• Stuart Fowler

Flatter to deceive: the Chancellor flattens taxes but fails to say why

Last week’s pre-budget report introduced one of the most radical reforms to capital taxes for 20 years. It showed courage in dealing with what may have become excessively generous tax concessions to wealthy foreigners with UK businesses and employment. But what did the public see? A tail-end Charlie of a government, bereft of its own ideas and rushing out initiatives stolen just days earlier from the Conservative Party conference. Labourites, old or new, must be wondering whether substance without spin is really such a good thing.

In these extracts from our latest client newsletter, No Monkey Business reviews the tax initiatives from the same perspective we bring to personal finance: technical and moral integrity. Open and simpler taxation is a sign of honest government. It also reduces the public’s need to take expensive financial advice in order to make sensible decisions and avoid errors. As a career money manager for institutions who found it necessary to qualify as a financial planner in order to manage private wealth efficiently, I see one test of sensible taxation as being that all that additional contextual knowledge would not have been necessary.

Capital Gains Tax In response to the grilling, by a House of Commons committee, of private equity bosses who typically pay just 10% ‘business rate’ CGT on their ‘carried interest’ in investee company shares, the Government has introduced one of the most radical reforms to capital taxes: sweeping away indexation (inflation uplift for costs between 1982 and 1998), taper relief (for gains realised after 1998), and the different rates applying to business and non-business assets. How odd, then, that they did not try to present it as a radical simplification and flattening of taxes, which is what it is. ‘Odd’ is a kinder description than that used by many in the Chancellor’s own party, enraged at gifting the opposition the appearance of setting the policy agenda!

The effective non-business rate of CGT (assuming a marginal tax rate on income, including the chargeable gain, of 40%) ranged between 40% and 24% depending on the length of holding. For the flat rate of 18% to be anything but lower, holdings also needed to benefit from inflation uplift of 25%. This corresponds to the inflation experienced between July 1995 and April 1998.

The only losers are therefore individuals with holding periods longer than 13 years, where both gains and inflation were typically higher. The FTSE All Share capital-only index rose four-fold between 1982 and 1995. Property investments are also amongst the non-business assets that will see the effective rate rise. There is therefore an element of retrospective ‘fiscal drag’ in the change but, to the extent older investors are leaving these gains to die with them, the rise in the effective rate is perhaps academic.

Fiscal drag is not what tax inspectors get up to on a Friday night. It describes the way governments can use inflation as a stealth tax, trashing the coin of the realm to buy votes. An honest, open tax system is one in which only real wealth creation (in whatever form) is used as a base for taxation. This has become recognised in the voluntary indexation by successive governments of most thresholds and allowances, because an earlier generation found out what fiscal drag was doing to destroy real wealth.

The indexation of costs of capital assets subject to the CGT regime came from this discovery. It was weakened in 1998 by the introduction of ‘taper relief’, which necessarily leaves an element of the gain due to inflation being taxed, but at least a diminishing amount. Years of holding do not equate to inflation damage. But the intention was both to simplify and to influence investor behaviour by rewarding long-period holders and penalising short-term traders (as America and other countries do by differentiating the tax rate according to the holding period). I never saw any benefit in these changes: they only served to make capital taxes even more inefficient and illogical.

On the face of it, removing any element of inflation accounting, however indirect, weakens the integrity of the regime. True, but the trade-off with flatter, simpler taxes is always the rate: if it is low enough, citizens will accept some incidental inefficiencies.

If the rate with no allowances and no special treatment is low enough, citizens most adversely affected at the margin will also accept, for the greater good, the loss of those advantages. The 80% jump in the effective rate of tax on business assets is a higher price to pay for flatter and simpler. It is also what makes this a tax increase rather than tax neutral. The 10% rate was reached in just two years and many intelligent people who have benefited from it do not even bother to try to defend it.

The triggers for the change, private equity partners with ‘carried interests’ in the shares of investee companies, will be relieved they are not going to be taxed as if it were income arising directly from their employment, as they would be in most countries.

Those most affected are business owners and farmers. The impact on future entrepreneurs is unlikely to be significant: I have started several businesses and none was motivated by tax efficiency. Existing owners have seen their after-tax wealth reduced but short of bringing forward sales into this tax year there is nothing they can do about it. And if they try to, my guess is the market will arbitrage the tax difference away anyway.

Holders of non-business assets with marginal tax rates above 18% will assume it is a no-brainer to delay selling, including buy-to-let investors and people with second homes. Delaying the changes until April invites the criticism this was a cynical ploy to prop the housing market up before the election. Whatever, the tax difference here may also be arbitraged by canny buyers, particularly as the gap before April shortens.

Inheritance Tax The ability to pool two lots of allowances between spouses alleviates the need to use will trusts to obtain the benefit of both. That is a welcome change, helping to separate gifting strategy from tax strategy and further reducing the use made of trusts for reasons unrelated to their original role. It may have been prompted by the Conservative’s plan to set the limit at £1m but it is not a reduction on the burden of IHT and will not reduce the number of estates paying IHT.

Pensions This dog did not bark, except that the Chancellor repeated the Government’s position that it was still looking at ways to prevent the use of pension funds to make tax-favoured inter-generational transfers. The only remaining advantage is on death between 60 and 75, where assets can bypass a spouse and pass to children without IHT. We wait to see whether this anomaly is finally to be dealt with.

Non-domiciled UK residents ‘Non-doms’ who have been living in the UK for at least 7 out of the last 10 years will be able to continue paying UK tax only on a ‘remittance’ basis if they pay a flat rate of £30,000 for the privilege. The Government is also closing the loophole that allowed non-doms to capitalise interest in offshore bank accounts by closing the income accounts annually.

The Government has been keen to collect more tax from foreign workers for nearly a decade but has been fearful of the unknown impact on business. The Conservatives’ proposal to tax at a flat rate of £25,000 was likewise an attempt to balance these aims. Neither is obviously likely to do serious harm to our status as a business centre (so take the squeals of protest with a pinch of salt). But the Labour proposals will hurt many people of foreign birth living here by virtue of marriage or for reasons other than employment. How much they are hurt depends in large measure on the availability of double taxation relief.

The pre-budget report also confirms HMRC policy (established now by precedent in the courts) to treat non-residents’ days of travel to and from the UK as contributing to their 90-day limit.

Economic Forecasts Taxes up, borrowing up. That is what the report projects, but only on the basis of a 0.5% loss of growth due to the credit crisis. Any worse and the Government’s financial position, already the weakest in 15 EU nations, will deteriorate severely.

No wonder Gordon Brown was tempted to call an election. If the Conservatives share a gloomy view of recession risks, they must be delighted Labour will be around to deal with the problems and then to be held accountable.

It is not going to be fun managing an economy that is softening, with consumers trying to rebuild their weak balance sheets and companies on the other side of that process seeing both strong cash flows and high net cash balances evaporate. The trade account is already dire and sterling very strong so sterling weakness will help balance flows via the foreign sector, but the US will probably be trying the same trick. The public sector financial balance is therefore left to take the strain, unable to bear the obvious response, in the form of a counter-cyclical spending boost.

Logically, these policy conflicts could be resolved by monetary reflation. But after a decade of low and stable inflation, which long-dated interest rates still reflect, creditors will quickly take fright if they see this option being exercised.

The Government is remarkably boxed in, considering our record-breaking period of stable growth. However, any of these policy options may appear for a time to be offering a way out of the box and the one safe projection for financial markets looks to be that there will be plenty of mood swings.

#economics #taxation


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