We need to talk about Taxes

Death and taxes — the certainties of life. This statement has become so ingrained in our consciousness that we’ve stopped questioning the legitimacy and purpose of the taxes we pay. I often try to remind myself that taxes are ‘me paying the government’ to fulfil certain functions for me and provide essential services to society. Government’s main purpose is to organise society in a fair manner. In return, we surrender some of our income towards the State and subject ourselves to the Rule of Law. It’s all for the greater good.

Trouble starts when the cost involved in running this governmental organisation becomes unbearable for those carrying the burden. Even worse, Government ‘unknowingly’ creates incentives to not pay one’s fair share or to stop being productive. When this happens economic activity and production declines, and the bedrock of our Socialist Capitalist economy and Government’s expenditure increases without the opposite balancing increase in income. Hence the position most western economies find themselves in.

How do governments handle this state of affairs? They borrow from their future revenues on the assumption they will be able to recoup the losses in more prosperous times ahead, or even better, it becomes the challenge of another government. In my and your terms: open the wallet and apply the Visa; unfortunately we can’t pass on the debt. I sometimes feel creating a similar restriction on government would greatly improve the notion of ‘democracy’. It is simply a matter of making do with what you have. It would prohibit the current government from buying votes with the income of future governments. Let’s not get side-lined by democracy just yet.

From a Keynesian perspective, additional government spending in tough times is required to help the economy overcome the ‘temporary’ slowdown. This additional spending would ideally be funded from State coffers that were filled during good years. Very sensible — but in reality the additional spending is funded by borrowing or, even worse, printing money.

Governments are like rich men’s wives wielding suitable Visa cards; not a great deal of common sense is used in considering the cost or justifying the purchase of the Louis Vuitton bag. The principal reason for their feckless spending is, of course, that someone else will pick up the bill. Their reasoning might very possibly be: they need the bag and it will make them feel better. How do you argue with that? No sensibility will find traction as long as the Visa card complies by allowing the ownership of the handbag to change. We ‘all’ know it might end in tears the day the store clerk says: ‘I’m sorry, dear, there seems to be something wrong with the card.’ But until then, this eat as much as you like diet will be the preferred solution of most politicians and the public.

I know Capitalism has had a few bad days in the press lately, but it would be difficult to argue with the notion that a free market, allowing all to compete and produce, is trumped by any other form of economic model. The absolute brilliance of an individual or group engaging their intellect to find a solution to a particular problem, designing and producing an item, taking it to market and making a profit as just reward for their ingenuity, is plain to see. It’s inspirational, it’s progressive and it keeps the world from consuming itself. In our analogy above, it also ensures the Visa card is paid at the end of every month and our dear lady can continue frequenting Harvey Nichols. That is — until her husband decides otherwise.

My question is: At what point does her husband lose his drive to work those long hours or, even worse, his business falls on hard times and he can simply not afford to do so anymore? In our terms: when do ‘I’ lose my drive to be productive, or simply become unable to be productive anymore. This as a result of policies put in place by the institution that is supposed to make society more egalitarian. Not only am I not rewarded for my valuable contribution, the government taxes me to such an extent that I am considering alternatives, or even to stop producing all together. God forbid, I might even consider claiming some of those generous incentives to not be in work that are available. Today more than 50% of the population is already dependant on the government in one form or other, so for many the incentives have already been sufficient motivation.

The thing is: I am not sure at what point disillusionment sets in, but Government is masterful at hiding the various taxes we pay. They window-dress our expectations with headline rates i.e. ‘Corporation Tax 20%’ and ‘Basic Personal Rates of 20%’. All are seemingly very fair. Upon closer inspection, the reality about taxes in the UK is quite different from what we think. Taxes are layered and hidden at every level. Taxes are renamed, called Insurances, Licences or Regulatory fees. In the end, does a rose not smell as sweet if it is called by any another name? A tax is a tax. They’re included in our airfares, petrol, gas, electricity, food, drink … I could ramble on, but you get the point. Taxes are everywhere.

The best way to illustrate this is by using an example. Forgive me for the boring role-play, but I need to elaborate with some background so that you can see how and where I get my numbers from (one might even recognise this small family in London’s’ suburbs).

They are Mr and Mrs Working. Mr Hard Working is a financial consultant and owner of Honest Advisor Ltd. His annual turnover is £240,000, for which he works very hard. (I’ve deliberately used a Financial Services Intermediary because this type of entity does not have to be VAT registered and will thus show the total taxes paid clearly.) Mr Hard Working employs two staff, both earn a salary of £30,000. Mrs Hastobe Working is an accountant in the City and earns £65,000. They have a two year old, Miss Not Working, who spends alternate days at nursery and with her nanny. Mrs Working only works a four day week, so that she can at least feel like a mother on Fridays. This benefit comes at the expense of a 20% reduction in salary.

On the face of it, this family is reasonably well off, but the numbers show otherwise. Let’s look at Hard’s business.

Like most small business proprietors he tries to be as tax efficient as possible and pays himself in salary the tax free allowance of £8,100 p.a. (2012/2013). The rest of his earnings will be paid by way of dividends from his limited company. After all operating expenses, regulatory fees and corporation tax, Honest Advisor Ltd. only makes a net profit of £51,787. In the process of generating this profit, the company has paid a total tax and pseudo tax bill of £72,064. This equates to 30.3% of the turnover and, even worse, more than 100% of the original net profit before taxes. You understood Corporation Tax was only 20%? Let’s look at the detail:

Value Added Tax on all services, consumables and rent            12,988
Insurance Premium Tax, on business insurances                  390
Bureaucratic Tax (FSA/FCA, FSCS, D.P.A., CCL, etc.)            13,390
Local Government Tax (Business Rates)            12,000
Income and Corporation Tax            21,704
Social Security Tax (NI paid by company and employees)            11,591
Total            72,063

All adding up to a staggering 30.3% of the turnover. In other words, the government was more profitable than the entity taking all the risk, producing goods/services while providing jobs and a contribution towards the economy. Hmmm … I smell a rodent.

