Earlier this year, an IMF paper declared Britain to be a tax haven. The comment passed largely unnoticed at the time, but the recent attention that has been focused on private equity companies has moved the issue of the taxation of the "super-rich," as well as legitimate tax avoidance, into mainstream political debate. The favourable personal tax arrangements for private equity executives and other high earners—many in the financial services sector—stem in part from Gordon Brown's decision back in 1998 to reduce the capital gains tax on the sale of business assets to a mere 10 per cent (if the asset had been held for ten years or longer) in order to reward risk. But the low tax bills of some of the very rich can also be located in historical arrangements like the non-domicile status of some rich foreigners (or people who can claim they are foreigners) living in Britain, and the sheer inventiveness of the tax avoidance industry, with its use of trusts, offsetting losses, offshore tax havens and so on.
This is an old subject, but it has been given a new twist in recent years by the growing importance to the British economy of the success of the financial services sector in general and the City of London in particular. Combined with other trends, such as globalisation and the rise of "winner takes all" markets in top talent, this has made Britain a magnet for a large number of the new super-rich.
To some, this is evidence of the success of an implicit deal between successive governments and the City. Governments have signalled to the City and its mobile top earners: we will flexibly regulate your activities and provide relatively favourable personal tax terms if in return you will bring or keep your business in London. But following recent revelations about the generous tax regimes for private equity executives, politicians of both right and left are asking if this "pact" needs some renegotiation, and if it is possible to increase the tax take on at least some of the super-rich without losing their business.
Who are the super-rich?
Nearly two thirds of the top 0.1 per cent are thought to work in financial services, with the rest made up largely of lawyers (400 lawyers in London earned over £1m last year and 1,000 over £500,000), top footballers (around 350 earned over £1m last year) and a scattering of figures from industry, media, property and other areas. The 340,000 people who work in the financial services part of the City now earn an average of more than £100,000. Moreover, City workers received £8.8bn in bonuses in 2006-07; over 4,000 of them received over £1m, a number that could increase this year.
On top of this, Britain has long been an attractive place for rich foreigners like Roman Abramovich. Seven of the top ten in the 2007 Sunday Times rich list were born outside Britain. They are the elite of the non-domiciled, the so-called "non-doms"—people of foreign background who spend part or most of their time in Britain. There are two ways of taxing people with an international aspect to their income. The US method is to tax citizens on their global income and then negotiate double taxation reliefs with other countries. The method used in most other countries, including Britain, is to tax residents only on income they earn from work or investment within the country, or on money they bring in. Non-doms can spend as much time as they like here, but are taxed only on British income. Non-residents—British citizens who go abroad for a long time—are also only taxed on income earned in Britain but face a less friendly regime: they can spend only 90 days a year in Britain.
Why the super-rich pay so little tax
HM revenue and customs' figures show that the top 1 per cent of taxpayers (those earning more than about £120,000) earned 11.0 per cent of total income of taxpayers in 1999-2000 and paid 21.3 per cent of income tax. Today they are estimated to earn 11.6 per cent of total income and pay 22.0 per cent of tax. Independent data points to far higher growth in top incomes than these numbers indicate, suggesting some of the very rich are successfully minimising their tax bills.
There are two reasons why the tax burden of the super-rich in Britain is relatively light. First, some of them are able to turn their income into capital gains, where the tax regime has been much friendlier since Gordon Brown's pro-enterprise gesture in 1998 of reducing the tapered rate of capital gains on the sale of business assets from 40 per cent to 10 per cent, and to 24 per cent on non-business assets, such as houses or shares. Second, an increasing number of the super-rich are non-domiciled for tax purposes, or take advantage of schemes that minimise tax.
Capital gains tax—which only accounts for just under 1 per cent of Britain's total tax take—is charged when a profit is realised on the sale of an asset. It was first introduced here in 1965, at 30 per cent. This was a time of very high marginal rates of income tax (rising to 83 per cent under Labour in the 1970s), so an incentive was created for rich people to turn their earnings into assets which might create a capital gain—a tax regime favourable to property and equity investors, who dominated the ranks of the very rich in the 1960s and 1970s.
As chancellor, Nigel Lawson reformed this system, and although he cut the top rate of income tax to just 40 per cent in 1988—making him a bête noire for the left—he closed loopholes for the rich and widened the tax base. He also raised capital gains tax from 30 per cent to an individual's highest rate of income tax—40 per cent for most richer people. So for a decade, until 1998, the incentive for the rich to convert earnings into capital gains was reduced. Significantly, this did not stop the rise and rise of the City or, indeed, the private equity industry.
By the time Labour was elected in 1997, the indexation of capital gains tax for inflation had become very complex and some reform was required. Business organisations like the CBI and the British Venture Capital Association (BVCA) lobbied hard for "taper relief" on capital gains tax, where the rate of tax on an asset falls with the length of time for which it is held. This appealed to Gordon Brown as a means of combating "short-termism."
