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Effective action

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Tax is hitting the head-lines again – this time in the US. The battle for the Republican nomination between Mitt Romney and Newt Gingrich has had a strong tax focus recently. President Barack Obama has also focused on tax, saying in his recent state of the union address, that tax reform and budget reduction should be guided by the principle that anyone with annual income of more than $1m should pay a minimum effective rate of 30 per cent.

It is the reference to the effective rate that is interesting.

It seems that Romney and many other high-rollers like him pay low effective rates due to the way they receive their returns from their endeavours. Most ordinary people on both sides of the Atlantic receive their returns from labour by way of employment income and returns from investment in the form of interest or dividends and maybe some capital gains. Unsurprisingly, the effective rate that many such unplanned US-resident individuals pay is double that paid by Mitt and his buddies.

Apparently, Mr Romney has declared that in 2010, he paid about $3m in tax on “income” of $21.6m. But this largely came from the return on investments in one of the US’s most successful private equity firms, which are taxed at a lower rate than ordinary earned income. His effective rate is, as a result, around 15 per cent – about the same as that paid by Warren Buffett.

It is Mr Buffett himself who has been one of the most vocal about the rightness of high-earners paying a minimum rate of tax – the proposed new tax in the US has even become known as the Buffett tax.

We, of course, have our own version here (the additional rate of tax) but at a much lower level of income, £150,000. This was intended, apparently, to be a temporary phenomenon but it is still here.

The effectiveness of high taxes measured by increased revenue is questionable. There seems to be a reasonable case for the proposition that a 50 per cent tax rate (as opposed to 40 per cent) will increase the likelihood of individuals changing their behaviour discernibly so as to be much more predisposed to taking action to reduce tax.

Financial planners can do much to reduce the effective rate of tax payable by their clients though. This aspect of the financial planning process carries high value (in that it is worth paying for) in the eyes of clients. Pension contributions to registered schemes within the annual allowance can reduce the overall effective rate significantly – obviously to nil in relation to the amount contributed.

VCT and EIS contributions also have a noticeable downward impact through their 30 per cent up-front relief – 50 per cent for seed EIS – from 2012/13 – plus possible capital gains tax reduction when funded by otherwise chargeable gains.

Pensions and Isas provide effective protection from tax on investment income too, as do UK investment bonds for higher and additional- rate taxpayers – although there is the life company tax rate to consider but this is nil on UK and most offshore dividends. Offshore bonds provide complete shelter from UK tax on dividends and interest.

For both, there will be the tax on chargeable-event gains to consider on the withdrawal of benefits and then there is the planning that couples can carry out to minimise the overall effective rate that is borne on their combined income.

The point is that it is the effective rate of tax that really counts for an individual – what they actually pay – and there is much that financial planners can do to ensure this is as legitimately low as it can be.

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