Few elements of the tax system are so desperately in need of reform as thisby Kate Smith / October 21, 2019 / Leave a comment
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…