Dragged into disrepute

PUT ASIDE DISTURBING mental images of Gordon Brown in a frock and reflect on this simple question: 'What can be better for a Chancellor who needs to raise more revenue than an automatic, virtually guaranteed increase in tax revenues that he does not need to announce or legislate for and that few people seem to notice?' Neo-classical endogenous growth may be a sad soundbite he would rather forget, but its effects bite ever harder into the incomes of UK taxpayers. An Internet survey conducted by Baker Tilly supported the concern of many in the tax profession: fiscal drag is steadily and insidiously distorting and debasing the tax system.
But first let us define our terms: fiscal drag arises when allowances, thresholds and bandwidths fail to keep up properly with economic conditions, so that the real level of taxation rises as a function of inflation or economic growth.

The survey

The survey started with a simple but obvious anomaly: the threshold for benefits in kind. In 1979-80, the threshold was set at £8,500, an increase from £5,000. At that time the threshold was the mark above which employees became 'higher paid'. Now, it would not cover a full-time employee on the national minimum wage, yet all that has changed is that when employment tax law was rewritten in the ITEPA 2003, the embarrassing phrase 'higher paid' was quietly dropped. Of those who responded to the survey, 71% felt that fiscal drag has created problems that need to be addressed.
Just how big is the problem? If we take the P11D threshold alone, 1979's £8,500 should by now have risen to around £28,800. That is well above the level of average earnings and means that today the threshold is meaningless; virtually all employees are taxed on all benefits.
The P11D threshold is a long-term example of fiscal drag in action. While there have been fundamental changes in the tax system since 1979, the underlying trend has been one of steady increases in the tax take. This is evident in other taxes.

Context is everything

Two of Einstein's more famous observations were that the hardest thing to understand is income tax and that everything is relative. Fiscal drag requires an analysis of tax relative to everything else, and we are not Einsteins. Our context is the changes that have taken place over the last 20 years, between 1985-86 and 2005-06.
In that time the UK's gross domestic product and tax revenues have increased fourfold, as shown by Table 1, based on HMRC's annual statistics.
The telling facts are that:

• tax is now higher as a proportion of GDP than it was in 1986; and
• income tax now yields more than corporation tax.

Table 1: Net receipts of former Inland Revenue taxes

Notes:

Amounts: £ million

The overall growth in the economy has also had the effect of bringing more taxpayers into the net, as is seen from Table 2, again based on HMRC's statistics.
This reminds us that while many more people now pay tax while they are alive, the most striking proportionate increase is in the number of estates paying inheritance tax.

Table 2: Estimated numbers of taxpayers

Notes:

Numbers: thousands.

The number of companies is for 2003-04, the latest available on the HMRC statistical table provided.

Income tax

The major increase in income tax reflects the failure of tax allowances and rate bands to keep pace with inflation. In 1985-86, the income tax rate bands ranged from 30% basic to the top rate of 60%. Higher rates started at £17,200 and the personal allowance (at that time, the single person's allowance) stood at £2,335. In 1985-86 the total income tax collected was £35,353 million (source: HMRC annual report).
In 2005-06, the standard rate was 22%, there was a single higher rate of 40% (the 32.5% rate on dividends being something of a fiction based on the abolition of advance corporation tax and tax credits on dividends) and the personal allowance had risen to £5,335. Meanwhile, the income tax take had increased to £131,361 million (HMRC estimate).
Over 20 years, therefore, the personal allowance increased by 128% while average earnings trebled (source: Department of National Statistics). Although tax rates have reduced, allowances and thresholds have not risen at the same rate as incomes, so the income tax take in cash terms has increased almost fourfold, in line with GDP.
In the same time period, National Insurance contributions had also increased, especially employers' contributions, with the thresholds tracking the income tax thresholds.
So, over the past 20 years it is clear that:

• tax rates have fallen;
• tax allowances have increased to some extent; and
• the amount of income tax paid has increased disproportionately.

Individuals are not free to opt out of taxation; the headline figure of 5.5 million more taxpayers than there were in 1986 (source: HMRC report) does not represent a real increase in the number of people paying tax because the number of 'taxpayers' now includes those receiving tax credits.
For those in the middle, especially on the cusp between standard and higher rates of tax, the persistent failure of rate bands to match earnings has hit especially hard. The Institute for Fiscal Studies has calculated where the higher rate threshold falls in relation to average earnings:

• in 1996-97 the higher rate threshold was 161% of average earnings;
• by 2003-04 the threshold had fallen to 143% of average earnings.

So, again, the squeeze imposed by fiscal drag is felt at the middle.