Let’s have look at Mr and Mrs Working: Between them they managed to earn a total of £125,982 before paying the Exchequer.

Total taxes paid by them were £51,119 which was made up by:

Value Added Tax on all consumables, services              6,792
Insurance Premium Tax                  151
Customs and Excise, on wine, petrol and airfares              2,350
Local Government Tax, Council Tax              2,880
Personal Income Tax            29,810
Social Security Tax (NI, employees paid by Hastobe and the nanny)              9,136
Total            51,119

This number equates to 40.58% of their income. It’s a long way from the token basic rate of 20%. If you consider that only 25% of their income fell in the higher tax bracket of 40%, how on earth did it manage to move above the 40% mark? What’s more concerning is that at the end of the year, allowing for very reasonable expenditure and childcare fees, they didn’t manage to stay out of overdraft. This after carefully watching their spending. Multiply this annual enactment by ten and one can easily see how an astute family like this can find itself in a position of depressing debt a few years down the line.

What else did the government manage to squeeze out of this economic group? The two employees of Honest Advisor Ltd. paid additional taxes totalling £6,278

This means that the total calculable taxes the government reaped from this economic group added up to a staggering £129,461. That does not allow for taxes paid by the clients of Honest Adviser Ltd., as most of the income generated by Honest was from income after tax paid by its clients. One can safely assume that the total tax harvest was way more than £129,461.

If you consider how common this type of economic factory is in the UK, and the amount of income tax generated by them, the government could still not manage to balance its books. Even more incredible is that economic groups like these are at all able to bear this disproportionate burden placed upon them. Maybe it’s because they don’t realise the real numbers involved.

If we look at the three tiers in our role-play: the company paid the most taxes and moreover created the most economic activity. It is the heartbeat of this small group. It supports three families and several suppliers that deliver services and goods to it, pays rent to a landlord and taxes towards the local government and the community. Considering its contribution and importance, government is in no way making life easy for it. It imposes National Insurance taxes (NI) on it which are payable even before the company has made one penny of profit. The government competes with it for its workforce by paying unproductive public sector workers unrelated market rates. It regulates it to death, all in an attempt to create a ‘fairer’ society. Government institutions like the FSA/FCA are bureaucratic Ponzi schemes and self-feeding monsters. They only ever expand and consume ever more of the precious resources generated by the producers, rarely never succeeding in the task they were created for. One would be challenged to find one genuine thing that can be put forward to show an attempt from government to improve the plight of this business.

In the second tier the family buckles under the weight of the super expensive childcare. They are simply paying for the privilege to work. Childcare equates to a total of £16,000 p.a. of after-tax income; 21% of their disposable income. Furthermore, they have to pay additional NI and Personal Income Tax on behalf of their nanny. They receive a small Child Tax Credit and Child Care Vouchers allowance through salary sacrifice from the government to help with the expense, but most of this will be lost in 2013 because they are deemed to be higher earners. Even so, this government contribution in no way compensates for the disproportionate cost. At least the nursery fees are VAT free.

Will this tax burden change Hard’s behaviour? Like most entrepreneurs he is resourceful and knows how to allocate capital efficiently. Unfortunately, most of the alternatives he is considering will be harming the UK economy. Using new technologies like voice over Internet phones, he could, with little effort, offshore one or both of his staff to cheaper countries like South Africa. Once he’s been successful with this strategy, it would be difficult to persuade him to appoint more staff in the UK. South Africa and other countries have no National Insurance contributions to pay, flexible well trained workforce, cheap infrastructure, etc. The upside is, he will show a higher net profit and so he will pay more Corporation Tax. This will not, of course, compensate for the ex-employees who now find themselves on Jobseekers and other allowances, never mind the other economic losses. Fewer staff means the need for smaller offices and so on. You can just see the cascading effect of the one decision leading to contracting economic activity through a range of following disciplines. The law of unintended consequences or, in this case, unwanted consequences.

Hastobe is considering leaving work and spending more time with her daughter. For the family, financially it will not make a big difference and at least she will value the time they spend together. This means the nursery loses business, the nanny is unemployed and Hastobe is contributing considerably less toward the government’s overdraft; don’t even mention the further loss in economic activity.

It is thus clear that taxes do change behaviour drastically and most definitely harm economic activity.

Governments rarely create efficiently, they mostly spend and consume, which is the ‘true’ tax on society! What it spends, it derives from taxing the productive. This act removes resources from entrepreneurial entities and leaves less to invest in next year’s harvest.

If this government is to make a meaningful difference to the prospects of small business and the future of the UK economy, it will have to lessen the burden placed upon small businesses, encourage them to take risks and allow for just reward when successful. There will always be inequality in society. The haves and the have nots. The purpose of government is not to take from one and give to the other, but rather to create an environment where everyone can reach their full potential and be rewarded for it. Increasing wasteful government spending is not the answer. Real assistance for small business and productivity is. ‘A government for those who want to work hard and get on in life!’ — David Cameron.

Do I think anything will change? No. Why do I say this? Because the day the voting public realised they could vote themselves free benefits, it was the beginning of the end. Politicians are under huge pressure to alleviate the ‘inequalities’ in society. This means they do not have the political power to do the right thing and even when they do, they will not be rewarded for their righteous acts as no one will know of the disaster averted.

Rene Lans