Capital in the Twenty First Century. And Tax.

Because something is happening here, but you don’t know what it is, do you, Mister Jones?

– Ballad of a Thin Man, Highway Revisited, 1965

Qui dit étude dit travail,

Qui dit taf te dit les thunes,

Qui dit argent dit dépenses,

Qui dit crédit dit créance,

Qui dit dette te dit huissier…

Alors on sort pour oublier tous les problèmes.

– Alors On Dance, 2010

The current dialogue on capital

A sign of the earnestness with which the issue of global concentration of wealth has now been recognized is the fact that the movement, which rose to headlines in the form of the Occupy protests in Zuccotti Park in 2011, has now culminated in a conference hosted and attended by the economic, political and business luminaries of the world. I am referring to the conference which was held in London in May 2014 by the Inclusive Capital Initiative, a non-profit organization. Keynote speakers included HRH Prince Charles, Christine Lagard and Bill Clinton. The ICI website states that Inclusive Capitalism is committed to fixing the ‘broken escalator’ in the economist Larry Katz’s metaphor. Larry Katz’s metaphor is as follows:

Think of the American economy as a large apartment block. A century ago – even 30 years ago – it was the object of envy. But in the last generation its character has changed. The penthouses at the top keep getting larger and larger. The apartments in the middle are feeling more and more squeezed and the basement has flooded. To round it off, the elevator is no longer working. That broken elevator is what gets people down the most.

The topic of the viability of capitalism has been on the agenda over the last few years. Waves in the publishing world were made recently and notably by the publication in English of the French economist, Thomas Piketty’s book, Capital in the Twenty First Century and its runaway success. Piketty researches the dynamics of capital and income, focusing mostly on historical data from Britain and France. Of particular interest to me were the chapters on the inefficacy of the tax codes in addressing this imbalance. Piketty’s theses resonated so much with me that they inspire this piece and undergird many of the points made here.

I write now with two audiences in mind and with the aspiration of bringing them together. First, I write with the view to bringing to the wider economic dialogue the perspective of someone who has practiced UK tax law for a period approaching 10 years. Journalists and economists – Piketty included – discuss tax primarily by reference to the headline grabbing rates and thresholds. The purpose of this article is to cast some sort of light upon the more impermeable recesses of the UK tax code and demonstrate how these contribute just as much to the phenomenon of Katz’s ‘broken elevator’ as do rates and thresholds. Second, as someone who in the course of his practice has often represented the interests of what is called ‘Middle England’, it appears to me that the ideas raised in Piketty’s book demand consideration by stakeholders in the tax field – the legislator of the UK tax code, tax practitioners and the wider public. The current debate on tax avoidance acquires an altogether different complexion when one takes into account the implications of the rising accumulation of capital in the hands of the top centile.

Any views expressed here are my own. Insofar as it might be relevant, I am only accidentally political, the accident being my vocation. Nor am I an economist. I am also aware of the detractors of Piketty’s book and other controversies. For instance, I note how Piketty himself has warned of the dangers to jobs of minimum wages being introduced in Seattle. Mervyn King objects to Piketty viewing the period from 1910 to 1970 as exceptional and not reflecting the evolution of wealth in a normal capitalist society. He also highlights that the share of the top one per cent is markedly lower than it was two hundred years ago (as Piketty accepts). Mervyn King notes how the risk premium, which constitutes a large part of the return on capital, reflects the uncertainty as to the recurrence of major shocks to which capital is vulnerable. By contrast, Piketty argues that the commonly used definition of growth rates do not account for capital depreciation and demographic factors such as increasing population. However, this ought not to detract from the book as much as it constitutes a snapshot of the current state of affairs. At the ICI conference, Christine Lagard gave the following statistic:

The 85 richest people in the world, who could fit into a single London double-decker, control as much wealth as the poorest half of the global population– that is 3.5 billion people.

Nor do they undermine my criticism of the particular central feature of our tax system which I highlight here.

Tax and capital: Imagine a Robin Hood who gives to the least well off – but only takes from the middle.

I only began to seriously think about the relationship between tax policy and capital a few months ago as I sat at the back of a taxi on the way home from dinner.

