(Those who tune into this blog for tips on systematic trading will want to look away now. Don't worry, they'll be back soon when I get this off my chest)
Over the last few days there has been a proposal to reduce the maximum payable tuition fee (for undergraduate education) from £9,000 to £6,000. This will be paid for by removing higher rate tax relief from personal pensions. I think the second idea is stupid because it doesn't go far enough, and the first idea is just plain stupid. What's more they are stupid ideas about two things that have stupid names that twist their actual meaning and make it hard to have a reasonable debate.
I have no particular axe to grind with the Labor party, and I'm equally frustrated by some of the one sided criticism of the proposal from the right wing press. In the interests of balance I am not impressed by the hysterical reaction to a series of potentially good ideas from Ed Milliband and other left leaning parties: mansion taxes (a wealth tax on houses worth more than say £2 million), other wealth taxes and a citizens income.
The tax and benefit system in this country is complicated. Most well intentioned attempts to do good will end up making it more complicated, when the better solution would be a complete reform. Most importantly language, and specifically, names matter a lot. But we shouldn't let language cloud the issue. That is what politicians want.
(That's why there is a big fuss over a 'bedroom tax' which isn't of course a tax. But that is another story.)
The badly named graduate tax
Why do names matter? If the proposal was rewritten as "Labor plans to reduce graduate tax on high earners" it would have been much less popular with the parties supporters. But economically that is exactly what is happening. Tuition fees aren't paid when you go to university, but are part of a student loan. This loan isn't repaid until you're earning £21,000 or more. The more you earn, the more you pay back. Because the interest rate is below commercial levels the faster you earn more, the higher the economic value of what you're paying
So this is effectively a tax, and like all good taxes its progressive; the rich pay more. Weirdly though it's a tax that's only levied on graduates. Arguably that is because they have received a service and they should pay for it. The argument goes that the plumber shouldn't have to subsidise the children of the middle classes. Although this seems a rather old fashioned argument when 45% of 18 year olds are going on to higher education. The plumber will probably be subsidising their own children as well.
But we don't take that attitude with other forms of education. Nobody I know seems to have a problem with single people paying tax so that the plumbers children can go to primary and secondary school. In economics terms education generates an externality; the overall good for society is far greater than the cost.
What would I do? I'd probably abolish tuition fees, or as they should be accurately named, the graduate tax. I personally think its right that society as a whole should fund higher education. Although to be precise it won't be society as a whole; just the better off paying for it - 10% of taxpayers, or about 5% of the population, pay 55% of income tax. A plumber on £60K will contribute as much as a second year investment banker on the same salary; and why not?
Disclosure: I paid £3,000 up front (no student loan) a year to fund my own education. I have several children who could benefit from this proposal around a decade from now.
Tax relief on pensions
The pension system in the UK is one of the most complicated things I have ever had the misfortune to come across, although it is fortunately getting a little simpler this year.
The basic idea is that you put pre-tax income into your pension, so effectively paying zero tax on your contributions. The money is then taxed on the way back out of the tax shelter. Another stupid name then; there is no tax relief, just tax deferral.
Those who will benefit most are those who pay higher rates of tax when earning, and lower rates when retired. So those who are on well above average incomes benefit the most.
(This doesn't include the mega rich; with a 10 million pound pension paying out about 300K a year you'll be paying the highest rate of tax at both ends. This is one reason why the very rich don't put much money into pensions; they like their legal tax avoidance to be a bit more exotic.)
Because this doesn't seem fair, a great deal of complexity has been layered on to the product. For starters there is a limit on how much you can contribute each year. There's also a limit on the total size of the pension; the so called 'lifetime allowance'.
Part of the reason for the mess is that politicians, and the civil servants who serve them, aren't exactly familiar with personal pensions. Personal pensions are defined contribution (DC). You put in some money, your employer puts in a bit, hopefully it earns returns (though you won't be this lucky), and what you get back is down to the whims of the market.
Politicians like most public sector workers get defined benefit (DB) pensions. They contribute a bit. Their employers contribute a bit, although often a lot more. For example in the teachers pension scheme starting teachers pay 7% into their pensions; and their employer puts in 14%. This compares to a minimum private sector employer contribution of 3% in the workplace pension scheme (after 2018. Before then it's 1 or 2%).
Their benefits are then based on a proportion of their final salaries, depending on how long they've been in service. Usually if you do a full working life in these schemes you get half your final salary.
Because of low inflation the market value of these schemes is very high. Most people with these schemes don't realise how valuable they are. If a just retired 60 year old averagely paid headteacher reads about a banker with a million pound defined contribution pension fund they'd probably scoff about how disgraceful it is. This is a bit hypocritical because their own pension of £50K a year inflation protected has a market value of about £1.2 million. The dark truth of DB pensions is they transfer wealth from younger and poorer workers, to older and wealthier ones. DC pensions do the same, but the old rich person is just an older version of the young poor one, so its fairer.
I'm not sure that Labour politicians understood this, at least initially. When it was pointed out that middle managers in the public sector - their core constituency - would be affected the by scrapping of tax relief they said there would be 'exemptions' (although the grounds for those exemptions wasn't clear). A great example of making things more complicated through good intentions.