But there was considerable surprise when Brown, in his first budget in April 1998, introduced taper relief that cut capital gains tax to just 10 per cent for business assets and to 24 per cent for non-business assets, so long as they were held for ten years. Brown emphasised that he wanted to reward the risk-takers and business-builders—and the investors ready to back them. But then, with little fanfare and after lobbying from private equity and venture capital firms and others at the high-risk end of finance, he reduced the taper relief period for business assets in two stages—from ten years to four years, and then, in April 2002, down to two years for the 10 per cent rate, with a taper to 20 per cent after just a year. There was no attempt to limit this lower rate of capital gains to backers of small businesses, which could have been done by capping the tax break, or insisting that the beneficiary own a big stake in the company.
Lawson's initiative was thus partly reversed. This has had some positive effects: it has rewarded many business creators, venture capitalists and risk-taking investors. It has also contributed to the growth of the Alternative Investment Market (AIM), a lightly regulated sub-market of the London Stock Exchange. The new taper relief rules apply to capital gains made on investments in the riskier companies listed on AIM, which has helped to make it the market of choice for many companies seeking international listings—at the expense of Nasdaq in New York. (Although critics say that AIM attracts too many of the wrong sorts of businesses.)
On the other hand, Brown's moves on taper relief effectively offered a big tax cut to anyone able to convert income into an appreciating asset who could wait two years for the reward. This encouraged many companies and partnerships to pay employee salaries or bonuses partly in the form of shares. In 2003, this "loophole" was partly closed with new rules on employee share incentives. But it remains the case that anyone who is an "engaged investor" in a company—a director, a significant investor, an employee—can buy shares in the company and two years later sell them and pay only 10 per cent tax on any gain. The BVCA also managed to negotiate an exemption from the 2003 rule change for the profits made by private equity firms. Private equity firms may or may not make British business more efficient, but it is a moot point how much real risk their executives take on, especially in the larger funds. Like hedge funds, they raise money from institutional shareholders and then, typically, aim to offer exceptional returns in exchange for a 2 per cent annual fee and 20 per cent of profits. (Where hedge funds generally deal in liquid assets like currencies and shares, private equity firms buy and sell companies.)
The normal model is for the private equity fund to buy a publicly quoted company, or part of one, that is undervalued or underperforming. The now private company then borrows heavily for its working capital (and because interest payments are tax-deductible, this typically means a low or zero corporation tax liability). If, two years later, the company is sold at a £50m profit, this creates a capital gain on unquoted shares. The 20 per cent of this that is taken by the private equity executives—their so-called "carried interest"—is taxable at the tapered capital gains tax rate for business assets of 10 per cent. It is the fact that such profits are treated as capital gains rather than income, and so taxed at 10 per cent rather than 40 per cent, that has caused such controversy in recent months. This may not have seemed so anomalous when the private equity funds were quite small—worth, say, £150m—and involved real, venture capital-style engagement with the companies they invested in. But when some funds have grown to £15bn and the private equity executives are taking over big, established companies like Boots, they are behaving more like investment bankers than risk-taking entrepreneurs.
It is not only Gordon Brown's favourable capital gains tax rate that has cut tax bills. Many of those in the most dynamic sectors of the City—such as hedge funds—are non-domiciled in Britain for tax. Since much of their income can be legitimately presented as being earned abroad, their British tax liability will be relatively low. Many of these people are domiciled in tax havens, or countries with low tax rates like Monaco. In 2005, Philip Green, owner of the retail group Arcadia, "paid himself" a record dividend of £1.2bn. Because much of the payment actually went to Green's wife, who was resident in Monaco, it was tax free. Many of those who claim non-dom or non-resident status also work for companies incorporated in tax havens and with offices in several countries. Although it is quite hard to escape tax on income from employment in Britain, it is simple to have capital assets paid into foreign bank accounts.
In 2005-06, HMRC knew of 112,000 legal non-doms. There are also about 400,000 British residents with undeclared overseas bank accounts. HMRC is now offering a limited amnesty to holders to declare these: so far, 60,000 have come clean. But many others have reacted by making a delayed claim for non-dom status. HMRC sources suggest that this may raise the total of non-doms to around 180,000.
Is labour too nice to the city?
Have successive governments been too deferential to big earners in the City? If so, it is easy to see why. Britain now has a very large trade deficit with the rest of the world—about £70bn a year—which is partly offset by "invisibles": services of various kinds and investment income. Of the £23bn net surplus in services in 2005, £19bn was earned by financial services, including insurance. This has grown from £9.9bn in 1999, and one of the biggest new earners has been the rise in profits from derivatives and other credit instruments for which private equity and hedge funds are large customers. It is true that many of the biggest banks and private equity/hedge funds are foreign-owned, so at least some of their profits are remitted abroad. On the other hand, nearly one third of British corporation tax is now paid by the financial services sector.