A member of a political party had that day made some comments in PMQs about the ‘Tories’ millionaires tax cuts’, referring to the reduction from the 50% to the 45% additional tax rate. I can’t remember how the driver and I jovially made the faux pas of getting on to this topic but I made comments to the effect that the tax reduction wasn’t a cut for millionaires. The driver didn’t agree – in his mind, the dichotomy was between people who earned in the tens of thousands and those who earned in the hundreds of thousands, with the latter category comprising ‘millionaires’. This came somewhat as a surprise to me, I had taken it for granted that everyone appreciated the difference between wealth and income. It appeared not to have occurred to my driver that to become a millionaire with earnings of £150,000 a year, one would have to work for more than 6 years, this assuming that one did not pay any taxes and saved the entirety of their income. To be fair, one cannot fault my cabbie – he was taking his cue from the political leadership.

I began to ponder over this matter and the more I did so, it seemed to me that tax – or at least, the tax system that we have here in the UK – has the effect of pitting earners in one income tax bracket against others, but very little consideration is given to capital at all. As Piketty states:

If the capital-labor split gives rise to so many conflicts, it is due first and foremost to the extreme concentration of capital. Inequality of wealth – and of the consequent income from capital – is in fact always much greater than inequality of income from labour.

He maintains that the real disparities in society arise from differences in capital. I understand this not to be contentious.

At the same time, many in society – my cabbie and the said political leader among others – appear preoccupied with inequalities in earnings. In the case of the politician, to be fair, he was clearly in his speech employing a populist, if rebarbative, manner of attacking the tax cuts.

Moving away from public perceptions, I began to ask myself whether the legislator of the UK tax code demonstrates some cognizance of this economic truth. When one gets round to asking the question, the answer is one which comes readily to all tax practitioners. Ours is a system which is fixated on income. Indeed, if there is any tax with which the legislator is particularly interested, it is employment income. The particular code which governs the taxation of employment income (known as the ‘Income Tax Earnings and Pensions Act 2003’ or ITEPA) is the longest and most prescriptive of all. The legislator is extremely concerned to ensure that should one earn remuneration through their employment, then there ought not to be any benefit accruing to him at all which remains untaxed. This seems a highly reasonable aspiration at first glance. Though when the stringent manner of execution is considered and when a comparison is then made with the treatment of capital, a very different picture emerges.

How we treat our workers…

Whilst rates grab headlines, the challenges which our tax system poses to our workers are often found in those rules which receive lesser or no coverage in the press. I only here mention a few examples.

A few months ago I was consulted by trainee GPs who had been denied deductions for the cost of GP examinations. The cost of these examinations was in the region of £2,000 (around the monthly wage of trainee GPs) and most trainees had to sit them a couple of times before they passed, very much in the manner of the driving license tests. The reason the costs of the examinations were not deductible was because the particular statute allows only a deduction of those expenses which are ‘necessarily incurred in the performance of the duties’. Since the examinations were viewed simply as a prerequisite to there being any duties in the first place, any sums expended towards them were not deductible.

Another instance which comes to mind is the case of Mallelieu v Drummond 57 TC 330, a case from 1983 which remains legally binding to this day. The case involved a lady barrister who expended sums towards acquiring black dresses, suits, tights and shoes, and white shirts or blouses in accordance with Bar requirements. (More accurately, the sums were expended towards maintaining and replacing such clothes, as the initial cost, being a capital cost would not have qualified for a deduction in any event). HMRC, or the Inland Revenue as it then was, disallowed the deductions on the basis that these had not been incurred wholly and exclusively for the purposes of her profession. On appeal, the Tribunal agreed. It held that her purpose in making that expenditure was not only to enable her to earn profits in her profession but also to enable her to be properly clothed during the time she was on her way to Chambers or to court – or, as counsel for HMRC put it, for her ‘warmth and decency’. The High Court allowed the taxpayer’s appeal and the Court of Appeal agreed. However, when the matter eventually came before the House of Lords, it decided against deductions. Lord Brightman stated:

But she needed clothes to travel to work and clothes to wear at work, and I think it is inescapable that one object, though not a conscious motive, was the provision of the clothing that she needed as a human being…

I regret that their Lordships were not able to find more purposive a construction of the statutory rule. Could they not have taken it for a given – given the particular socio-cultural context in which the expenses were borne – that the taxpayer would have worn clothes for the purposes of warmth and decency and then arrived at the conclusion that the expenses borne in respect to these particular items of clothing were for the purposes of her profession? In our northerly jurisdiction, very little is done which does not involve considerations of warmth.

