The UK tax system treats certain taxpayers differently to others, which leads to inequality in terms of the amount of tax paid on similar levels of funds.
Capital vs income
Capital gains are taxed at lower rates than income in every tax band, with the exception of tax due on dividends.
The tax that Zahawi allegedly paid late arose from a gain of £27m, on which he was ultimately liable to pay capital gains tax (CGT) of £3.7m, amounting to around 14% of the gain. The top rate for CGT at the time of the disposal was 20%. The discount in the effective rate was likely due to entrepreneurs’ relief, which applied a rate of 10% on gains of up to £10m in the lifetime of the taxpayer. That lifetime cap has since been reduced to £1m.
There is no solid evidence that having a lower tax rate on gains stimulates growth or employment. A study by the CAGE group at Warwick university has found that half of all taxable gains are received by just 5,000 people in the UK, who each receive more than £1.5m in gains, mostly from the disposal of businesses or business assets.
In 1988 Chancellor Lawson aligned the tax rates that applied to income and capital gains, while at the same time introducing indexation allowance to relieve the effect of inflation on the value of assets. A similar rate alignment could be made today, as suggested by the Office of Tax Simplification.
Earnings vs dividends
Income from employment and trading suffers tax at higher tax rates than dividend income, which is also exempt from national insurance contributions (NIC).
The favourable tax treatment of dividends, and the ease of operating through a company since the audit requirement for small companies was removed, has encouraged the growth of personal service companies (PSC). The pressure on workers to operate through a PSC also comes from engagers who seek to avoid employer’s NIC, the costs of pension contributions, holiday pay, sick pay and parental pay due for employees.
This imbalance led to the IR35 rules enacted in 2000, which did little to solve the problem, as the underlying tax advantages of the PSC structure for both the individual and the engager remain strong. Off-payroll working has tipped the scales again, but there is still an exemption for small and medium-sized engagers.
The solution to the gordian knot of employee/self-employed tax differentials must involve tackling the issue of employer’s NIC. But this won’t be easy as HMRC statistics show the amount of employer’s class 1 NIC paid in 2021/22 was around £89.5bn. This amounted to 12.5% of all HMRC receipts and was 40% more than the total corporation tax collected in that year (£63.5bn).
If employer’s NIC were to be abolished and the tax burden shifted to corporation tax, the main rate of corporation tax would have to rise to around 35% to make up for the loss in NIC revenue. The advantage gained by non-corporate employers by the abolition of employer’s NIC would also have to be addressed.
Property owners vs renters
Landlords pay no NIC on their property income, unless the property is held by a corporate vehicle and the ultimate owner extracts funds as a salary.
Where the individual landlord doesn’t pay sufficient class 1 or 2 NIC in a tax year, they won’t build up an entitlement to the state retirement pension. But that may not worry certain landlords who view their let properties as a pension fund, with a plan to sell up on retirement.
On disposal the increase in the value of the properties will be taxed at 18% or 28%, which is significantly lower than the tax due on regular pensions at 20%, 40% or 45% (higher tax rates apply in Scotland).
Individuals who own their own homes also benefit from the rise in property values over time, particularly for homes located in the south of England. The CGT exemption for the taxpayer’s only or main home means that this increase in value is completely free of tax, a relief worth £30.2bn per year according to HMRC statistics.
Renters by comparison will never benefit from the growth in property values, and generally pay tax and NIC on their income at 32%, 42% or 47% (higher rates in Scotland), plus student loan repayments in many cases.
To equalise tax treatment between homeowners and renters the CGT exemption for main homes could be restricted or removed, and the rates of CGT could be aligned with those of income tax, as Tax Policy Associates have suggested.
Older vs younger
Charging NIC on pension income would be a step towards equalising the tax rates between the generations, but the incredible burden of student loan repayments would aslo need to be addressed.
UK domicile vs non-domicile
The tax advantage that Zahawi was attempting to exploit was based in the UK’s non-domicile rules, which are peculiar to this country.
Dan Neidle has argued that the non-dom regime should be removed, along with excluded property trusts that provide non-doms with an inheritance tax shelter, and I agree with him.