Make the tax system simpler, sure, but don't make it worse

The Office for Tax Simplification is trying to make the UK tax system simpler. That's a great idea. But it's important to note that we shouldn't be making the tax system worse as we do so - that, sadly, being precisely what the OTS is doing here with its suggestion over the taxation of dividends.

The OTS says the allowance leads to complex calculations in some cases, and suggests one option is to tax any dividend income above the allowance at people's income tax rates of 20 per cent, 40 per cent and 45 per cent instead.

That is absolutely not the way to do it at all. Quite the contrary, we should be lowering those dividend taxation rates. Or alternatively changing the corporation tax regime.

The reason being something that is mentioned in the full report but not teased out. Before recent messing around with the system there was a clear system of imputation. Corporate profits are taxed, first, at the level of the company, through corporation tax. Dividends are - always - paid out of this post-corporation tax income.

So, when the dividends arrive in the hands of shareholders they have already paid some tax. Do not think that the company pays then the shareholders - this is one stream of income and it is the accumulation of taxes upon it which is the true tax rate. Thus that old system operated along the lines of "some tax has already been paid, pay only a little more now." More specifically, higher income in general taxpayers paid more tax, bringing that on their dividend income up to something like their marginal rate, lower income taxpayers perhaps nothing as corporation tax had already taxed it at their marginal rate of income tax.

The suggestion is to entirely do away with any vestige of this imputation, the current version of which is to have lower dividend tax rates.

This is wrong. For it is still true that the dividends are paying tax at the corporate level and then also at the individual.

Yet it's entirely standard that we want to tax capital incomes at lower rates - even nothing - as opposed to labour incomes. The reason being, obviously enough, that capital accumulation is what makes then society generally richer over time. We want people to be saving and investing therefore.

We're aware that politics means that the rentiers are not going to be allowed to have tax free incomes, even though that's what optimal tax theory and standard economic theory insist. The Mirrlees Review shaded this, by arguing that normal profits should indeed be tax free, only excess such - economic rents if you prefer that terminology - being taxed.

Yet it is still true that we want to have lower, not higher, capital income tax rates than labour income. Raising the dividend tax rate to that of standard incomes goes the wrong way with this. That the profits are already taxed at the corporate level means we'd have higher accumulated taxes upon capital income. Entirely the wrong direction of travel for the tax system and economy as a whole.

We could avoid this mistake and still simplify the system by stating that dividends be paid out of profits untaxed at the corporate level, without corporation tax applied. But that won't fly either, given the large revenue gained by taxing foreign shareholders in this manner.  

By not considering the economics of the matter, by mentioning but not examining that point of imputation, the OTS has recommended moving the taxation system in entirely the wrong direction. Capital incomes should be taxed less than labour incomes, doing the opposite is a terrible suggestion.