The UK Taxation System - Term Paper Example

Taxation Definition of terms: British Tax System: In 1901, the progressive tax system was introduced in Britan whereby both earned and unearned income was taxed (Macleary, 1991:15). The theoretical basis of taxation in the UK has been set out on the basis of comprehensive tax, which is a direct tax on all forms of income earned by an individual and is defined as the amount consumed by the individual without depleting wealth. As an alternative to the comprehensive tax system, the expenditure tax system taxes an individual on the amounts of his total receipts minus the amounts spent on his purchases, together with consumption expenses drawn from capital. (Macleary, 1991:17). The UK Tax system is based upon a combination of both these forms of taxation and a compromise between them, with individuals being taxed progressively higher, in accordance with their income level. Tax incentives are provided to encourage savings by providing relief from taxation for such amounts. Earnings arising from gifts or winnings from gambling may be exempt from tax, capital gains are taxable, although it may not fall specifically under the category of income tax. (Macleary, 1991 :22). Tax exemption is provided on a personal allowance, usually about 5000 pounds a year. Progressive tax rates: The application of progressive tax rates indicates that different tax rates apply for different income bands, with higher tax percentages being applied to higher income bands. Such a tax system is justified on the basis of fairness, and because it provides a buffer for the poor to be protected from indirect taxation, promoting social cohesion by using taxes collected from the rich for health, educational and other programs to benefit of the poor.(Ruane, 1999). However, it is also argued that progressive tax is unfair because it is akin to a form of double taxation, because those who earn more income already pay a greater share of tax even on a standard rate (Ruane, 1999). This method of taxation results in maximum revenues coming from a small segment of the executive population, hence in a recession, there is a real danger of a sudden drop in taxes collected. The higher income bracket of talented individuals may also be tempted to migrate to other countries where tax rates are more conducive, thus creating a brain drain. There is also a greater tendency to evade the payment of taxes when the rates are too high and the Government in the long run, ends up with a reduced amount collected from taxes because the tendency to double taxation is resented by individuals, who try to escape it through various means. Capital gains tax: This is the tax that is paid on profits realized on the sale of an asset. The capital gains tax is paid only once rather than on a periodic, recurring basis; it is paid only when an asset is sold. Since this a voluntary tax, holders of assets can avoid payment of taxes by holding on to an asset, which is known as the locking-in of assets (www.finance.indiamart.com).Where the issue of capital gains tax is concerned, one of the inherent problems is that they are not indexed for inflation, as a result, the seller not only pays the tax on the actual profits accrued, but also on the illusory profits he can be attributed to earn due to inflation. (www.finance.indiamart.com). While the stocks of a business are taxed, gains accruing in subsequent years are also taxed, hence once again, there is a double taxation that takes place of the same asset, i.e, the stocks. (www.finance.indiamart.com). A similar situation arises in the case of dividends, where the companies have to pay tax as a part of corporate income, but the same dividends when distributed to shareholders are taxed yet again as income of the shareholders. All interest income that is earned on bank deposits is also liable to taxation at the corporate tax rate, reducing incentive to save (Choudhry and Harrison, 2003:57). National Insurance System: The National Insurance System is a tax that is charged on earnings that is taken out at the payroll stage itself. An employee’s income is deducted right at the source, constituting about 11% of salaries between 97 to 645 pounds a week and 1% on amounts over and above that amount. Employers also have to pay 12.8% of all salary that is in excess of 97 pounds per week (Hoare, 2007). This payment is collected solely for the purpose of funding the Welfare system and is distinct and separate from Income tax, which is charged separately on the income earned by an individual. The National Insurance System is based on the principle that the benefits received by an individual will be in proportion to the amounts paid into the fund over the years of the individual’s working life.(Adam and Reed, no date). Basic rates of income tax were 22% in 2002-2003 as compared to the rate of 11% charged on the National Insurance System. A significant difference between national insurance and income tax is that while the former is a tax on earnings, the latter is a tax on income, including unearned income as well.(Adam and Reed, no date). However, on an overall basis, what is being taxed is the money that is being secured by an individual, whether through his or her earnings or through all forms of income, even those unearned. Therefore, it appears to make greater sense to combine the two systems into one and charge a single tax on it rather than subjecting individual income to taxes at two stages, firstly at the earnings state in reducing the salary amount actually payable and then further taxing those earnings as income. Compliance costs: The amount that is collected from the public through the process of taxation is greater than the amount which is used by the Government. This difference in the amounts are known as compliance costs which includes labor costs and other expenses which are incurred in the process of complying with tax rules and the laws. The Government incurs costs on tax collection but individuals also incur expenses on filing taxes and preparation of documents, which are the compliance costs. When the tax system is more complicated, then the costs of compliance are higher, which further discourages the payment of tax and makes individuals seek loopholes to avoid payment of tax. Reforms proposed in the British tax system: The progressive tax rate is to be replaced by a flat tax rate of 20% which will be applicable to all income levels, replacing the current three level system with tax rates at 10, 22 and 40 percent. Under the flat tax system, the rate of tax is lowered but no deductions of any kind are allowed. This system would thus eliminate more than thirty forms of relief and expenditures that are allowable under the progressive system.