What would I do? In an ideal world I'd completely scrap pensions. We already have a very simple and effective saving vehicle known as an ISA, which has an annual allowance, but doesn't get tax relief at the point of funding. Most of the rules which separate pensions from ISA's, which are mainly there for paternalistic reasons to stop you blowing your retirement in one go, are going anyway. I'd increase the annual ISA allowance to say £50K a year, soaking up the pension contribution limit. These larger ISA's would still benefit the rich more than the poor, but the benefit would be considerably less than that of higher rate tax "relief" (I can show you the maths if you want to know why).
Contribution limits make more sense than lifetime allowances, which penalise those who manage to get their investments to grow more. A tax on people who are clever (or to be honest just plain lucky) doesn't seem fair.
However this doesn't solve the conundrum of defined benefit schemes. I don't have a problem with the existence of such schemes; though it would be nice if their value was properly recognised since they help close the gap between well paid private sector workers and their downtrodden fellow citizens in the private sector. In 2013, average hourly earnings in the public sector were £16.28 an hour, compared to the average £14.16 among private employees, so yes I'm being sarcastic.
(The perception of the pay gap comes from comparing the top earners in each profession. That of course is that the media focuses our attention on. Nobody in the public sector earns more than a million quid a year, whereas about 10,000 people in the private sector do. In fact public sector workers earn more than private sector right up to the top 10% of the income distribution. Only in the top 10% is there a benefit in being in the private sector - £57K a year rather than £49K. If we add on the differential in employer pension contributions then even this gap almost vanishes. Its probably only in the top 5% that you earn more in the private sector.)
So what to do?
- I'd reduce public sector DB employer contributions down to average private sector levels of 3%
- increase employee contributions to get back to the same level of overall funding
- scrap all tax relief at source on these pension, to make them like ISA's
- and increase gross salaries to compensate.
Economically this amounts to the same thing, but seeing 40% of their salary leaving their payslip at source should have a sobering effect on public sector workers and help them understand where their pensions come from; as well as making it clear that public sector workers are not underpaid on the whole; at least not in middle management.
Rather than final salary, I'd make the schemes pay a set amount depending on the accumulated size of the fund at retirement; the 'fund size' rolling up and the scheme payout set at levels that would be slowly readjusted as acturial circumstances changed (the changes wouldn't affect existing employees). This would give employees the certainty of a DB scheme, without the unfairness where schemes reward the most highly paid and longest serving employees the most.
It would also make the annual limit on contribution a meaningful brake on the size of the fund, removing the need for a lifetime allowance.
Disclosure: I have contributed to a DC pension in the past, and gained higher rate 'tax relief'. I don't currently contribute, or plan to. The current lifetime allowance doesn't affect me, and probably won't unless my investments grow much faster than I'm hoping for.
Citizens income, income taxes and benefits
The complexity of pensions is only a small part of the overall mess of the tax and benefit system. Nearly all of this is as a result of successive governments trying to target specific groups of swing voters or those felt to be good political targets. To name just a few parts that are particularly stupid:
- the very high effective marginal tax paid by people on unemployment benefit who then start working
- the withdrawal of the tax allowance when you earn more than £100K (why not just have another marginal tax band?)
- not paying child benefits if one person in a household is a higher rate tax payer (even if their total income is less than another household where both earn just less than the threshold)
- lower rates of tax on dividends and capital gains income
- higher tax allowances for retired people. Why is this fair? It isn't, but the grey vote is too powerful. Language again - a proposal to withdraw this was described as a tax on the elderly; when in fact while it exists its actually an "anti-tax" or benefit if you like.
- the winter fuel allowance for pensioners. Why not just increase the total state pension by the same amount and pay it all year?
A really big mess is the false dichotomy created by the Victorian era language we use around large parts of the tax system. National insurance was called that for a reason. It is supposed to make people who didn't want to receive 'handouts', feel better. But we've moved way beyond that. Most people have no compunction about receiving benefits, whatever they are called.
National insurance is just a way of making the tax system more complicated. Unlike other insurance companies there is no big fund - its a so called pay as you go system. Typical gripe by old person "Oh but we've paid in, so we should get back what we are entitled to.". Nonsense. The amount of state pension you get is much larger than you would have got in the private sector for an equivalent NI payment. Even the weak historic link between what you pay in and what benefits you receive has almost been completely broken.
Working 'tax credits' are a more modern abuse of language. They are a benefit plain and simple, they don't reduce the amount of tax you pay, but for some reasons we don't want to call it a benefit.
Tinkering around the edges doesn't work and will probably make things worse. One radical simplifying proposal I really like is from the Green party, although its not original to them, for a citizens income. Everyone in the country gets an income. There might need to be three rates, for children, adults and those with a disability (with perhaps graduated levels for more serious conditions). This would need to be set at a level so that nobody loses out in the move from the current system. By the way this requirement makes it hard to make these simplifying proposals revenue neutral. So you need to fund them in other ways (see inheritance and wealth tax below).
