Why we oppose taxing capital

Last week, I set out the ASI's position on tax policy in 2017. In making the case for scrapping all taxes on capital, I mentioned that existing tax rates and reasonable interest rates imply massive taxes on future consumption.

"Taxes on interest income, capital gains, inheritance and corporate profits all effectively tax future consumption higher than current consumption, incentivising short-termism. And this future consumption tax goes up every year you forgo instant gratification. A few months back, I did the maths. Assuming a 5% interest rate and the European Commission’s estimate for the Marginal Effective Tax Rate on capital (47%), you’re effectively paying 97% extra in tax for waiting 30 years and a whopping 147% if you leave it another 10 years."

I think it's worth expanding on this point, but the mechanism isn't exactly clear. Why does a 47% tax on capital imply a 147% tax rate 40 years down the line? It's worth going back to basics.

People prefer to have things now rather than later. Market interest rates reveal how strong that preference is. If the market rate of interest is 5% (high for today but not by historical standards) then it means £100 of consumption today is worth £162.29 of consumption in ten years time.

Should I spend now or save for tomorrow? Capital taxes distort that choice. Let's pretend we have a flat 20% income tax with no deductions or exemptions. If you get paid £125, you'll pay £25 in tax and then you can choose to save or spend the rest of the money. If you saved £50 and the market interest rate was 5% you would end up with £81.44. But you'd have to pay 20% of your interest income each year in tax. Leaving you with £74.01.

It's the equivalent of the interest rate falling from 5% to 4%. That might not make much of a difference over 10 years. That's just £7.43 extra in tax, effectively a 10% additional tax on consumption. Not huge, not small either, but not huge.

However, as Einstein probably never actually said "compound interest is the most powerful force in the world". The difference between a bank account paying out 4% and one paying 5% becomes much larger over 30 years (4% = £162.17, 5% = £216). That's a difference of £53.93, or to put it more generally you'd be almost a 1/3 richer with an account paying 5%. To put it another way, a flat income tax of 20% implies an extra 33% tax on consumption in 30 years time. The longer you wait to bigger the extra tax you must pay is.

But we don't have a flat tax of 20%. We have an income tax with a top rate of 45%, a corporation tax of 20%, capital gains tax of 20% (not to mention inheritance tax). We also have some tax exempt savings vehicles like ISAs but they have a maximum limit so those most able to increase savings are still taxed.

To figure out how high the extra taxes on future consumption are we need to know the marginal effective tax rate (METR) on capital. Unfortunately that's rather tricky to work out. The best estimate I could find is from 2000 and by the European Commission, they reckon the UK's METR is 47%. Things have changed since then - income tax and capital gains tax is higher, while corporation tax has fallen, so buyer beware. But, an METR of 47% means a consumption tax of 97% in 30 years time. And if you waited another 10 years that tax would rise to 147% (even Jeremy Corbyn's bonkers maximum salary cap only implies a 100% rate).

Tax rates of 97% and above are absurd. Yet, rates like these are the status quo for those who defer gratification and make productive investments. This isn't just bad for those rich enough to max out their ISA limit, it's bad for ordinary workers as their wages stagnate due to chronic under-investment.

The tax code should be neutral between the frugal and the spendthrift. In 2017 we'll be pushing for tax reforms that fix this imbalance.