One cannot help but feel that whilst, when it comes to tackling tax avoidance, the emphasis remains at all times on overlooking the form of the transaction to arrive at the economic substance of it, when it comes to quotidian payments incurred by everyday people and which would be accepted by most economists as business expenses, an altogether different rule applies. One begins here to acquire a greater appreciation of Larry Katz’s ‘squeezed middle’.

For a much lesser known instance, I cite the decision in Flanagan v HMRC TC02161. An employee of a bank took out a mortgage from his employer. The rates of interest were commercial, those at which the bank would have lent to the public at large. There is a rule in the said ITEPA which stipulates that when an employee receives a loan from his employer and interest is paid at less than the prescribed HMRC official rates (as was the case here), then he is deemed to receive a benefit equal to that difference. Employment income tax is then levied on that benefit. The tribunal therefore held that the employee taxpayer was liable to tax on this basis. This even though the tribunal readily accepted that the stipulated official rates may be higher than the rates at which loans may be commercially available to the public at large.

Flanagan leads me to the last of the points I would like to raise in the context of employment income planning, though it is a broad one. One might well understand how a government would wish to tax a benefit (such as a loan on beneficial terms) from an employer to an employee which constitutes remuneration to the employee for his services. However, in Flanagan, the taxpayer simply happened to be an employee of the bank, which provided loans to the public at large. The purported benefit was never intended to constitute remuneration to the employee for his services. The problem arose because ITEPA assumes that a loan made from an employer to an employee is always made in connection with the employment. The tax code is peppered with assumptions of causation such as this. These many legislative assumptions contained in ITEPA, made without any opportunity of rebuttal, bar the taxpayer from being able to demonstrate his facts and place reliance on them. So keen is the legislator to prevent any benefit from slipping through the tax net, that he appears not to care that the predicated facts on which the tax is charged bear little semblance to the truth.

One of the most egregious forms of legislative deeming at present occurs in the context of self-employed workers or contractors. ITEPA contains a raft of measures which deem contractors to be employees. The tax and National Insurance position of workers and of the persons who engage their services is beneficial where the worker is self-employed rather than employed. It follows therefore that the government is concerned to discourage parties from arranging their affairs so that there is no employment. What is neglected in the course of this deeming of contractors as employees, however, is that there is a fundamental difference – well recognised both as a matter of general law and economics – between employment and self-employment. A contractor is more akin to an entrepreneur, has a greater degree of freedom and, for instance, is often likely to have ownership of intellectual property developed by himself. On the other hand, he will have none of the security and concomitant rights (such as employment pension rights – an area which has seen major recent changes in favour of employees) that come with employment. What has been held to be especially objectionable about the law in this area is not only that it seeks to tax contractors as though they were employees, it refrains from going that one step further and deeming them to be employees for the purposes of general law and, in particular, employment law. So, a contractor is left both burdened with the detriments of employment as far as tax is concerned and exposed to the vagaries of self-employment in almost every other sense. This is unfair.

Equally objectionable is the fact that the law has been introduced in the name of ‘False Self-Employment’. This stigmatises self-employment and confuses the debate. As the test which has been set by the courts as to whether or not there is employment is comprehensive and substantive, there can be no such thing as ‘false employment’, a formal shift in the drafting of the contract itself does not preclude there from being employment.

And how we treat capital…

So far, I have solely discussed the tax treatment of earners. The position is aggravated when we stand back and consider the wider arena and, in particular, asking the question: what taxes are imposed by reference to the entirety of the capital of the taxpayer?