You then pay tax on any income earned, regardless of the type of income. No lower rates on capital gains or dividends that mainly benefit owners of private equity businesses; and make filling in tax returns for ordinary hard working private investors a nightmare. If you are consistently earning enough you could opt to waive your citizens income in return for an equivalent tax allowance (this wouldn't be of any financial benefit, but saves you and the government some paperwork and two money transfers a month).
There would be no tax allowances or any other benefits. No state pension, job seekers allowance, "tax credits" of any sort. No means testing. It would sweep away all of the messes above, and many more, and release tens of thousands of civil servants who are needed to run the system to do more interesting and socially productive jobs, as well as saving a whole rainforest full of paper.
Notice the language again. "Citizens income" recognises that in a modern fair society everyone is entitled to a minimum standard of living, and that is something the state should pay for. It achieves the same end economically as the complicated morass of things that are supposed to be insurance but aren't really, are supposed to be funded pensions but certainly aren't, and targeted 'benefits'. Unlike them this proposal is much simpler and doesn't obfuscate the language
A proposal I am less keen on is the 'flat tax' (which used to be UKIP policy, but isn't now). I'd keep progressive taxes (higher rates on higher incomes). Firstly because they are fairer, and secondly for pragmatic reasons the flat tax would need to be relatively high (about 35%) to make the proposal revenue neutral, as most tax is paid by the richest tenth and you'd need to hit the middle classes by much more to compensate.
Disclosure: The citizens income wouldn't affect me but higher taxes on capital gains and dividends would be bad for me; whilst freeing up some of my time currently wasted doing my tax return.
Wealth and mansion taxes
As you've probably realised I can't easily be classified as a communist or a raving capitalist lunatic. What may swing your opinion once and for all is that I am a fan of wealth taxes. Not just a specific mansion tax, but a Thomas Piketty style tax on all forms of wealth.
A level of two million pounds seem about right (and should catch enough of the current UK cabinet to be deeply satisfying). At this level you have enough that with a reasonably diversified and quite safe investment portfolio would give you an income of two to three times the UK household average. Bluntly, you have more than enough money and it seems reasonable that you contribute more to society. A rate of 3% annually on all wealth above 2 million quid doesn't seem exactly onerous, and would help pay the cost of the simplifications I've outlined above.
I will now answer all the usual criticisms. Won't this stifle entrepreneurial innovation? I doubt it. I think there are two kinds of people. Lazy people like me who would stop working if they won the lottery or earned enough money to retire early. And others who continue working hard even once they are multi millionaires, not because they need yet more money but because they are driven by other motivations. Paying a little bit more tax isn't going to stop them.
Also the tweak I would suggest is that if you already paid more than 3% tax on income derived from your wealth (dividends, capital gains) wouldn't have to pay any more. The tax is designed to hit rentiers who deliberately minimise the income from their wealth, or who own large unproductive houses in a country that is desperately short of housing, not those who invest in risky assets like start up firms.
What about all the people in London? The tax is on net wealth, so unlike a mansion tax someone with a massive but heavily mortgaged house and no other wealth won't pay anything at all - they aren't rich, just stupid. Note this is why the tax has to be on all forms of wealth; or you could just avoid a net equity housing tax by keeping your mortgage nice and high.
What about elderly people living in London with low incomes but who have mult-million pound houses owned outright 'through no fault of their own' as many people like to say.
(I love this phrase - yes I am very rich, but its through no fault of my own, so why should I be taxed? Brilliant. Yes only those who have worked hard for their money or created businesses and given jobs to people should pay tax on it.)
Solution: Anyone who owned an asset that couldn't be easily moved from the UK would be allowed to borrow money from the government secured on the asset to defer the tax until death, with an interest rate of say inflation + 1% charged on the roll up. Note that this loan including interest will count against your wealth, so you'd never be in a situation where there was no net wealth left on your death.
Isn't it easy for people to avoid it? It's true that no wealth tax will ever work properly unless its adopted globally at the same rate. Fortunately moving money offshore is getting harder. Even if you're not worried about someone leaking your Swiss bank account details to HMRC, you'll be hit by the negative interest rates. Even if the globally mobile super rich pay 3% only on their UK assets above two million quid, that is still a tidy sum (say £1.3 million a year on a modest london home).
Disclosure: I wouldn't pay the wealth tax under as it is described above.
Inheritance tax
It makes sense to finish with the final tax we will all pay. The hysteria about inheritance tax is so great that I believe no party is proposing increasing it, even though it should be a fairly soft target. This is daft. You're dead, why do you need the money? Let your kids survive on their own. Give it all to charity if you don't want the government to get it.
But older people don't seem to like this tax, and as they vote in large numbers changing it is politically toxic, hence the media's favorite name "the death tax". If you like your kids so much give them the money now. Live for seven years and its tax free. Plus you don't have to worry about your offspring putting arsenic in your tea to speed up the process.
Disclosure: Under my current will my children get the lot, and will have to pay inheritance tax. But we're planning to spend it first. Sorry kids.
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