Stephen Hunsaker examines the UK tax system in light of the recent release of Rishi Sunak’s tax return, highlighting the favourable treatment given to capital gains compared to other forms of income.
The Beatles might have grieved that the taxman would come for them no matter what they did; but they obviously didn’t have Rishi Sunak’s accountant. Rishi Sunak was the first Prime Minister to release his taxes since David Cameron did so in 2016, in the aftermath of the Panama Papers.
While a similar crisis is not looming for Sunak, the richest Prime Minister to date (sharing a net worth of £730m with his wife) felt the need to be transparent about his tax affairs while the country faces a cost-of-living crisis, even though the tradition of releasing tax returns is more typical of US leaders.
Sunak paid £1 million in taxes on £4.7m he made over the last three years. While it looks like a staggering sum, it comes out to only around 20% of his total income for the period. So why does someone as rich as the Prime Minister pay the equivalent in taxes as someone making less than £50,000? It all comes down to the favourable treatment of capital gains compared to other forms of income.
The UK has a progressive income tax system, meaning the tax burden increases the more a person earns – for example, income under £50,000 is taxed at 20% while earnings over £150,000 are taxed at 45%.
However, an income stream that many wealthy individuals rely on – realised capital gains – is treated differently. Realised capital gains are the amount of profit made after selling an asset, usually real estate or stock investments. The ‘gain’ is the amount earned by the sale minus the original amount. A capital gains tax will then tax the seller on the profit made from the sale.
In the UK capital gains tax is currently set at 28% for property and 20% for other assets such as stocks, after an initial £12,000 of gains over the course of a year which is untaxed. The reason that Rishi Sunak only paid around 20% in taxes on his earnings is because most of his earnings in the last three years (~92%) were capital gains.
This is not a situation which is unique to the Prime Minister, most wealthy individuals are not making their money through income, most are doing so through real estate and stock options and the capital gains made on those assets.
The UK has not always had this discrepancy between income and capital gains tax rates. Capital gains tax was first introduced in 1965. In 1988 Nigel Lawson aligned capital gains tax rates with income tax rates, stating that the contrast between income and capital gains rates is ‘hard to justify’, and this remained the case until Gordon Brown lowered capital gains tax rates to a flat 18% in 2008 while income tax rates were 20% and 40% below and above £34,800 respectively.
Since then capital gains tax has been lower than income tax rates. This has incentivised wealthy individuals, especially those who own businesses, to re-characterise income as capital gains allowing for them to be taxed at a lower tax rate via capital gains in lieu of a higher taxed salary. They do so by not taking a salary and instead taking money out of their company in the form of capital gains.
Even though the current system incentivises taxpayers to re-characterise income as capital gains, neither party has indicated any plan to change the current system.
The lack of enthusiasm is in part due to concern that aligning capital gains tax rates with income tax rates would disincentivise people from investing in the UK. However, many tax experts disagree, arguing instead that targeted investment allowances in the areas where investment is needed are a more effective way to incentivise investment than lowering capital gains.
Lower capital gains taxes do not guarantee investment. As research by the Institute for Fiscal studies has shown, individuals being able to divert tax on their personal earnings from income to capital gains does not lead to direct investment into the economy – instead it places a larger tax burden on those with more traditional income streams such as salaries.
Advocates for capital gains tax reform argue that a change to the system could bring in a significant amount of money. Dan Neidle of Tax Policy Associates estimated that aligning capital gains tax rates with income tax rates could generate £8 billion of additional revenue for the government. He also found that historically when changes were made to the rate, after a short period of adjustment, people’s decision to divest remained largely unchanged. This implies that there would not be a mass exodus of investment.
Many in government, think tanks and academia have contended that tax reform is needed in the UK, with widening income inequality and where the cost-of-living crisis has cut real take-home pay for most jobs, especially those in the public sector. Proposals, such as a wealth tax, changing dividends tax rates, reworking inheritance taxes, reforming National Insurance rules, ending the non-dom regime, and an exit tax could address charges of unequal tax burdens.
But for advocates of reform, changing capital gains tax rates could be a non-technical first step first step to reforming the wider UK tax system. Aligning capital gains tax rates with income tax rates would not be a system-altering change. As mentioned, many Chancellors have done it before – and it would not require a complete rewrite of tax law.
It would, however, need a long-term commitment, preferably endorsed by both major parties, one that wouldn’t be at risk of changing from budget to budget, preventing individuals deferring gains until a time when rates are lower.
At the moment neither party has made such a commitment. But for many Sunak’s tax return is further proof of the need for reform.
By Stephen Hunsaker, researcher, UK in a Changing Europe.