Britain’s outdated tax system needs to shift from earnings to capital

November 8, 2024HubMP2012

By Stewart Lansley

Reaction to Rachel Reeves’s long awaited budget has been mixed.  The boost to public spending is to be welcomed, but there were also some big gaps. One of them was the missed chance to begin tackling one of the most fundamental flaws of the tax system: its bias to taxes on income from work rather than from assets (on dividends, capital gains and inheritance). Such a shift could not happen at speed, but the first budget of a new government faced with multiple economic and social crises was a perfect opportunity to signal intent.

While income is taxed at an average of around 33%, wealth is taxed at less than 4%. Yet despite its dismal economic performance since the millennium, Britain is increasingly asset-rich.  As chart 1 shows, private wealth holdings are worth close to seven times the size of the economy, up from three times in the 1970s. Moreover, most of this great surge in wealth has been captured by the already rich.  It also has little to do with a leap forward in wealth creation that would have served the common good. Most of it has been unearned, the product of endemic corporate wealth extraction, the rolling sale of former public assets, and state-induced asset inflation.

Chart 1: Wealth as a ratio of GDP, UK

Strengthening economic performance and social resilience requires a phased and modest shift in tax from income to capital. High levels of tax on earnings distort choices about work and enterprise and weaken the state’s ability to generate sufficient tax revenues.  Through political inertia, the tax system has failed to catch up with the growing importance of wealth over income in the way the economy operates, and does little to dent the growing concentration of wealth holdings at the top. The Gini coefficient for wealth – a summary measure of the inequality gap – is much higher for wealth than income.

While wealth offers security to households, those who need it most are the least likely to be able to fall back on private assets. Indeed, the share of all wealth held by the poorest half of the population has never exceeded a tenth, and has actually fallen since the 1970s. Even a modest shift towards capital taxation would help to build a more progressive overall tax system.

The fall-out from the low taxation on wealth is well illustrated by the role of inheritance. An accident of birth, this remains the dominant source of both aggregate wealth holdings, and a household’s rank in wealth levels across society. Its significance has also risen sharply in recent decades. Those born in the 1980s are likely to receive more than twice the sum relative to their income compared with those born twenty years earlier. Inheritance is the key source of the reproduction of the privileges of the past and plays a big role in Britain’s persistent failure to tackle the great and growing gap in life chances. Moreover, the scale of the transfer from the so-called ‘baby boomer’ generation to the young is set to dwarf all previous wealth transfers, and drive even higher levels of wealth inequality. 

Asset holdings are often little more than passive resources, while big inter-generational wealth transfers can play a counter-productive role in the economy, even more so when they are lightly taxed. Around 36% of all wealth is stored in property and mostly only realised when passed on through inheritance and gifts, where its benefits are enjoyed by the already privileged, and often spent on property. Little of this process contributes to more productive activity, with one of its primary and malign effects to fuel higher house prices.

These fault lines have long been recognised.  “A power to dispose of estates forever is manifestly absurd,” declared the patron saint of economics, Adam Smith, 250 years ago.“The earth and the fulness of it belongs to every generation, and the preceding one can have no right to bind it up from posterity.” 

Smith’s wisdom was often quoted by Thomas Jefferson, the third President of the United States and the primary author of the founding  Declaration of Independence  in 1776.    Progressive taxation –with those with the broadest shoulders paying more proportionately – is a fundamental principle of tax fairness endorsed by a succession of tax commissions in a variety of countries. Achieving this requires wealth to play a bigger role in financing wider social needs.

Only 3.7% of deaths in the UK result in an inheritance tax charge. This compares with 10% in Germany, and 9.3% in Japan. Chart 2, shows that capital taxes, including in inheritance, make a tiny contribution to the public purse.

Chart 2: Sources of tax revenue, UK, 2023/24 (percentage of all tax revenue)

Note: Capital taxes include stamp duty, inheritance and capital gains tax

A modest and phased shift to capital taxation would help to reduce the illiquid and passive role played by wealth holdings. Even modest rates would release resources for social reconstruction that would otherwise play a negative economic role.  An important effect of higher taxes on top layers of wealth, for example, would be to weaken the volume of what the Italian-born radical journalist and future British MP, Leo Chiozza Money,  called “wanton extravagance”, extreme levels of luxury spending on “non-productive occupations and trades of luxury, with a marked effect upon national productive powers.” One of the most damaging effects of lowly taxed wealth concentration is the way resources are steered away from meeting high social value basic needs to feed the often low social value demands of the rich. Hence the rising social crises facing affluent countries.

Reeves did take some steps to raise the revenue from both inheritance and capital gains tax, but these were too modest to alter the overwhelming dominance of tax on earnings.

An effective strategy for reconstruction, to meet the growing needs of an ageing population and strengthen fiscal resilience, needs to harness, through taxation, a little more of the country’s ill-used and immense private wealth base. 

Stewart Lansley is a visiting fellow at the University of Bristol, a Council member of the Progressive Economy Forum, and the author of The Richer , The Poorer,  How Britain Enriched the Few and Failed the Poor, a 200 year history.

An earlier pre-budget version of this article appeared on the Fairness Foundation’s blog.