Chapter 14 - reforms to taxes on savings
This contains possible reforms, following on from chapter 13.
14.4. CONCLUSION
The taxation of savings in the UK is distorting, inequitable, and complex.
Reforms in recent years have not been governed by any broad strategy or direction. There remain substantial differences between the ways in which different assets are taxed. Ordinary interest-bearing accounts are harshly taxed. There is, bizarrely, more limited availability of TEE tax treatment for cash than for equities. The taxation of capital gains continues to be contested and continues to provide substantial incentives to take returns as capital gains rather than as income. The taxation of pensions has been beset by uncertainty as governments worry more about tax revenue than maintaining the integrity of the system. And the treatment of employer contributions to pensions provides a substantial tax subsidy for saving in that form.
In these circumstances, a coherent package of reform is needed. In our view, the priority should be to move towards a system that is much more neutral in its treatment of savings as a whole—neutral between consumption now and consumption in the future—and one that limits the distortions between different types of assets. Getting there is not straightforward and does not mean treating every asset the same.
To reduce opportunities for tax avoidance, it is important to align the tax rates on earned income and on investment income in excess of the normal rate of return. This would remove numerous complexities and opportunities for avoidance. It requires National Insurance contributions to be charged on returns to savings in the same way as they are charged on earnings. We have shown specifically how this might be achieved for pensions.
Aligning the tax treatments of returns to savings in the form of income and of returns in the form of capital gains is also important. This is difficult to achieve under an income tax (TTE) treatment because there is a natural benefit to be had from the ‘lock-in’ effect of capital gains tax. In addition, the current system fails to index gains for inflation, offers a substantial additional tax-free allowance for capital gains, charges capital gains tax at below standard income tax rates, offers very generous ‘entrepreneur’s relief’ to those owning their own business, and forgives CGT entirely at death.
The way we suggest achieving the desired neutral treatment is through a combination of a straightforward TEE system of taxation for ordinary bank and building society accounts, a reformed EET treatment of pensions, and the introduction of a rate-of-return allowance for holdings of shares and similar assets.
This combination of reforms would achieve a great deal more rationality in the savings tax system. The RRA system for shares would ensure that returns above the normal return, and only those returns, are taxed. These returns could be taxed at the full (income tax and National Insurance) rates applied to labour income. To ease the possible compliance burden of such a regime, we propose that equity ISAs remain in place for the vast majority of people, who have relatively small holdings of shares. In addition, those who do not choose to use the RRA would, by default, be subject to tax on the full returns.
Ordinary bank and building society accounts should just face a straightforward TEE system—saved out of taxed earnings and then no more tax applied. This is appropriate for assets on which ‘supernormal’ returns cannot be earned. Indeed, it would be inappropriate to apply an EET or RRA treatment to such assets because of the failure to tax financial services that this would imply.
This contains possible reforms, following on from chapter 13.
14.4. CONCLUSION
The taxation of savings in the UK is distorting, inequitable, and complex.
Reforms in recent years have not been governed by any broad strategy or direction. There remain substantial differences between the ways in which different assets are taxed. Ordinary interest-bearing accounts are harshly taxed. There is, bizarrely, more limited availability of TEE tax treatment for cash than for equities. The taxation of capital gains continues to be contested and continues to provide substantial incentives to take returns as capital gains rather than as income. The taxation of pensions has been beset by uncertainty as governments worry more about tax revenue than maintaining the integrity of the system. And the treatment of employer contributions to pensions provides a substantial tax subsidy for saving in that form.
In these circumstances, a coherent package of reform is needed. In our view, the priority should be to move towards a system that is much more neutral in its treatment of savings as a whole—neutral between consumption now and consumption in the future—and one that limits the distortions between different types of assets. Getting there is not straightforward and does not mean treating every asset the same.
To reduce opportunities for tax avoidance, it is important to align the tax rates on earned income and on investment income in excess of the normal rate of return. This would remove numerous complexities and opportunities for avoidance. It requires National Insurance contributions to be charged on returns to savings in the same way as they are charged on earnings. We have shown specifically how this might be achieved for pensions.
Aligning the tax treatments of returns to savings in the form of income and of returns in the form of capital gains is also important. This is difficult to achieve under an income tax (TTE) treatment because there is a natural benefit to be had from the ‘lock-in’ effect of capital gains tax. In addition, the current system fails to index gains for inflation, offers a substantial additional tax-free allowance for capital gains, charges capital gains tax at below standard income tax rates, offers very generous ‘entrepreneur’s relief’ to those owning their own business, and forgives CGT entirely at death.
The way we suggest achieving the desired neutral treatment is through a combination of a straightforward TEE system of taxation for ordinary bank and building society accounts, a reformed EET treatment of pensions, and the introduction of a rate-of-return allowance for holdings of shares and similar assets.
This combination of reforms would achieve a great deal more rationality in the savings tax system. The RRA system for shares would ensure that returns above the normal return, and only those returns, are taxed. These returns could be taxed at the full (income tax and National Insurance) rates applied to labour income. To ease the possible compliance burden of such a regime, we propose that equity ISAs remain in place for the vast majority of people, who have relatively small holdings of shares. In addition, those who do not choose to use the RRA would, by default, be subject to tax on the full returns.
Ordinary bank and building society accounts should just face a straightforward TEE system—saved out of taxed earnings and then no more tax applied. This is appropriate for assets on which ‘supernormal’ returns cannot be earned. Indeed, it would be inappropriate to apply an EET or RRA treatment to such assets because of the failure to tax financial services that this would imply.