(Grecu, 2004). The system would still allow for a base level of tax exempt personal income of 5000 pounds. In terms of benefits, the imposition of a flat tax rate is unlikely to have an impact on fifty percent of the population, including those people who pay no taxes at all and those who earn an income of less than 5000 pounds (Grecu, 2004). However, it is also possible that a flat tax rate could benefit those who pay no taxes at all by providing jobs through improved economic growth which is likely to take place. Similarly, those who earn 5000 pounds or less might be motivated to work harder and earn more because their earnings will not be taxed so heavily. The taxpayers who currently pay 22% tax may enjoy marginal benefits, depending upon the extent to which they are currently utilizing some of the forms of tax relief and exemption that are available under the progressive tax rate. This group of taxpayers could stand to lose if their savings from tax shelter schemes are considerable. The Government may theoretically be a loser with the levy of a flat tax rate, because they will lose the greatest share of tax revenue which comes from the richest upper income bracket of the population (Grecu, 2004). However, in practice, it appears likely that the Government may actually collect more revenue due to less evasion in tax payments and less expense incurred in monitoring tax payments. The major winners under the flat taxation system would be the 11% of taxpayers in the upper income brackets who pay a tax rate of 40%, since the flat tax rat would considerably reduce the amount of taxes that they have to pay (Grecu, 2004). As a result, the fiscal activity of such income earners would change from a tax minimizing strategy to those activities which actually generate profits and thereby boost the economy. The biggest losers under the flat tax system would be the special interest groups, who are in the business of lobbying to create loopholes for their particular businesses, under the various tax relief incentives and schemes that exist, Under the flat tax rate, such incentives would cease to exist altogether, hence these special interest groups would have no role to play at all. The impact of the reform: Is the proposed reform likely to make the system more equitable? Under the current progressive tax rate, it has been argued that a buffer is provided for the poor through bringing about social cohesion, whereby the richest tax payers help to fund programs for the benefit of the poor. However, as discussed earlier, the progressive tax rate system also results in double taxation and complicates the tax system due to the many exemptions that are provided. There is a tendency for the rich to evade the payment of tax and divert their income into tax-minimizing schemes rather than fiscal activity that can stimulate economic growth. The imposition of a flat tax rate that applies across all categories of individuals thus appears to suggest a measure of equity, since an individual would be taxed in proportion to his earnings and the same tax rate will be applied to every individual. Moreover, it would also eliminate the system of double taxation that currently exists, where capital gains, dividends and savings are taxed (Grecu, 2004). Another benefit of the flat tax is that it is likely to boost economic growth and allow those who are currently limited within the low income tax bracket to improve their position. The most important benefit is in the elimination of the complications created by the tax evasion loopholes which currently exist. Economic growth is likely to ensue, both from the higher income brackets investing in true profit making activities and an increase in foreign investment. Hence the proposed reform is likely to be beneficial in the long term and bring about a measure of equity. However, it must also be noted that the change to a flat tax system is likely to be met with fierce resistance from special interest groups who currently enjoy an advantage due to their facility to provide tax savings. Changing over from the current complicated system to a flat tax rate is likely to difficult to execute in practice and may require significant adjustments to be made and create confusion and chaos in the short term. However, in the long term, the system is likely to provide benefits and result in a higher level of equity. References: * Adam, Stuart and Reed, Howard, No Date. “Income tax and national Insurance Contributions”, Retrieved March 2, 2008 from: http://www.ifs.org.uk/budgets/gb2003/ch5.pdf * “Capital Gains Tax: What is capital gains tax?” Retrieved February 29, 2008 from: http://finance.indiamart.com/taxation/capitalgains.html * Choudhry, Moorad and Harrison, James, 2003. “The gilt-edged market”, Butterworths * Grecu, Andrei, 2004. “Flat tax – the British case” Adam Smith Institute, London. * Hoare, Edward, 2007. “UK Taxation”, Retrieved March 1, 2008 from: http://www.faegre.co.uk/articles/article_1114.aspx * Macleary, Alistair, 1991. “National taxation for property management and valuation”, Taylor and Francis. * “National Taxation for property Management Taylor and Francis * Ruane, Christopher, 1999. “Progressive Tax rate”, Retrieved March 1, 2008 from: http://www.idebate.org/debatabase/topic_details.php?topicID=264 Read More