Paul Lewis: Why do we value earnings less than wealth?

Paul Lewis

There are those who think any sort of taxation is unfair, especially when it applies to them. But one argument frequently used to object to taxes centres on double taxation. In other words, that they can tax the same income twice.

Take those who object to inheritance tax because their parents “worked hard and struggled to buy their home”. They argue the house was bought out of taxed income and so taxing it again when they die is taxing the same money twice.

But most of the value of a home today is a windfall gain due to the surrounding economy. And from 1983 until 2000, mortgage interest relief at source gave people tax relief on the interest they paid on their mortgage, so some of the cost was not paid out of taxed income at all.

IHT is, quite rightly, blind to the tax history of the assets taxed at death. In any case, only one in 23 estates pay IHT and new rules starting in April will exempt part of the value of a family home, keeping that percentage low despite rising house prices.

Also on double taxation, I came in for some stick recently after I wrote the tax on unearned income (savings interest and dividends on shares) was much less than the tax taken from a similar amount of earnings. In other words, income from work is taxed much more heavily than income generated by capital.

There are three specific rules that make unearned income worth a lot more after tax than earnings from work. First, interest on savings now has a specific tax-free allowance of £1,000 for basic rate taxpayers and £500 for those on higher rate, on top of the personal allowance of £11,500 (all figures 2017/18).

For those on very low incomes, up to £6,000 of interest can be tax-free. It works like this. If their other taxable income is the same as the personal allowance no tax is due on that. Another £5,000 of savings interest is then taxed at 0 per cent starting rate for savings and then another £1,000 is tax-free under the personal savings allowance. So, someone can have a total income of £17,500 entirely from savings and pay no tax. They could own around £1m in fixed-term cash deposits and pay no tax on the income. Second, dividends have a special allowance so the first £5,000 is tax-free (for now at least. From April 2018 this will drop down to £2,000). So, someone with no other income could have £16,500 of dividends and pay no tax. With typical FTSE dividend return around 3.5 per cent, that could mean shares worth almost £500,000 and no tax due.

Even when the dividends exceed £5,000 the balance up to £45,000 is taxed at just 7.5 per cent instead of the standard basic rate of 20 per cent. Someone whose only income is £45,000 of dividends from rather more than £1.25m of shares would pay just £2,138 income tax on it. Someone earning the same £45,000 would pay £6,700 income tax (£7,100 in Scotland as the threshold for earned income will be £43,000 in 2017/18).

Third, earnings also suffer the tax known as National Insurance. That would take another £4,420 from £45,000 earnings, leaving the worker with just £33,880 net income after all taxes compared with £42,863 net if the same income all came from dividends. So the person living entirely on investment income of £45,000 is £8,983 a year better off than the person who earns that money. Someone who works a full week to earn average pay of around £27,000 will pay £5,360 in tax and NI, leaving just £21,640 to spend. Someone sitting at home living purely on dividends of £27,000 will pay just £787 income tax, leaving them £4,573 better off than their working friend.

Now for the stick. A man called Mark emailed me the following: “Unearned income is derived from savings that have been made out of already taxed income. There is a limit to how many times tax can be applied to the same asset.” Mark concluded that favourable tax treatment of dividends and savings interest is, therefore, fair. His argument is faulty.

First, the savings or investments themselves are not being taxed. It is the interest or dividends they earn which are taxed. There is no double taxation of the same money.

Second, even if they were, double taxation is common in the tax system. When a basic rate taxpayer earns an extra £250 gross they pay £50 tax and £30 NI, leaving them with £170 net. If they then use that to buy a suit priced at £170, they are paying £141.67 to the shop and £28.33 VAT: tax taken from already taxed income. Finally, the money saved in a deposit account or invested in shares is not necessarily from earned or taxed income. It could be a windfall gain on the value of a home. It could come from an inheritance or untaxed capital gains. These are just as likely sources of wealth than saving up the taxed income from working.

Investment income used to be taxed more heavily than earnings because it was unearned. In 1972, Edward Heath’s government introduced a 15 per cent surcharge on investment income above £2,000. Add that to regular income tax between 30 per cent (up to £5,000 a year) and 75 per cent (over £20,000) to get a top tax rate on unearned income of 90 per cent. Two years later Denis Healey raised it to 98 per cent. In 1984, Nigel Lawson scrapped the investment income surcharge. Today, money earned by working is taxed more heavily than any other source of income. The conclusion? We value working and earning a living less than we value making money from wealth.

Paul Lewis is a freelance journalist and presenter of BBC Radio 4’s ‘Money Box’ programmeYou can follow him on Twitter @paullewismoney