One of the distinctive things about London as a financial centre is its international character. Many businesses are foreign-owned and potentially footloose. London has, of course, acquired a "critical mass," and has many advantages besides low personal tax rates for top earners—the English language, the time zone, the world-class support industries and relatively light regulation. Nonetheless, policymakers—even Labour ones—should worry about the mobility of some of the nimbler parts of the industry, and about the decline in the amount of business they might undertake if the tax regime changed too sharply. There are also low or non-existent capital gains tax regimes in competitor countries such as Switzerland, the Netherlands, Italy and the US.
The favourable tax regime for some high earners might be seen as a kind of industry subsidy. But while a subsidy to the shipbuilding industry or small farmers might make political and social sense, a subsidy to the rich and successful is more problematic. For that and other reasons, there are grounds to believe that in due course we will see a move to raise the two-year tapered capital gains tax level on business assets back up from 10 per cent to 15 or 20 per cent, at least for the larger private equity "mega-funds." Ronald Cohen, one of the founders of the sector and a confidant of Gordon Brown's (see News & curiosities, p7), along with several other industry leaders, has said that a clearer distinction should now be made between the real risk takers who are building or re-building business and the "mega-funds." A 10 percentage-point increase in the rate to 20 per cent would still give a post-tax return of 80 per cent.
In opposition, Brown talked loudly about clamping down on the tax avoidance industry, and in government he has followed through on his pledges—up to a point. He has launched many anti-tax avoidance schemes, some more successful than others. He has also tried to make the industry more transparent by requiring that all professionals—tax lawyers, accountants, barristers—declare to HMRC in advance any new tax avoidance scheme they invent. But despite a huge amount of tinkering (the Tax Justice Network, a campaigning group, estimates that at least 40 per cent of all tax legislation from 2004-06 was avoidance-related), the avoidance industry usually stays one step ahead. And although the government has managed to lean on the big accountancy firms to stop them marketing their avoidance schemes to the merely ordinarily rich, the small, independent, firms are busy doing so. If that started to do real damage to tax revenues, one response could be to extend the requirement to disclose tax avoidance schemes in advance to a system which requires such schemes to be officially licensed.
Geoffrey Howe in the early 1980s and, more recently, Gordon Brown have both looked at changing the regime for non-doms. Both concluded that any sudden change would be adverse for Britain. The government could, however, clamp down on a loophole that allows second and third-generation "foreigners"—who are in fact British—to maintain non-domiciled status. Checking the degree of commitment to another country of tens of thousands of people would be an expensive and time-consuming matter. It would be simpler to rule that once someone has clearly treated Britain as their main residence for, say, 15 years, then they are domiciled here.
Conclusions
One way of looking at the light treatment of the super-rich is to applaud the British tax system as a brilliant if cynical exercise in tax discrimination. The 17th-century French finance minister Jean-Baptiste Colbert described the objective of taxation to be to pluck the maximum amount of feathers from the goose with a minimum of hissing. The British system achieves a good approximation to this result.
In the past ten years, the ratio of tax receipts to GDP—38.56 per cent—has been exactly the same, to two decimal places, as the previous ten years. But within that, many people are paying a bit more and a few paying a lot less. This may be rough justice, but it enables a lot of revenue to be protected while using flexibility to discriminate in favour of those who have a choice about where to pay tax. And if some of the richest non-doms pay little or no tax, non-doms in general appear to pay a reasonable amount: HMRC reports that the 112,000 legal non-doms in 2005 paid £3bn tax on British earnings of £9.8bn.
But another principle of taxation is that people in equivalent circumstances ought to be taxed similarly. Although the original attack on private equity came from the GMB union, it is significant that the objection to the tax privileges of the super-rich have been most forcefully expressed in the Daily Mail and the Telegraph. The people who feel strongest about this seem to be those just below the very rich on the income ladder; those for whom it is not worth investing in the tax accountants and international travel necessary to keep their tax bill down. No one knows how much tax "leakage" there is from the system at the top. But the perception that the very rich do not play by the rules is socially corrosive and undermines economic incentives.
In the long term, the option for such overt tax discrimination may not persist. People lower down the income scales will become internationally mobile too, and international organisations like the OECD and the EU are campaigning strongly against "tax competition." Governments will have to start to switch some of the taxes on income, which is internationally mobile, to taxes on assets like property and land, which cannot move.
In the short term, there is likely to be some symbolic upward readjustment of the capital gains tax rate paid by private equity (an industry which is, in any case, probably past its peak). But Alastair Darling, the new chancellor, has said he will not be rushed. And the government is acutely aware—partly as a result of its own past errors—of the danger of inadvertently damaging business activity and hitting the incomes of smaller savers through sudden changes to tax rates. But there is now a consensus across all the political parties, and much of business too, that the privileges enjoyed by the big private equity funds are not fair. A similar consensus may be emerging in the US, too, where Hillary Clinton has just backed higher taxes on private equity managers. An anomaly will be removed, but do not expect the super-rich in general to start paying ordinary rates of tax—that is for the little people.
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