Thursday, 21 February 2013

Thou Shalt Not Inherit

There's been a lot making the headlines recently about our (largely incompetent) coalition Government's proposals for stealthily getting more out of the taxpayer.  The dishes of the day are currently centred on inheritance tax and mansion tax, as well as gimmicky taxes like fizzy drinks tax, fatty food tax, booze tax and all that malarkey (a subject which deserves a Blog of its own one day). I emailed my local MP to ask her to speak on behalf of the coalition, and was told:

"It is not true to suggest the inheritance tax amounts to double taxation. The wealth in most houses has never been taxed because it is largely in the form of unrealised capital gains."

Who is feeding MPs this kind of nonsense?  It's simply not true. The wealth in most houses has already been taxed at least once, because taxation occurred when the money was earned to pay for the house. You can't even begin to grasp what's wrong with the Government's reasoning until you understand this simple example.  Jack earns £100, makes some fruitful investments, and leaves £100 million in unrealised capital gains tax to his progeny.  If Jack paid 50% income tax on that £100, then he invests only 50% as much, earns 50% as much, and leaves his progeny only half as much as he would have done with no taxation.  This is simple economics - taxing Jack 50% on his £100 pounds eventually costs his progeny £50 million pounds.

You see, when I probed my MP about her error, she emailed with a confused response -

"If I understand you correctly, Mr. Knight, you’re saying that if a multi-millionaire died tomorrow and left his gains to his family, they shouldn’t have to pay inheritance taxes because he already paid a few thousand on the original income?"

Here's the problem - I'm not arguing against a few thousand, I'm explaining that the taxation already amounts to a lot more than a few thousand. My MP is failing to grasp that a “few thousand” paid many years ago is the equivalent to far more than a few thousand today. If Jack has a converter machine that magically makes several thousand pounds from 1987 into several million present day pounds, then taxing him several thousand pounds in 1987 is the equivalent of taxing him a few million pounds in the present day. So it’s quite misleading to say he’s only paid a few thousand in taxes - his net contribution is much more.  Moreover, here is another damaging consequence of these kinds of taxes - savers and investors will be deterred from saving and investing, which is contrary to the ethos of the present Government.  Not all will be deterred, but some will, and those will be important players in the economy.  

The real problem with this issue is one that I haven't seen any politician addressing.  Although, I understand why - MPs are elected with mostly no prior knowledge of the kind of economic thinking needed to tackle these issues, so it's hardly surprising they (and their advisors) don't.  They may know economists who could advise on this, but I doubt they’d listen because good economic advice is often contrary to the Government's aim – which is to get as much money as possible without obtaining it at the cost of being found out and unelected. 

Here's how the situation should be looked at. The argument isn’t about how much to tax, or about who should pay those taxes - it is primarily about the most efficient way to raise those taxes. Taxing earnings once at a higher rate is more efficient than taxing it twice later at two lower rates because the latter distorts the desire to save*, it makes people circumspect about investing, and it encourages people to over-consume in the here and now.  Remember, savings now is consumption in the future.

A similar level of stability is required in the consumers’ market if the economy is to achieve the right balance in encouraging sensible consuming and mobility.  That is why consumption goods are taxed at the same rate, not different rates.  Try to imagine the kind of consumers’ world we'd live in if different products were taxed at different rates. If you tax two different goods at two different rates, you'd have a new budget line with a slope that differs from the present one. Call the optimum point X. If you tax the goods at the same rate and hold Government revenue at a fixed rate, meaning you get a new budget line with the same slope as the original, also going through point X. To avoid the crossing of these indifference curves, the optimum along this new budget line must sit on a higher indifference curve than X (you can draw the diagram yourself), which is why consumers are better off with an equal taxation consumer policy**.

Returning to efficiency – the consideration of efficiency is important.  The notion that it is more “efficient” to tax earnings than to tax investment income is ridiculous if it means mega-rich people can earn hundreds of millions on their investments and pay too little tax or no taxes at all.  That's an argument in favour of taxing investment income and labour income as two wings of the same bird that lays the golden egg.  As you can gather, either way causes problems.  At one extreme, earnings that brought the investments on which taxes are already paid (a house in an investment, don't forget) are being taxed again via the route of inheritance.  At the other extreme, a man can switch income to investment and avoid paying tax on income. Here's how that's done. Suppose there is a business that earns £100,000 per year after paying all expenses except income. The business operator could pay himself a salary of £100,000 and the business would record zero earnings, or he could pay himself zero earnings and the business would earn £100,000, which he could then distribute surreptitiously to himself as “investment income.”  Under those conditions, investment income is not double-taxed when compared with labour income.

