Think-tank urges aligning UK tax rates on different income sources

Reforming the UK’s tax system by aligning the rates charged on different sources of income would improve equality and raise more revenue from wealthy individuals, according to a report by a leading think-tank.

Researchers at the Institute for Fiscal Studies found that the UK’s tax system was largely progressive, raising more tax from those with higher incomes.

But they added that differences in the way business income, capital gains and inheritance are taxed compared to employment income led to “horizontal inequity”. This is when different groups get similar returns for their work but are taxed at different rates.

The study found that in 2018-19 the top 1 per cent of adults paid 28 per cent of income tax and national insurance contributions combined, up from 25 per cent in 2009-10.

However, tax rates varied enormously within this group. The average tax rate for employees in the top 1 per cent was 42 per cent.

In comparison, people with their own companies paid an average of just 27 per cent because they took income in the form of capital gains, which is charged at a lower rate than income tax and NICs.

Meanwhile, those who held on to capital gains until death paid 0 per cent on the gains, under the existing system.

Business income, from either self-employment or owning and running a company, was found to be more common in the top 1 per cent and 0.1 per cent of earners, accounting for 21 per cent and 29 per cent, respectively. In comparison, business income represented just 9 per cent for the rest of the population.

Helen Miller, IFS deputy director and author of the report, said successive changes since 2010, such as the introduction of an additional tax rate charged at £150,000, had led to the system becoming more progressive. But she added that it was “striking” that the tax which people paid depended not just on how much income they had but on how they obtained it.

“Preferential rates on business income change how people choose to work and take their income but are not well targeted at promoting entrepreneurship,” she added. “There is a strong case for aligning the tax rates on different forms of income, while reforming the tax base so that taxes on business income do not discourage investment.”

Miller said the current system effectively made being employed a “tax penalty” and this often led people who could change the way they received their income to make tax-motivated decisions.

Last year the Treasury shelved proposals made by the Office of Tax Simplification, a statutory body, which had recommended that the government consider aligning capital gains tax rates with income tax.

At the same time, the Treasury rejected making any changes to inheritance tax — as was suggested by the OTS in reports in 2018 and 2019. The Treasury did, however, say that it keeps the tax system under constant review.

The report, which analysed tax data records from HM Revenue & Customs, found that there were about half a million people who made up the UK’s top 1 per cent of highest-income earners, before tax.

Over 55 per cent of the top 1 per cent of UK adults lived in London and the south-east, with nearly 60 per cent aged between 45 and 64. The group had incomes above £130,000, and were 80 per cent male, although the proportion of females had increased from 15 per cent in 2003-04.

The top 0.1 per cent were found to have incomes far in excess of £500,000. This small group of 50,000 individuals accounted for 6 per cent of all income, the IFS reported.