For most purposes – and, in particular, those of raising revenue – there is none.

The closest is IHT, which is sometimes described as a ‘voluntary’ tax. This view stems from the relatively low takings, which amount to only slightly over £3 billion. The truth is that the tax is better described as a manageable tax, which allows for planning under the auspices of the legislator, such as through lifetime giving. Piketty argues that lifetime giving is more commonplace than is thought. (During the period from 1820 to 1870, the total annual value of gifts was 30 to 40% of the annual value of inheritances – these gifts mostly taking the form of dowries and other gifts on marriage. In Britain lifetime gifts have remained stable at 10% of the inheritance since the 1970s whereas in France and Germany they have increased to 60% to 80% of the total. He concedes that there may be a statistical bias and for my part, I wonder whether forced heirship laws in certain countries have some effect here on the extent to which record-keeping extends to lifetime gifts in these countries). There are two points to be made here. First, the making of lifetime gifts is made easier the more capital one has. Second, the same is true for the obtaining of legal advice. Manageable taxes are especially resented by the wider public on account of their supposedly indirect regressive nature – as in the case of expense deductions, this too is something which is not discussed as much by economists. It is interesting to note that almost whenever participants in television and radio debates complain about tax avoidance, it is more to do with the fact that wealthier individuals have access to legal advisors. In other words, it is not so much the case that others are ‘avoiding’ tax, it is more the case that others are able to pursue a route which is not seen as open to them. In actuality, neither of these two hindrances ought to constitute a bar to effective tax planning. An advisor’s fees are unlikely to constitute more than a small fraction of the inheritance tax savings (even for the more average-sized estate). And the inheritance tax code contains various straightforward exemptions, such as the spouse exemption and the donor-donee cohabitation exemption, which ought to be as applicable to those who have only the one house in their estate as it is to the wealthier. Alongside this, one must also list the one factor which an economist is more likely to focus on – the ‘nil rate band’, the threshold which is protected from inheritance tax in all estate. Whilst this band has the effect of exempting most estates in the land, it provides little comfort to greater estates. In light of all this, it appears mysterious as to why the tax continues to be levied on smaller estates. It is more likely the case that people, as in the case of pensions, simply do not plan until too late. In any event, my purpose here is not so much to consider the effect of the taxes across different classes of estates but more to compare the taxation of capital with that of earned income. As between the classes, it appears to me that inheritance tax is equally manageable in practice.

SDLT and the new ATED are not latched to wealth – even as glimpsed through the ownership of one property. They do not even take into account the extent to which the particular purchase (or ownership) has been affected through financing. In other words, the fact that I buy a house with a 90% mortgage or with no mortgage at all has no bearing on the amount of SDLT payable. Rather mysteriously, there is no principal private property relief for buyers as there is in the context of capital gains tax. This seems strange when considered alongside the ‘help to buy scheme’ and the policy objectives which must have propelled its implementation.

Capital gains tax is levied on gains alone. The tax applies asset-by-asset and that too on disposals, the timing of which the taxpayer has control over. As with the other taxes, the rates are not affected by reference to the overall capital of the person making the disposal. Furthermore, to the extent that capital is tied in the principal private residence, a disposal of the asset escapes this tax. Perhaps some indication of the regressive nature of this tax can be gleaned from the way in which the private principal property relief is defined:

222 Relief on disposal of private residence

(1) This section applies to a gain accruing to an individual so far as attributable to the disposal of, or of an interest in—

(a) a dwelling-house or part of a dwelling-house which is, or has at any time in his period of ownership been, his only or main residence, or

(b) land which he has for his own occupation and enjoyment with that residence as its garden or grounds up to the permitted area.

(2) In this section “the permitted area” means, subject to subsections (3) and (4) below, an area (inclusive of the site of the dwelling-house) of 0.5 of a hectare.

(3) Where the area required for the reasonable enjoyment of the dwelling-house (or of the part in question) as a residence, having regard to the size and character of the dwelling-house, is larger than 0.5 of a hectare, that larger area shall be the permitted area.