Capital gains tax

At first sight an allowance of up to 40% off the gain on an investment asset held for ten years looks generous while inflation remains at around 2.5% to 3%. The fact that taper relief stops accruing after ten years means that it is considerably less advantageous than indexation for, say, a private residential landlord who retains properties for the long term, even on the basis of retail prices index. Bearing in mind that inflation operates in compound fashion, so that inflation at a steady rate of 2.5% would compound up to a total discount of 31.2% over a ten-year period, taper relief offers little better than a compensation for inflation and not the inducement to retention that it was announced to be. Longer term retention gives the prospect of paying capital gains tax on inflation.
For all its faults, indexation gave individuals a form of hedge against inflation, which grew over the whole ownership of the asset. It would give a fairer measure of the true gain than taper relief, should inflation ever take a grip again.

Inheritance tax

1985-86 was the last year of capital transfer tax. In that year, with a nil rate band of £71,000 on 5 April 1986, compared to £275,000 in 2005-06, inheritance tax appears to have kept pace with inflation better than other taxes, especially when one takes account of the reduction in rate from 60% in 1986 to the current rate of 40%. But inheritance tax is a tax on assets and the greatest increases in asset value have affected homes: the Nationwide's figures indicate that the average house quadrupled in value between 1986 and 2006, so the nil rate band has barely kept pace with inflation. Meanwhile, despite the relaxations, receipts of inheritance tax rose from £881 million in 1985-86 to £3,300 million in 2005-06, an increase of 275%.
Inheritance tax had traditionally been referred to as a 'voluntary tax'; this is clearly a misnomer judging from these figures. Nevertheless, it was manageable for many, at least until the introduction of the pre-owned assets tax. Inheritance tax has been brought to the fore as a tax that has started to extend its reach ever lower as family homes have increased in value. Average house prices have increased from around £36,700 in 1986 to £165,000 in April 2006 according to the Nationwide Building Society house price calculator. That increase in value outstrips all other measures of inflation and it is a common fear that the continuing trend threatens to bring more homes into the inheritance tax net.
The recent sharp increases in the number of estates paying inheritance tax, and its yield, confirm that fiscal drag is now beginning to bite on rising house values. A nil rate band well in excess of £400,000 is needed to restore the original purpose of inheritance tax, followed by a link to a property index instead of the retail prices index.

Corporation tax

Corporation tax is the most quoted example of fiscal drag in action. In 1986 the limits for smaller companies and main corporation tax rates stood at £100,000 and £500,000 respectively, levels which had existed since 1981. Between 1990 and 1994 the bands were expanded, eventually to the levels at which they still stand 12 years later: small companies' rate is up to £300,000 and the full rate is applicable to profits in excess of £1.5 million.
At the same time the main rate has reduced from 35% to 30% and the small companies' rate from 29% to 19%. But while rates of tax have fallen, the sluggish changes in thresholds have contributed to another fourfold increase in tax yield: the nation's corporation tax bill in 1986 was £10,708 million and in 2006 it had risen to £41,273 million.
The effect of this drag is especially pernicious as it bites into the profits of companies making the transition from smaller beginnings into full maturity. Furthermore, the failure of corporation tax to keep up to date is in stark contrast with the advance of accounting definitions of small, medium and large companies, thresholds that have themselves been criticised for the slowness of their changes.

Indirect taxes

Indirect taxes, mainly VAT, are principally levied on supply or throughput, so they are not as susceptible to fiscal drag. Patterns of expenditure might account for increased indirect tax revenue if national spending on VATable goods and services increased. However, HMRC's own published statistics show that the proportion of household expenditure on VAT standard-rated goods and services is staying fairly constant at 55% or 56%.
The one area where fiscal drag has a significant effect is the registration threshold. In 1986 the threshold was £19,500; for 2005-06 the threshold was £61,000. This substantial increase spares VAT from the worst excesses of fiscal drag.

Conclusions

The effects of fiscal drag are seen across the whole spectrum of direct taxation. Fiscal drag causes distortions in markets and adversely affects the taxpayer caught in the middle.
While some thresholds, in stamp duty for example, have kept up with economic growth, the overall picture masks long periods of fiscal drag interspersed with sporadic upratings. This is not acceptable in a sophisticated economy.
Thresholds have consistently been uprated by reference to the wrong criteria; the retail prices index consistently lags behind earnings and true economic growth with the result that middle-income individuals and companies bear a disproportionate share of the tax burden.
Simply rebasing rate bands and thresholds that have fallen out of date will not be enough; what is required is a system of automatic uprating of bands and thresholds by reference to relevant economic criteria. Otherwise the system will remain tainted by the stain of institutionalised taxation by stealth.

George Bull is national head of tax; Chris Williams is a senior manager in Baker Tilly's national tax department.

Issue: 4084 / Categories: Comment & Analysis , Capital Gains , Companies , Income Tax , Inheritance Tax , VAT