Expensive, distortionary and inequitable: time to sort out the way we tax business owners

Small businesses are widely perceived to be the engines of growth and employment. That’s one reason why most self-employment income, dividends and capital gains are taxed at lower rates than wage income. The trouble is that most such businesses are no more and no less than the way in which people decide to earn their living and have little to do with entrepreneurship. Meanwhile, as new IFS research shows, the associated tax breaks can be expensive, distortionary and inequitable.

Among all the tax breaks available to business owners, probably the most egregious is “Entrepreneurs’ Relief”—a reduced, 10 per cent, rate of capital gains tax available to, effectively, all business owners. What a great name—who could be against entrepreneurs? In truth, it has little to do with entrepreneurship. It is simply an incredibly valuable tax break for business owners, which disproportionately benefits those at the very top of the income distribution.

People who run their own businesses can earn and declare income with much more freedom than can employees. Company owner-managers—those who run their own incorporated businesses—can choose when to take income out of the company, and therefore when to pay tax on it.

It turns out that extraordinary numbers of owner-managers report earning an income exactly equal to the higher rate threshold in income tax (income above this point is taxed at the higher rate). It was also this group that reported particularly big falls in taxable income when the 50 per cent additional rate of income tax (on incomes above £150,000) was introduced and when a policy to remove the personal allowance for people earning more than £100,000 came into force back in 2010.

It’s possible that these lower incomes are due to people working less when they face higher taxes, but we find no evidence of this. Instead, it’s driven by changes in the timing of when incomes are declared. This is a particularly useful option for owner-managers whose income fluctuates around the higher rate threshold. Someone who earns £55,000 in one year and £35,000 the following year can withdraw £45,000 each year and avoid the higher rate of income tax. This allows them to smooth out fluctuations in their income such that they are not penalised by the progressivity of the tax system, relative to someone who earns the same amount on average, but whose income fluctuates less from year to year.

That seems fair enough. The case for Entrepreneurs’ Relief, which allows owner-managers to enjoy significant tax savings by retaining income in their companies, often for long periods and until liquidation, is harder to make. Our analysis of tax records and investment behaviour shows no evidence that tax-motivated retention of profits translates into more investment in business capital. Profits retained with companies are held as cash or other liquid assets. This tax break is not working to incentivise investment.

At £2.4bn a year it’s also expensive. And, as you might expect, it’s the highest income owner-managers who benefit most. Of those earning approximately £150,000, half retain more than £50,000 each year, and a quarter retain more than £90,000. Taking £90,000 as capital gains rather than as dividends reduces an individual’s tax liability from over £20,000 to less than £10,000.

The other tax advantages enjoyed by business owners also tend to favour the well off. Owner-managers are twice as likely as others to be in the top 1 per cent of income taxpayers (those with taxable income of at least £160,000). Partners (those who co-own an unincorporated business), are seven times as likely to be in the top 1 per cent, while those operating in financial services are 35 times more likely to be in the top 1 per cent. Although partners are not taxed as generously as company owner-managers, they are taxed at lower rates than employees, most notably because their income is subject to lower National Insurance contributions.

There may well be good reasons to incentivise business activity. But tax breaks that apply to all businesses are poorly targeted, costly and, arguably, unfair on employees who can’t take advantage of them. Lower rates of capital gains tax on business income can also limit the government’s ability to raise revenue from income tax: some people will be able to avoid higher rates of tax on employment income by becoming business owners, and avoid higher rates of tax on dividend income by retaining profits and withdrawing as capital gains.

There are plenty of parts of the tax system that are ripe for reform but few as desperately in need of change as this.

Kate Smith