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Poisoned chalice?

What is the point of tax reform, asks JEREMY MINDELL


  • Constant reforms of capital gains tax have caused confusion.
  • Offsetting new taxes by decreasing others.
  • Tax reform should be tax neutral.
  • The international influence on corporation tax.
  • Could the VAT zero rate face attack?

Why has tax reform descended into nothing better than hiking taxes? Is it because, as the former chief secretary to the Treasury allegedly wrote in a note to his successor, ‘There’s no money left’? Or is the problem with tax reform as a principle?

The current capital gains tax controversy suggests the latter. Ever since 1965 when capital gains tax was introduced it has been tampered with, adjusted and reformed. Given the small amount of money that it raises, it causes a disproportionate amount of anxiety.

The current problems with capital gains tax arise from, you guessed it, tax reform. Capital A bottle of poison tips overgains tax has for many years attracted several reliefs, notably to ensure that taxpayers did not pay on gains caught solely by inflation.

The original relief, indexation, was superseded by taper relief, which reduced the amount of the gain dependent on the number of years the taxpayer had held the asset.

There were different rates for business assets and non-business assets. As a result, if a taxpayer had held business assets for a little as two years, he would pay only 10% capital gains tax.

Give and take

Then the elastic band and brick effect comes into operation. The maximum taper relief was achieved after four years and was then cut to two years (stretching the elastic).

This was just too generous and was bound to be attacked when managers boasted they were paying less tax than their cleaners.

The reaction came disguised as reform; the brick came back and hit taxpayers. Remember the nil rate band for corporation tax? A similar process was at work.

There is a pattern here:

  • create a relief;
  • give it time to take off;
  • make the tax relief more generous;
  • then complain about aggressive tax planning and;
  • indiscriminately sweep it all away.

Alistair Darling, in a move to simplify capital gains tax, decided to abolish the taper relief system and unify the capital gains tax rate at 18%. This was good for people who had non-business assets, as they were previously taxed at the rate of near 40%, but bad for those who had business assets.

The outcry from the losers was greater than that from the winners and effectively forced Alistair Darling to introduce entrepreneurs’ relief.

Laudable though the attempt at tax reform was, one could have guessed that it would not last very long. Politicians conveniently forgot that a number of reliefs were abolished to pay for the lower rate of tax which is the normal way of any tax reform.

The Liberal Democrats concentrated on the low rate of capital gains tax and decided it should be matched with income tax.

This was resisted by the current Chancellor but the new rate of 28%, with no relief for inflation or the period that an asset is held, make UK capital gains tax one of the most penal in the developed world.

Promises unfulfilled

Hypothecating tax to reduce other taxes and, then, conveniently forgetting to do so is another trick. This happened in a number of taxes such as, for example, landfill tax.

The government of the day promised that increased landfill tax, which affects companies, would be offset by reductions in employment National Insurance contributions to keep the overall cost of the business the same.

That did not happen after the first year; the same is true of the climate change levy, as well as cuts in government support for statutory sick pay and statutory maternity pay, which were supposed to lead to permanent National Insurance reductions.

There has been only a small reduction in income tax rates in exchange for the many allowances which disappeared, such as the married couples allowance and mortgage interest relief.

The generous personal equity plans and tax-exempt special savings accounts were replaced by the parsimonious individual savings accounts.

Preventing pension funds from reclaiming the UK dividend tax credit was never compensated and has cost British pensions funds at least a £120 billion. More than any other single measure, this tax reform has created the pensions gap that we now have.

A true reformer

To find the last true tax reforming Chancellor, it is necessary to go back to Nigel Lawson – who has been receiving more attention than usual because it was he who unified income tax and capital gains tax rates in 1988.

However, it should be remembered that indexation relief cushioned the effect of inflation. He also rebased assets to 1982 values so that only six years of gains were taxed. Rebasing has not happened since.

The abolition of huge numbers of reliefs and the reduction in tax advantaged benefits like company cars was counterbalanced by a real reduction in income tax rates and the abolition of the investment income surcharge. Indeed, Nigel Lawson’s top rate of 40% lasted 22 years.

However, he presided over a period of expanding economy and a strict control of public spending. These elements are always prerequisites of successful tax reform as it is broadly revenue neutral.

Be honest!

Using tax reform as an excuse to squeeze more money out of the taxpayer is dishonest. If governments need to raise tax, they should be upfront about it. The last Chancellor to raise the basic rate of income tax was Denis Healey, but that does not mean that the tax take has not been raised since.

There is a cynical combination of spin and the use of technical instruments to try to mask tax increases, known as stealth tax rises. Increasing the scope of a tax while reducing its rates for a few years, and then deciding that the rate can go back up, is an example in true cynicism.

Using National Insurance contributions as a way of increasing revenue was a favoured weapon of the previous Government. This led to the wry comment, ‘the good news is that income tax has stayed the same; the bad news is that taxes on income have gone up’.

The main beneficiaries of lower taxes and higher National Insurance are pensioners, who coincidentally are most likely to turn up at elections.

Meanwhile, the tax code has grown to be the second largest in the world after that of India. Perhaps tax advisers should welcome the complexity as making it easier to make a living.

However, when it gets beyond the point where anyone can understand single aspects of taxation let alone all of it, the system starts to break down. This increases the pressure on the taxpayer, HMRC and the advisers.

Tax reform has worked well only in one area, corporation tax, where there has been a steady reduction in rates from 52% to the current 28% (and the intention of reducing it to 24%) with an accompanying reduction in reliefs. This has proved beneficial to business and not harmful to the Exchequer.

However, what has kept Chancellors on their toes in this area has been the threat of international competition. Even with the rate of 28%, the Government is anxiously looking over its shoulder at Ireland with a rate of 12.5%.

VAT threat

The real fear comes on VAT. The UK VAT system has been remarkably stable since 1973 with generous zero-rated exemptions designed to protect the less well-off.

Many commentators have suggested that the zero rate should be abolished, with VAT introduced on most of the products which have been zero rated, (as it is in Europe) and a compensatory reduction in the standard rate.

However, you can bet that after a few years of lower rates, paid for by the end of exemptions, the Government would increase the rates again.

You may recall that, in 1991, the rate of VAT was increased from 15% to 17.5% to compensate for the introduction of council tax at a lower rate than the poll tax. Council tax rates have since increased but the VAT rate remained unchanged (until 2008).

So far, the Government has ignored this ruse, but don’t say you haven’t been warned.

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