The subsections above define the scope of the land which qualifies for relief. What I find telling is subsection (3). If one has a small house, then the surrounding land which is also eligible for relief is limited to 0.5 hectares. On the other hand, if one has a mansion, then the prescribed upper limit is explicitly occluded.

The combined effect of these taxes is that whilst benefits are conferred to those already in the ‘real estate’ club (in the form of capital gains tax exemptions), hurdles are posed to those outside (in the form of SDLT). Of course, in this piece I am only discussing how tax contributes to growing inequality. The stretching out of society is, of course, exacerbated by the poisoned chalice of rising house prices and even without tax considerations. Rising house prices in London have made all home-owners wealthier in absolute terms and their position, relative to each other, also remains the same. The problem, of course, is that the difference between those occupying the upper echelons and those at the middle rises in absolute terms, a difference so great that normal earnings alone are unlikely to compensate for it in the future. This is a vast topic and the tax strategy to adopt in light of it ought to make up for a separate piece.

As far as the taxation of capital income is concerned, the rate on savings and on dividends is generally lower. A very curious feature of the tax code is that the exact rates here hinge on the total amounts of income – so that if I work and have greater earned income, then I may end up paying more tax on my savings and dividends income. Surely, a fairer system would ring-fence earned income so that our workers were not penalised for their industry by bearing a greater burden on unconnected income (and capital gains, which is also top-sliced). Another anomaly is that the taxation of distributions does not discriminate between distributions which have in a sense been earned and those which arise from passive investments. Indeed, cases such as PA Holdings highlight that if we earn our dividends, then we are to be treated worse off than if they were simply passive investments. One would have thought that this is just the sort of dividend which we would wish to encourage.

All this forms part of the very same UK tax code which denies trainee GPs deductions for exam expenses. Cases like Mallelieu and Flanagan may seem petty to us, but that may be part of the problem. I suspect that their implications loom far larger in the minds of the many thousands of people whom they affect than they do in the minds of our luminaries, politicians and the media.

Concluding Thoughts

It appears to me that there are various counter-intuitive dynamics at play here. Primarily, the notion that the same income tax rates apply to all individuals (subject only to the various thresholds) appears fair at first glance. However, as seen, even the income tax rates actually favour Balzac’s ‘rentiers’ or Aldous Huxley’s Tantamounts.

And when one takes into account capital as well as income, then the counterintuitive truth which emerges is that a parity of rates actually results in a more disparate society. The greater the capital, the smaller a proportion the income bears to one’s overall wealth. The disconnect between capital and income is most significant in the case of earned income, where the income far more often than not constitutes a greater proportion of the individual’s wealth. A taxation of this income therefore constitutes a greater detriment to a worker’s wealth and especially so when one considers the proportion of this income which must be expended towards subsistence. On the other hand, a capitalist will normally expect a yield of 5% on his capital (this usual rate of return has apparently remained constant since 1700). So, even assuming a tax of 50% on his return, one is only taxing 2.5% of his original capital (and even less of his accumulated capital), ignoring any appreciation in the course of the year.

And what can be said of rates, can be said of the wider manner in which tax is implemented. Judges are often concerned that the principle espoused in one case might result in taxpayer abuses in others. This often restricts their responsiveness to the particulars of the case before them. (For instance, in Mackinlay v Arthur Young, the House of Lords disagreed with how the lower court had factored in the large size of the firm before allowing partnership expenses. Though, as I discuss in my TAA piece, the judges are not always concerned that principles espoused by them might result in abuses in other cases by HMRC). The idea that everything and everyone should be governed by a set of uniform principles of course represents the best of British values. But could it be that we might actually wish to treat some individuals more leniently than others? Can one imagine another jurisdiction (Spain, Italy, further afield?) where a judge posed with the problem in Mallelieu v Drummond would have said, ‘You are a young barrister, a worker and have taken certain risks to secure yourself a career which is itself fraught with uncertainties….I will allow you these expenses, though I cannot promise that the same approach would be taken if you were a company laying pipelines in the North Sea.’

Why is there no reverse-Ramsay? And where are the Lord Dennings?

