is desirable to provide equal treatment, but lower rates are deemed desirable to support saving and investment. Setting tax rates as a compromise between these two sets of goals means that neither aim is achieved.
The IFS-led Mirrlees Review of the tax system argued that this tension can be overcome. The two-part solution involves reforming tax rates and the tax base. The tax base can be reformed so that taxes do little to discourage saving and investment. Tax rates can then be aligned across all forms of income.
Why the tax base matters and how to fix it
The tax base defines what is taxed. For example, it determines the extent to which businesses and their owners can deduct the costs of buying equipment or servicing loans from their taxable income. A well-designed tax base would automatically ensure that marginal investments – those that are only just worthwhile – were not taxed: taxing them deters such investments by making them unviable. Tax would be levied on more profitable projects, but investments that were profitable before tax would remain profitable after tax, so tax would not prevent such investments.
This is not what the UK tax base achieves. Some marginal investments are taxed; some are actually subsidised without good reason. Tax affects investment incentives in a way that varies with the type of asset being bought, who does the investment (for example, whether they are self-employed or operating through a company), whether it is financed by debt or equity and the rate of inflationInflation is the change in prices for goods and services over time.Read more. The design of the tax base creates an incentive to borrow, a disincentive to invest (equity) in companies, a bias towards investing in some assets rather than others, a disincentive to take risks, and an incentive to hold on to assets for longer than commercial decisions would dictate. By distorting a range of decisions, the tax base creates inefficiency – in short, some decisions are being driven by tax rather than by what is best commercially, and, ultimately, this reduces society’s aggregate output and well-being.
Flaws in the tax base cause more problems when tax rates are higher. Moreover, the efficiency costs created by a distorted tax base rise more than in proportion to tax rates, because low tax rates only change behaviour when the decision is marginal anyway; higher tax rates discourage not only more activities, but also more valuable activities. However, while reduced tax rates on business income mitigate the problems caused by the tax base, they do not solve them: reduced rates can still deter marginal projects while leaving the array of distortions in place and giving unjustified support to some highly profitable activities which would go ahead in any case.
The tax base is a more effective tool than tax rates for ensuring that taxes do not discourage investment. There are broadly two ways to reform the tax base to largely remove disincentives to save and invest and the other distortions cited above. In summary:
- The ‘cash-flow’ approach would give 100% up-front tax deductions for all savings and investments and tax all incomes when they are received.
- The ‘deferred-allowances’ approach (known as a ‘rate-of-return allowance’ in personal tax and ‘allowance for corporate equity’ in corporation tax) would provide a stream of annual tax allowances for a risk-free return to money saved or invested, which would be as valuable as a 100% up-front deduction.
Each approach ensures that all investment costs are fully deductible from tax. Under either approach, there would need to be reform of the tax treatment of borrowing and of the treatment of losses. For a detailed discussion, see the report cited at the end of this article.
Aligning tax rates
Levying different tax rates on different forms of income creates a range of problems. It is unfair when similar people doing similar work – for example, two IT professionals doing similar work but where one is employed and one operates through their own company – pay very different taxes. The tax differences also distort a range of decisions. For example, some people operate through companies, or take money from their business in the form of capital gains rather than income, even if, absent the tax advantages, they would be better off making different decisions. And because there are such large differences in tax rates between types of income, much time must be spent devising, administering and complying with rules that determine, for example, whether someone is really working as an employee and whether a particular receipt represents income or capital gain.
Bringing tax rates closer together would, therefore, alleviate a range of problems. But, as noted above, if tax rates on business income were increased in isolation then problems caused by the tax base, including disincentives to invest, would be increased. At present, therefore, changing tax rates involves a complex trade-off between different types of problem. With a reformed tax base, however, tax rates on income from business could be increased with little concern about weakening incentives to invest and take risks.
With a reformed tax base, there would be a strong case for aligning tax rates so that income from employment and from business were taxed under the same overall marginal rateThe amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).Read more schedule. (If this were so, the bars in the above chart would all be the same height.)
There are many combinations of rate changes that could achieve this and, overall, tax rates could be levelled up to current employment tax rates, levelled down to current capital tax rates, or set somewhere in between.
The two-part ‘solution’ we describe here builds on a large body of economic research and was laid out by the IFS-led Mirrlees Review of the UK tax system. Delivering all the components of an ideal system at once would be daunting, but there are ways to reform taxes incrementally to start tackling the main problems and get the UK moving towards a set of well-designed taxes. We discuss the problems with the current system, the proposed solution and reform options in the following IFS report: ‘Taxing work and investment across legal forms: pathways to well-designed taxes’.
This article, and the underlying research report on which it draws, have been funded by the Nuffield Foundation, but the views expressed are those of the authors and not necessarily the Foundation. Visit www.nuffieldfoundation.org.