Even if capital gains taxes were capped at 1%, income subject to those taxes would be taxed at a higher rate than off the peg compensation. That’s because capital gains taxes (as well as other taxes on capital income) are surcharge taxes, assessed on top of the tax on compensation. An illustration will explain why.  Jenny and Jack each work a day and earn £1. Jenny spends her £1 right away. Jack invests his £1, waits for it to double, and then spends the resulting £2. Let’s see how the tax code affects them. First add a wage tax - Jenny and Jack each work a day, earn £1, pay 50p tax and have 50p left over. Jenny spends her 50p right away. Jack invests his 50p, waits for it to double, and then spends the resulting £1.

What does the wage tax cost Jenny? Answer: 50% of her consumption (which is down from £1 to 50p). What does it cost Jack? Answer: 50% of his consumption (which is down from £2 to £1). In the absence of a capital gains tax, Jenny and Jack are both being taxed at the same rate.  Now add a capital gains tax, let’s say 10% - Jenny and Jack each work a day, earn £1, pay 50p tax and have 50p left over. Jenny spends her 50p right away. Jack invests his 50p, waits for it to double, pays a 5p capital gains tax, and is left with 95p to spend. What does the tax code cost Jenny? Answer: 50% of her consumption (which is down from £1 to 50p). What does the tax code cost Jack? Answer: 52.5% of his consumption (which is down from £2 to 95p).

So there you have it: A 50% wage tax, together with a 10% capital gains tax, is equivalent to a 52.5% tax on Jack’s income. In fact, you could have achieved exactly the same result by taxing Jack at a 52.5% rate in the first place: He earns £1, you take 52.5% of it, he invests the remaining 47.5p, waits for it to double, and spends the resulting 95p.

Why is this so hard for so many supposedly intelligent people running our country to understand? Just like the above observation, people tend to look for a wealthy businessman with £1 million capital gain on his investment, and they forget that were it not for wage taxes, he would have invested twice as much and earned a £2 million capital gain. In that sense, the capital gain is taxed in advance.  Who you want taxed the most is one thing – but there’s no room for rational debate about the impact of the tax code, which is a matter of simple arithmetic.  The arithmetic shows quite clearly that anyone who pays taxes on capital income is effectively paying at a higher total tax rate than anyone who doesn’t.

To be fair, it is awkward suggesting that people who inherit wealth should have the right to lifetime tax-free income, but it's also disingenuous to suggest that people are inheriting this money tax free - they are not.  If you inherit £500,000 from your relative - what is being forgot is that your relative paid tax on that £500,000 (let's say 50% for simplicity's sake). As a consequence you inherited £500,000 instead of £1 million, which means you are already paying £500,000 income tax before your capital gains even begins to be taxed.

I must end by saying, when Mr Pomsonby-Smythe leaves his £10 million fortune to his layabout son who has never worked a day in his life, I, as a caring member of society, am quite comfortable with a system that sees over £4.5 million of that money given to the Government and spent on things like health, schools, transport and social services for the elderly.  But on the other side of the coin, I dislike the sense of entitlement that Governments feel they have on people's equity, because that equity is the leftovers of a sum that has already been taxed by the Government. 

A further issue is that everyone worth, say, £500,000 is not in the same position.  In London you can find someone worth half a million who has four children to send to university, high value council tax, and generally high expenditure, and you can find someone else worth half a million who dosses about all day wasting it on drugs, booze and yuppie parties. That's why I think we shouldn't have a blanket threshold - we should assess each situation on a case by case basis.  Yes, that will require extra resources for those actuarial studies, but I have an easy way to pay for it – we can do so by drastically reducing the number of MPs and the number of local councillors who are ornaments for every district and county council in the land - that is just pure waste through and through.  I think there are at least 250 MPs too many, and 50-60% too many local councillors, all of which are sucking expenses funds out of central services and every district and county council.  Let’s drastically reduce those, and spend the money on being more resourceful with taxation.  There - problem solved.

* Incorporating a tax for consumption tax on top of a tax for earnings is equivalent to raising the tax for earnings, whereas incorporating a tax for capital gains tax or a tax for inheritance on top of a tax for earnings is not equivalent to raising the tax for earnings, since it brings about a disincentive to save.

** Point of note, though, this model relies on indifference curves and therefore applies only to consumption goods, not capital gains, income tax or other non-consumer taxes.