“Low rates of capital gains tax on business income lead to large tax savings but do not boost investment”
By Helen Miller and Kate Smith, courtesy of IFS
People who work for their own businesses are taxed at lower rates than employees. One of the most prominent examples of this is Entrepreneurs’ Relief – a reduced, 10%, rate of capital gains tax available to, effectively, all business owners. This is part of a broader regime that taxes most self-employment income, dividends and capital gains at lower rates than wage income and that is commonly defended as a means to promote investment and entrepreneurship.
Our new research shows that company owner-managers respond to changes in income taxes by adjusting how and when they take money out of their company and not by changing the amount of income they create or how much investment they do. Many company owner-managers hold significant sums of cash in their companies in order to access lower capital gains tax rates and thereby substantial tax savings. Business incomes, and therefore the benefits of lower taxes on such income, accrue disproportionately to those at the very top of the income distribution.
Business owners avoid tax by shifting income over time
Company owner-managers – people who own and work for their own company – are very responsive to taxes. For example, HMRC tax records show that a large number of owner-managers report earning an income exactly equal to the higher rate threshold in income tax (the point where the marginal tax rate increases by 20 percentage points). We also see large reductions in taxable income following the introduction of the 50% additional rate and the withdrawal of the personal allowance above £100,000.
In principle, these responses could reflect a higher rate of tax deterring real business activity, but we find no evidence of this. Instead, the responses to thresholds and policy changes are due to owner-managers changing the timing of when dividends are taken out of the company.
Owner-managers whose income fluctuates around the higher rate threshold choose when to withdraw income in order to smooth their taxable income across tax years and thereby avoid paying the higher rate when their incomes are temporarily high. For example, someone who earns £55,000 in one year and £35,000 the following year can withdraw £45,000 each year and avoid the higher rate of income tax. This form of tax avoidance has the positive side-effect of allowing individuals with volatile incomes to smooth out fluctuations such that they are not penalized by the progressivity of the tax system, relative to someone with a less volatile but the same average income.
Retained profits are held as cash, and do not lead to higher investment
Company owner managers also enjoy significant tax savings by retaining income in their companies, often for long periods and until liquidation, in order to access Entrepreneurs’ Relief. We do not find any evidence that tax-motivated retention of profits translates into more investment in business capital; profits retained with companies are held as cash or other liquid assets.
If one of the aims of reduced capital gains tax rates on business assets is to incentivise individuals to invest more in their businesses, this evidence suggests they are not working.
Preferential rates on capital gains also come with costs. Entrepreneurs’ Relief costs the government £2.4bn a year relative to taxing gains at the full capital gains tax rate. This revenue cost would be even higher if calculated relative to taxing the income as dividends or labour income. The policy is also arguably unfair in that it favours those who are able to save their income within a company.
Lower rates of tax on business income produce large benefits that disproportionately accrue to the rich
Retention of income in companies is particularly large among higher income owner-managers. For example, of those earning approximately £150,000, half retain more than £50,000 each year, and 25% retain more than £90,000. If an individual retains £90,000 and withdraws the income as capital gains, their tax bill would be more than halved relative to taking the income as dividends taxed at the higher rate.
More broadly, business owners are disproportionately located at the top of the income distribution. 2% of owner-managers are in the top 1% of income taxpayers (those with taxable income of at least £160,000). This rises to 7% of all partners (those who co-own an unincorporated business), and over 35% of partners operating in financial services. Partners are not taxed as generously as company owner-managers, but they are taxed at lower rates than employees, most notably because their income is subject to lower National Insurance Contributions.
Although there may be good reasons to incentivise business activity (such as the existence of spillovers associated with trying new ideas, or financing constraints), tax breaks that apply to all businesses are poorly targeted and therefore costly. Lower rates of capital gains tax on business income can also limit the government’s ability to raise revenue by increasing rates of income tax: some people will be able to avoid higher rates of tax on employment income by becoming business owners and avoid higher rates of tax on dividend income by retaining profits and withdrawing income as capital gains. These options aren’t available to everyone however, with many stuck paying more tax on their employment income.
This article draws on:
Who are business owners and what are they doing?, IFS Report R158, Jonathan Cribb, Helen Miller and Thomas Pope
The characteristics and incomes of the top 1%, IFS Briefing Note BN253, Robert Joyce, Thomas Pope and Barra Roantree
Intertemporal income shifting and the taxation of owner-managed businesses, IFS Working Paper WP19/25, Helen Miller, Thomas Pope and Kate Smith
Helen Miller is Deputy Director of the IFS and head of the Tax sector. She is chair of the Royal Economic Society’s Communications Committee. Kate Smith is a senior research economist at the IFS and a PhD student at University College London.