Wednesday’s budget will not be a big revenue raiser. Rishi Sunak has already raised £40bn in tax this year.
A combination of freezing the income tax thresholds while inflation is roaring, and expanding national insurance contributions, mean that he has raised tax as a share of the economy to the highest level in British history. However, if the chancellor wants to go down in history as a great reformer, rather than merely a revenue raiser, there are some big tax changes he could make.
Top of that list is fixing the taxation of capital gains. This is money received from the sale of assets for more than they were bought. While people often imagine this is the sale of second homes or shares, most of the value of capital gains comes from selling small businesses.
UK could gain £16bn a year if shares and property were taxed like salariesRead more
Capital gains have skyrocketed in recent years. They almost trebled, from £22bn to £63bn, between 2012-13 and 2019-20 (pre-pandemic), while average incomes remained broadly flat. Almost all these gains went to a tiny minority: 92% of taxable gains went to people with more than £100,000 in gains.
The rise in total gains has gone hand-in-hand with the growth of “super gainers”: individuals receiving more than £1m in gains in a single year.
More than half of these “super gains” come from the sale of small businesses which the person works for. The money they receive is essentially the compensation for working. But, while ordinary workers pay income tax and national insurance – costing 32% of income for someone on the basic rate, and 47% for those at the very top – capital gains tax rates are only 10% up to £1m for these small business sales, and 20% thereafter.
Fixing this doesn’t require radical innovation or out-of-the-box thinking. The chancellor merely needs to look to his political hero, Nigel Lawson. In 1988 Lawson, recognising “there is little economic difference between income and capital gains”, equalised the rates at which these were taxed.
The chancellor should embrace this history, and – with some tweaks – return us to that system. A move in this direction was also recommended last year by the Office of Tax Simplification.
This would have three major benefits. First, it would make the system fairer. In 2017, almost a quarter of people taking home £1m paid the headline tax rate, while one in 10 paid a lower effective tax rate than someone earning just £15,000. The differences, both between rich and poor, and among the rich, are striking.
Second, it makes the economy more efficient. The current system rewards being a mediocre business owner rather than a highly productive employee. Someone taking home £1m could save almost £370,000 in tax if it can be classed as capital gains rather than income.
Third, it would raise substantial revenue. In 2019-20, the static tax revenue raised from taxing capital gains like income would be almost £16bn. Going beyond Lawson to remove peculiarities such as “death uplift” – whereby the tax is wiped out on death – and reducing the very large amount of gains that can be received without any tax, would make the system fairer and raise more.
The chancellor may well say that he has raised enough already, so reform is unnecessary. But this is to confuse revenue-raising with reform. In our new, higher-tax state, an important question is who should pay. The current system is full of inequities, including taxing income from work at much higher levels than income from wealth. Reforming the taxation of gains would be a first step towards fixing that.
Three ways to make tax fairer
1. Reform the taxation of capital gains
By value, most capital gains come from activities that are otherwise taxed as income. But by structuring that income as capital gains, individuals can benefit from much lower tax rates. Someone taking home £1m could save almost £370,000 in tax if it can be classed as capital gains rather than income. This could be fixed by returning to 1988, when gains were taxed at the same rate as income.
2. Extend national insurance contributions
National insurance contributions are an additional tax on income from work. Landlords and investors do not pay them. Nor do those over state pension age, even if they keep working. They are also charged at a higher rate on lower incomes: 12% between about £10,000 and £50,000, but only 2% thereafter. A simple extension of national insurance to cover all income equally would raise £31.4bn.
3. Fix inheritance tax
Most households will not pay inheritance tax: currently about 4% of estates are valuable enough to pay it. But the tax looms large in the minds of many. One objection to the current system is the presence of large reliefs, that mean the wealthiest pay less than the “merely well-off”: an estate worth £2-3m pays about 20% tax on average, while an estate worth more than £10m pays only 10%. Removing or capping some of these reliefs could fund a reduction in the 40% headline rate to just 25%.
Arun Advani is assistant professor of economics at the University of Warwick’s CAGE research centre and a research fellow specialising in tax at the Institute for Fiscal Studies
