Tax Anomalies, Cowards and Encouraging Cheating

A competent Conservative Government would have rectified the anomaly of taxable income between £100,000 and £125,140 being subject to an effective tax rate of 60%. It is clearly anomalous for the effective tax rate to rise from 40% to 60% on income in this band and then fall to 40% on income between £125,141 and £150,000 before rising to 45% on income over £150,000.

This anomaly exists because in 2009 Messrs. Brown and Darling decided to make so called "high earners" pay for an increase in the personal allowance to benefit lower paid workers. They did this by reducing the personal allowance by 50p for every £1 earned over £100,000. The effect of this decision was to create an effective tax rate of 60%. This is because for every £1 earned in this band tax was levied on £1.50 at 40%. Messrs. Brown and Darling made this decision in the immediate aftermath of the financial crisis. The decision was, at least, partly targeted at high earning bankers. However, the longer this anomaly exists the wider the group of employees that it will catch and the increase in the rate of inflation will accelerate this process. The 60% tax rate is already preventing employees working over-time, or accepting promotion. We are now in the position that NHS consultants are caught by the 60% tax rate.

There can be no doubt that a competent Conservative Government would have addressed this anomaly in priority to reducing the 45% tax rate of income over £150,000. The 60% tax rate affects more people than the 45% tax rate, and the 60% tax rate is also is also more inequitable. The Government could address this anomaly without it costing the Exchequer, as it would be better for the economy to have a flat rate of, say, 42.5% on income between £100,000 and £150,000 than to have an effective tax rate of 60% on income between £100,000 and £125,140.

I fear that we now have a cowardly Conservative Government. The new Chancellor of the Exchequer, Jeremy Hunt, will be advised against addressing this anomaly, because of the backlash his predecessor received after announcing his intention to cut the 45% tax rate. PR consultants would advise Hunt that if he addressed this anomaly he would be opening the Government to criticism of pandering to "high earners".

To be clear, we currently have a 60% tax rate on income between £100,000 and 125,000 and yes, it is causing a host of problems. Employees don't want to work overtime, if they know they will be taxed at 60% on the overtime pay. Employees will not accept promotion if it takes them into the £100-125k bracket. When you are being taxed at 60% there is a huge incentive to evade tax. More and more people are being caught by the 60% tax on income in this bracket.

The tax code has become so large and complex that politicians have to rely on civil servants to propose amendments that will keep the code up to date and relevant to the needs of our changing society. For example, in the thirty-eight years that have elapsed since the Inheritance Act 1984 (IHTA) was enacted our attitudes toward fairness have changed. We no longer think it is acceptable for tax legislation to contain loopholes that can be used by a small minority of highly paid individuals to escape the liability to pay tax, while the overwhelming majority of taxpayers are caught by laws that require them to pay taxes. The reason the IHTA still contains loopholes for a small minority of highly paid individuals to exploit is because Governments of all political persuasions have a propensity to enact new legislation and neglect reviewing existing legislation to ensure that it still meets the demands of our changing society.

Consider, for example section 19 and section 20 IHTA. These two sections relate to exempt gifts (i.e., gifts which are not subject to the 7-year rule). There is a limit on section 19 gifts, which has not been increased since 1984. By contrast there is no limit on section 20 gifts. In theory, an individual is able to benefit from both section 19 and section 20, but in reality, only highly paid individuals are able to benefit from section 20 gifts. This means that we have one law, which is extremely mean, for the overwhelming majority of taxpayers and another law for the small minority of highly paid individuals, which is extremely generous.

An individual is able to make a gift in one of two ways: either out their accumulated savings over a number of years, or out of their excess income in an individual year.

The overwhelming majority of taxpayers have limited ability, if any, to make gifts out of their surplus income in a specific year. If they make a gift, it will be out of their accumulated savings over a number of years. Such gifts are subject to the limit of £3,000 contained in section 19. The limit of £3,000 has not be changed since 1984.

Section 20 allows individuals to make gifts out of their excess income. Excess income is defined as income which exceeds normal living expenses. There is no limit of section 20 gifts. This means if an individual has an annual income after tax of £3 million and normal living expenses of £1 million they are able to make exempt gifts of £2 million per annum.

It is difficult to imagine that any politician today would be able to justify the discrepancy between section 19 and section 20 gifts. The limit on section 19 gifts should be raised to reflect the effect of inflation, and there should be a limit imposed on section 20 gifts. Given that the small number of wealthy individuals have more influence in our society than the overwhelming majority it is likely that if there was a limit on section 20 gifts, Governments would come under pressure to increase this limit with inflation, and we would see a corresponding increase in the section 19 limit.

There are potentially four tax rates on income over £100,000: 60% on income between £100,000 and £125,140, 40% on income between £125,141 and £150,000 and 45% on income over £150,000, and then there is the average rate of tax if the total income is greater than £125,140. The tax system is currently designed so that the average rate of tax falls that greater the income is over £100,000. This is because the first £50,000 of income over a £100,000 is taxed at an average rate of 50% (i.e., £25,000 at 60% and the next £50,000 at 40%), whereas all subsequent income is taxed at a lower rate, namely 45%. This means that the greater income is over £100,000 the excess income is subject to a lower average tax rate. The table below illustrates this.