A cynic might even conclude that the purpose of taxation, as it presently is, quite far from being redistributive, is actually the opposite – as it preserves capital accumulated by the ‘landed gentry’ and prevents accumulation by newcomers. That this verity is somehow intuited by the young people of the land can be seen from the rise of celebrity culture – the number of those who aim to become actors, singers, footballers and the like appears to far eclipse those who aspire to join the middle classes. Admittance to a class which does not promise even a footing on the housing ladder does not appeal. The motto of the day is very much ‘All or Nothing.’ I note that Mervyn King uses ‘Winner Takes All’ in his piece.

Peripheral Thoughts

I have wondered why it is the case that things are this way and, also, why it is not discussed more among practitioners.

As to the former, it may simply be that there have been historical reasons for this – most of the European (rated) income tax codes were set up hastily in anticipation of war. In his book, Black Swan, Nassim Nicholas Taleb argues that so taken is the system by the statistically small likelihood of certain occurrences taking place (in this context, a massive accumulation of capital), that it fails to address the contingency of them actually occurring. There is also in our system, at first glance, a very proper reluctance to subject to taxation that which has already been taxed. In other words, once something has been processed through the system, the taxpayer ought to be left in peace to enjoy the remainder. The view might be taken that to tax capital which has already been subject to income or inheritance tax is unfair. However, it appears to me that under the present system, it already is the case that, when one looks across various taxes, the same property may be subject to multiple taxes to the detriment of the same individual. For instance, a middle class earner may pay up to 45% of income tax on his earnings and his estate might then suffer a 40% charge to inheritance tax on the remainder when he dies.

As to the silence of practitioners, my brethren in the tax industry may well be wondering why I am arguing in favour of the tax net being cast even wider. Over the course of my career, I have encountered a range of moral attitudes espoused by practitioners. On the right, there are those who have a principled objection to the state’s encroachment over private property. In general terms, when one appreciates how hard it is for most earners to earn a living, one certainly has some sympathy with this diametrical reaction to the nonchalance with which people in television debates say, ‘Tax this or that person’s income….’. However, so absolute a response will not succeed in the real world. Others choose to remain silent in the name of professionalism, the idea being that it is one’s job to comment on the law as it is, not as it is meant to be. The reasoning, however, is not without conceptual problems – because of the purposive nature of interpretation, the law is at least sometimes what it is meant to be. In any event, the problem with silence is that there is a danger that moderates and well-meaning individuals are mistaken for unprincipled easy-riders.

I began with Capital in the Twenty First Century and ought to end with it. The book makes a case for a small capital tax on net wealth. This because whilst net public wealth in the richer countries is pretty much nil, net private wealth is greater than it has been for centuries. But the book also acknowledges that the time is not yet right for the imposition of such a tax. This is primarily because of the amount of global co-ordination which would be needed if such a tax were to be effective. Failed instances of such a taxation being attempted in Spain, Italy and Cyprus are cited. I would agree with the administrative objections and also have concerns that such an infrastructure, once set up, might become an instrument for populist pillaging by governments of the future. I have other problems with the book. For instance, Piketty does not ask the question as to what end tax revenues ought to be devoted to (his arguments for taxation are primarily redistributive). Also, he does not really address the question as to what steps individuals might take to better their position relative to the rich. The book makes the point that mass education is not a solution as this has the effect of turning a diploma into the high school education and simply defers competition. I query whether this is true – or, rather, whether it has to be true – in a time of globalisation. However, it is hard to take exception to a book which is expressly written with the view to encouraging debate. And in light of the extreme amounts of concentration which are the real subject of his book, it is questionable whether there is anything which could be achieved other than through taxation or central banks (in the form of inflation).

The purpose of this piece is more to highlight the issue than to provide answers. In general, it appears to me that the exemptions, reliefs and thresholds (such as the CGT residence relief discussed above or even those that might be said to emasculate IHT in many respects) are in fact undergirded by sound policy considerations, at least when applied to the wider public. What is needed is a greater, albeit measuredly gentle, articulation of the rules towards the tail end of the Bell curve which represents the spread of capital in the UK. And, equally, a reciprocal relaxation of the rules in favour of workers.